(FORTUNE Magazine) – WHAT DO YOU DO when your business starts catching flak? ''I used to be a pilot,'' says Renso Caporali, CEO of Grumman, which delivered its last F-14 seven months ago -- and currently has no orders for any new fighters or bombers. ''When you have an emergency, the first thing you do is keep flying the plane. You can't get so engrossed in the engine failure that you crash.'' Few businesses have seen their engines fail so dramatically as the U.S. defense industry. Since 1985, its major customer -- the Pentagon -- has seen its procurement spending authority fall in real terms from $127 billion to $54 billion (see chart). Now President Clinton promises to cut even deeper. To stay aloft, major defense contractors like Grumman have been frantically laying off workers, cutting capital expenditures, paring debt, and boosting foreign sales. ) The surprising result: Industry balance sheets have never been stronger. ''Everyone talks about the bad news,'' says Judith Bollinger, vice president of investment research at Goldman Sachs. ''But defense companies are all generating phenomenal excess cash. The next five years will be incredible for cash flow.'' Reacting to that welcome news, the share prices of some of the most actively traded defense stocks easily outpaced the 4.5% growth turned in by Standard & Poor's 500 in 1992. General Dynamics led the way with a 93% gain, followed by Lockheed (26%), Raytheon (23%), and Martin Marietta (17%). Still, despite their heroic efforts, many defense companies -- possibly one or two of the largest -- will fall to earth in the next few years. Since 1985, 259 defense contractors have sold out to stronger or better-positioned rivals, according to JSA International, a consulting firm in Cambridge, Massachusetts. Analysts at Booz Allen & Hamilton estimate that 75% to 80% of the top 100 defense companies or divisions that remain could be gone by 2000. That's likely to leave the U.S. with just three to four producers of military aircraft, down from seven today, and just one supplier of submarines, down from two. The future is bleakest for specialists in strategic weapons, such as Northrop, maker of the B-2 bomber. It's brightest for Rockwell, Martin Marietta, Hughes, Loral, and others that supply precision munitions and electronic, avionic, and communications gear that can keep older planes, ships, subs, and tanks up to date. (For more on the outlook for companies, see table.)

Will this dramatic shrinkage weaken America's ability to defend itself? It shouldn't, say the defense CEOs, provided they get sound guidance about future military strategies. Says Kent Kresa, Northrop's chairman and CEO: ''Once we know what that new vision is, we'll design and build the proper force structure for the contingencies identified. We know we have to rationalize our industry, and we'll do it.'' Beyond that consensus, industry leaders differ widely on how best to profit from the coming builddown. Here are four major strategies that are reshaping America's defense business.

-- Shrink and share the returns with shareholders. Among major defense companies, this approach so far has just one disciple -- William Anders, chief executive of General Dynamics. Since assuming command of the nation's second- largest defense contractor (after McDonnell Douglas) in 1991, this former NASA test pilot and Apollo 8 astronaut has sold off nearly $3 billion worth of businesses, including the company's crown jewel, its tactical aircraft division in Fort Worth. He has also repurchased more than $1 billion of General Dynamics' stock. Result: Since he took charge, the company's share price has soared from $25 to more than $110. Like most defense CEOs, Anders is a devout believer in the Gospel of Critical Mass. ''Rationalization involves both downsizing and consolidation,'' he says. ''Just downsize, and you all shrink to inefficient little midgets. You've got to get the chimpanzees together to fight in their particular shrinking jungle.'' What makes Anders unique among his brethren is his willingness to sell as well as buy. ''I'm not happy about selling,'' he says. ''I'd like to see the industry consolidate around General Dynamics. But if it won't I'm not going to go down to the garden and eat worms. The people who move first are going to be the winners.'' Consolidation helps two ways. First, it saves money on overhead. Case in point: the F-22 advanced tactical fighter, the Air Force's next generation. A few months ago the F-22 was in danger of being canceled due to soaring costs. As the demand dropped for other weapons programs at General Dynamics, Lockheed, and Boeing -- the fighter's joint developers -- the overhead they charged to the project rose. By selling its fighter division, including its share of the F-22 program, to Lockheed, General Dynamics reduced the F-22's cost by saddling it with one less bill for corporate overhead. Second, consolidation helps companies finance defense-related research and development. In recent years many of them have been throttling back. According to a recent report by Salomon Brothers, from 1986 to 1991 Northrop trimmed R&D spending from 6.7% to 1.8% of sales. At General Dynamics the comparable decline was from 3.5% to 2.6%. Washington could help by making research more rewarding. Contractors now earn about 90% of their profits from production. ''If the government wants us to become R&D houses,'' says Bernard Schwartz, chairman and CEO of defense electronics manufacturer Loral, ''then we've got to be paid for that.'' Even with that change, however, only the very biggest companies will likely find the expense of developing tomorrow's major new weapons systems worth the risk. Bill Anders may be the first big defense company CEO to exit a core business. He won't be the last.

