Raytheon, a US-based defense contractor, faced a supply crisis in 2010 regarding the procurement of magnets for its Tomahawk missiles, which contained rare earth elements (REEs). REEs include 17 elements from the periodic table, and the definition has been expanded to include tungsten and molybdenum. They are used widely in defense applications, consumer electronics, and alternative energy solutions to support proper functioning. While an estimated 47% of the world’s REEs exist in China, 97% of the world’s supply of REEs are currently mined and exported there. Due to a number of political, environmental, and economic reasons, China imposed duties, quotas, and trade restrictions on the export of REEs, causing global supply disruptions and the tripling of prices in 2010. The REE crisis highlighted the supply risks that firms face and their impact on the end-consumer, who in this case is the Department of Defense. As an aside, the WTO ruled in March 2014 that China had, in fact, breached its WTO obligations in this case. China has 60 days to appeal, and upon the WTO’s final ruling, the US, EU, and Japan may impose economic sanctions within 15 months. This paper provides and argues that Raytheon faces two options to overcome the dilemma: 1) Invest in foreign-direct investment in China 2) Lobby the US government to file a trade dispute with the WTO. We decided that option two would yield the strongest financial and long-term strategic benefits.
Raytheon: A Rare Earth Dilemma
William Swanson stared longingly out his window on a cold October night in 2010. As he as he sat in his Massachusetts home, he could not help but wonder what the future of the Raytheon Company would entail. There was a rare earth elements (REE) crisis where a key player, China, was changing its policy of how these materials would be handled and exported. Such a policy would threaten Raytheon’s Missile Defense division since REE’s are a primary component in many of the division’s products, and a cutback in the supply of REE’s would ensure disaster to the bottom line. Swanson picked up his phone and called Vernon Clark, a retired Navy Admiral currently on the board of Raytheon. They had a lot to discuss, and this was going to be a long night.
The Beginning: A History of the Raytheon Company
In 1922, two engineering students, Vennevar Bush and Laurence Marshal, teamed up with a scientist, Charles Smith, to form a small appliance company specializing in refrigeration. They called it “The American Appliance Company” (AAC), and based their headquarters in Cambridge, Massachusetts.14 Shortly after its inception, AAC veered into the field of electronics, working mainly with radio technology and components.14 In 1925, AAC was re-named “Raytheon Manufacturing Company” (RMC) and began marketing its products under the Raytheon name.14 In the next decade, the company acquired several other firms whose specialties ranged from electron tubes and switches to transformers and power equipment.14 By this time, RMC had become one of the largest radio tube manufacturers in the world, allowing all households affordable access to radios. 14
It was not until 1945 that the company bolstered its electronic capabilities into the defense field. With its newly acquired potential, RMC developed the first missile guidance system capable of intercepting moving targets, and in 1948, began manufacturing guided missiles.15 In 1959, after the acquisition of a marine electronics company, RMC changed its name to “Raytheon Company.” Raytheon is now the largest producer of guided missiles in the world17 and primarily serves as a defense contractor, with the US military as its most prominent client. Raytheon’s missile products have come under threat because they use magnets, which contain REEs, in their guidance systems. A dependency on REEs has placed the firm at considerable risk given the increasingly protectionist environment in China, who dominates world exports of these materials.
Rare Earth Elements (REEs)
The set of REEs includes 17 elements from the periodic table that are spread across the world in the Earth’s crust.18 Once refined, these materials have been pivotal in many of today’s emerging technologies such as LED screens, missiles, and alternative energy solutions.18 While only ~47% of the world’s supply of REEs are thought to reside in China, 97% of the world’s REE exports come from China because extraction and processing are labor-intensive and China has an abundant supply of cheap labor.19 The WTO dispute filed by the US extends the definition of REEs to include tungsten and molybdenum.