-- Bulk up by acquiring a larger stake in key defense businesses. This is the buy side of the Gospel of Critical Mass. If you want to thrive in a shrinking market, get bigger. Fast. Since 1987, Loral has spent $1.8 billion to buy six high-tech military electronics businesses, including Ford Aerospace and LTV's missile division. In November, Martin Marietta acquired GE's aerospace businesses, which generated $6 billion of sales last year, for just 50 cents on the revenue dollar. As part of that transaction, Martin Marietta gets to use GE's corporate R&D center, while GE gets $1 billion in Martin Marietta convertible preferred stock. Why would anyone want to expand their military business? ''I believe defense will come back,'' says Norman Augustine, Martin Marietta's chairman and CEO. ''I read history books. Human nature has not changed in 1992.'' Even if defense budgets don't rebound, the efficiencies gained by eliminating overcapacity can make a slow-growth business profitable. GM Hughes Electronics, based in Los Angeles and owned by General Motors, is consolidating its sole missile plant with the four it acquired last year from General Dynamics for $450 million. Says Hughes Chairman Michael Armstrong, a former top IBM executive: ''Our missile business wasn't viable long term without consolidation. We didn't have enough platforms over which to spread R& D expense, or enough volume to be the low-cost producer. We preserved the business by doing this.'' Dealmaking is briskest these days among smaller electronics and avionics companies, whose components are critical to the Pentagon's current strategy of modernizing old weapons rather than replacing them. Says Chet Krentzman, a director and part owner of Signal Technology, a major supplier of microwave and radio frequency components and subsystems to Raytheon, Loral, Hughes, and others: ''If it's a live product, it won't die. It will be acquired by somebody else.'' Maybe by Krentzman himself. In the past three years Signal has grown from $40 million to $90 million in sales -- and brought together a cadre of top-notch technologists -- by buying unwanted divisions and subsidiaries from larger companies in California, Florida, Arizona, and Massachusetts.

-- Convert to flexible production lines. Most laymen, when they hear the word ''conversion'' in a discussion of defense policy, think it refers to transforming a tank plant into a tractor factory. That may be what some politicians have in mind as well, but it's not what industry executives mean. Says Daniel Pinick, president of Boeing's defense division: ''Conversion won't be to new products. It will be conversion from rigid, hard-tool production lines to soft-tool, flexible machines and agile teams that can build more than one thing without facility changes.'' Translation: While most defense contractors today are set up to make money from long production runs, the future lies in limited production of customized items. Gone are the days when the Pentagon will buy 8,000 tanks and more than 2,000 F-16s from General Dynamics, or more than 1,000 F-15s from McDonnell Douglas. Instead, if Defense Secretary Les Aspin gets his way, military procurement will increasingly be of the ''silver bullet'' variety. The military will buy super-high-tech weapons in limited quantities and save them, like Chanel No. 5, for special occasions. One likely candidate for this treatment is the advanced tactical fighter. The Air Force has already cut its order from 1,000 to 700; by 1997, when a final decision must be made, the number could drop to as low as 50. As a result, says Pinick: ''Industry has to get good at doing limited production at a reasonable cost.'' That can be done. Lockheed produced just 59 F-117 stealth fighters over nine years, at an average cost of only $42.6 million each. (By contrast, the cost of Northrop's B-2 bomber ballooned to $2.2 billion per plane, mainly because orders were cut back from 132 to 20.) The secret, says Lockheed CEO Daniel Tellep, is getting realistic instructions from the government to avoid setting up for 100 orders and receiving only ten. His wry advice, rendered in classic Pentagon-speak: ''You ought to err on the side of underfacilitizatio n.'' Better manufacturing processes are critical to increased flexibility. Says Victor Reis, director of research and engineering at the Defense Department: ''In the past, contractors did little R&D on process technology. That's going to change.'' Texas Instruments is leading the way. With backing from the Defense Advanced Research Projects Agency (Darpa) and the Air Force, the company is trying to develop equipment, processes, and software that will allow U.S. chipmakers to make small numbers of customized semiconductors for the military quickly and cheaply. Explains Texas Instruments research manager Robert Doering, who is running the experiment: ''Today's factories have lots of expensive equipment oriented toward large-volume, batch manufacturing -- turning out as many as 30,000 silicon wafers a month. What we're not efficient at is making small volumes of specialized products for the government -- for example, 100 chips for airplane night vision.'' Most commercial chips can be customized by slightly altering their circuit design. Creating a radiation-hardened military chip demands a completely different process. That makes shifting from one type of production to another cumbersome -- and potentially perilous. Says Doering: ''Once you turn the knobs to run a different recipe, all kinds of things can go wrong.'' Texas Instruments' goal is to make that changeover easier and virtually mistake-free. Early results from a demonstration project that began operating in January are encouraging. If it can be perfected, this technique, known as 100% single wafer processing, should make it possible to produce commercial and military chips on the same production line. If these kinds of breakthroughs can be achieved, the main barrier keeping highly skilled civilian suppliers out of military businesses will be regulatory, not technical. The Pentagon's accounting requirements are onerous. As R. James Woolsey, the man Bill Clinton has picked to head the CIA, told FORTUNE a few weeks before his appointment, ''If the Securities and Exchange Commission tried to get financial reports the way the Pentagon does its cost accounting -- by flooding plants with inspectors and auditors -- the SEC would need three or four armored divisions.'' In the new age of lean defense, that has to change.

-- Evolve into nondefense businesses. In the past, when the going got tough for defense companies, the tough got some crazy ideas -- like selling coal slurry (McDonnell Douglas), buses (Grumman), guitars (Kaman Aerospace), and coffins (Teledyne Ryan Aeronautical). ''In down cycles, and I've lived through three, the traditional solution is to diversify into things far away from defense,'' says Norm Augustine of Martin Marietta. ''That has always failed.'' He recommends, instead, gradually moving into commercial markets that take advantage of a defense contractor's core competencies. Martin Marietta, for instance, sees its comparative advantage in the areas of high technology, systems engineering, and large projects. By 1997 it hopes to have evolved into a diversified high-tech company that gets 50% of its revenues -- up from 34% today -- from nondefense businesses such as postal sorting machines, environmental robotics, and construction materials. To strengthen its hand in that last market, Martin Marietta has for the past five years been buying up rock quarries on the cheap, hoping to reap the benefits when the next road-building boom begins. Says Augustine: ''Clinton is going to be the infrastructure President, and we will be the infrastructure company.'' Many companies hoping for a slightly less rocky transition into nondefense markets are turning toward commercial aerospace work, which now accounts for more than half the overall U.S. aerospace market, up from 33% in 1987. In the first six months of 1992, sales of military aircraft to the U.S. government fell by 17%, vs. the comparable period in 1991, while civil transport sales grew by 17%. That shift helps explain why McDonnell Douglas Chairman John McDonnell, whose commercial aircraft division has barely made money the past few years, still likes that business better than his bread-winning military operations. When the world economy picks up, McDonnell thinks, the commercial airline market will take off again -- and he wants to be there to catch the updraft. The odds on his succeeding remain long, especially since his bid to sell 40% of his commercial business to Taiwan Aerospace for $2 billion fell through last year. But he is determined to keep searching for foreign partners and to hang in for as long as possible. Says McDonnell: ''The commercial aircraft business is not a market we'll lightly give up.'' Kent Kresa of Northrop, which is scheduled to deliver the last B-2 bomber in 1997, agrees the future looks increasingly civil. To increase commercial subcontracting work, he recently bought a 49% stake in Vought, a maker of civilian and military aircraft structures, from LTV for $47 million, and set up a commercial aircraft division. (Northrop already makes fuselages for the Boeing 747.) Given the enormous overcapacity this industry faces, however, it's hard to imagine all these ambitious entrants can survive. The toughest transition will be for defense companies trying to shift all the way into consumer goods and services. The trick is finding a market that has not already been saturated. Says Grumman's Renso Caporali: ''The problem with conversion is that people look at World War II, when tank plants retooled to make autos. Back then there was huge unmet consumer demand. Today there are no markets that don't already have suppliers who know them well. So we have to invent something new or evolve into something new.'' Since 1965, Hughes Aircraft has been trying to do just that. Back then Hughes sold 100% of its satellites to the government. Today 50% of that business is commercial, and Hughes has expanded into owning and operating communications networks and providing ground services and other support equipment. Says Hughes Chairman Michael Armstrong: ''We evolved over time, incrementally, into new areas that take advantage of the technologies and talent that already existed here. You don't change the culture overnight.'' Maybe not, but next December Hughes will plunk down its biggest bet yet -- an HS601 satellite capable of broadcasting 100 to 150 channels of television to 18-inch satellite dishes anywhere in the continental U.S. By 1994 the company will have invested $500 million to develop this so-called direct broadcasting service, which will compete with cable TV. To foster a keener focus on customers and markets, Armstrong recently reorganized his company, merging divisions that used to concentrate on flogging specific products into groups based on geography. ''Hughes is very good at breakthroughs, engineering stuff that's never been done before,'' he explains. ''But we lacked an orientation towards the marketplace.'' Hughes is not alone. Next to their lack of new markets, lack of marketing know-how is the biggest problem defense contractors face when they diversify. Says Mitchell Waldman, corporate sales manager for Essex Industries, a $30- million-a-year supplier of military aircraft components: ''Making the product is the easy part. Taking it to market is the hard part.'' He notes that defense companies aren't accustomed to betting heavily without a Pentagon contract in hand: ''It's a big risk, but you have to take it.'' Essex has successfully taken that plunge a number of times. To offset anticipated cuts in military spending, the company began expanding its product line ten years ago. Visit Essex's flexible manufacturing facilities in St. Louis today and you will see workers turning out stick grips for the F-15 one day, fuel system components for high-performance vehicles the next, and medical valves the day after that. Contrary to popular wisdom, this kind of dual-use capability can be developed. Says Waldman: ''The key is adaptable people and good work instructions. There is nothing magical here.'' Magical, no; imaginative, yes. Already Waldman is fantasizing about future ( products: personal smoke hoods, videogame sticks, you name it. ''What's out there?'' he wonders. ''You have to dream.'' But dreaming is not something that defense contractors traditionally spent a lot of time doing. In a world of declining military budgets, they will have to start. With one large exception -- their outsize reliance on a single, deep- pocketed customer -- America's armsmakers are basically in the same fix as America's car, steel, and mainframe computer makers. To survive in a slow- growth industry, they must downsize and right-size, get leaner and more flexible -- all the while preserving or strengthening their critical technological edge. Some will fail miserably. But if the others can do all that, while learning to anticipate market demands rather than respond to government commands, they won't merely survive the 1990s: They will thrive.

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