China’s Environmental Policy
China established several national environmental programs that contain four guiding principles. The first principle is the coordination of environmental protection and economic development. National environment protection plans must integrate into national economic development plans, and the state should adopt financial and technical measures that are environmentally beneficial. The second principle is pollution prevention. While currently there are measures to abate existing waste discharges, future releases should be prevented, primarily by using enhanced environmental management at new pollution sources. The third policy is polluter responsibility, where waste dischargers must bear the costs of cleaning up environmental problems they cause. Thus polluters pay discharge fees on waste releases that exceed discharge standard, and they should invest in waste treatment facilities. Finally, companies must strengthen their environmental management. Because reducing pollution by investing in new waste treatment facilities is expensive, the first line of attack is to cut waste releases by improving management procedures.22
Rare-Earth Industry Development Plan of 2009-2015
While Chinese policy had nominally affected the acquisition of REEs before 2008, the Rare-Earth Industry Development Plan of 2009-2015 would completely shake-up the industry. The new policy highlighted four changes to the REE export market. First, the export of REEs would be limited to 30,000 tons per annum, down from 60,000 tons just a few years ago.7 Next, China would begin to consolidate the 100+ REE separation facilities in the country down to around 20. With all of these companies under the control of the state, the Chinese government would have much greater control of REE prices moving forward. Third, China would start to ban the export of heavy REEs (dysprosium, terbium, and yttrium) which were widely used in many emerging technologies. Finally, China would begin to stockpile a percentage of annual REE refinement so that prices would stabilize if any shortages occurred in the future.11 The Chinese government was defending this plan based on its environmental conservation policies (outlined above) and did not view it as protectionist.
Raytheon has Two Options:
While Raytheon’s current dilemma may severely hinder its missile manufacturing operations, there are two possible strategic directions the company can go to combat this problem.
Choice 1: FDI in China
One option Raytheon has for the REE crisis is to establish foreign direct investment within China. Through this process, Raytheon would build a missile manufacturing plant on Chinese soil with the intention of manufacturing missiles and missile components within the country. The benefits of a Chinese FDI would be substantial for Raytheon, both logistically and financially. A manufacturing plant near REE mining sites would enable faster production of missiles and subsequently increase throughput efficiency. Since all materials would then be acquired locally, Raytheon would avoid overseas shipping costs for the raw REE’s to the US. An additional shipping benefit would be the elimination of potential export tariffs the Chinese government may impose on REEs. While the final product would still have to be shipped to Raytheon’s various clients, it could leverage the relationship between the US and China to allow for the US to pick up directly from the manufacturing plant via USAF cargo planes. While this specific option may not work for Raytheon’s other clients, it would still substantially increase efficiency, as the US government accounts for 75% of Raytheon’s total revenue.12 Additional benefits of FDI in China would stem through the deepening of relationships between Raytheon, the US, and China. A major plant in China would benefit the country economically while having a major US defense contractor located in China would enhance trust between the US and the Chinese government. However, the latter benefit may be a double-edged sword.
While the benefits of manufacturing in China are clear, the potential risks may be substantial as well. Since Raytheon is a major supplier of missiles and defense products to the US military, having FDI in China may not sit well politically with the US government. While the potential to deepen political ties between the two governments sounds feasible in theory, a future conflict between the two governments would ensure disaster for both Raytheon and the US. Raytheon is not manufacturing children’s toy; it is producing sophisticated military-grade weapons, which the US defense department relies upon heavily. From this angle, two potential calamities could result. In one scenario, the Chinese government could cease missiles manufactured for the US government. Doing so would substantially weaken US military operations and its image, while severely cut into Raytheon’s operating profits. There is also a high likelihood that the Chinese government could infiltrate and acquire Raytheon’s missile technology, potentially strengthening Chinese military power, the result of which could be detrimental to US national security.
Another major weakness of this strategy is that it would hinder Raytheon’s reputation both politically and socially. FDI in China would be grounds for attack by US policymakers. Any politician who may have supported Raytheon in the past would now want to cut ties, as it would be prime material for political opponents to use against them during mid-term elections. Defense contractors rely heavily on political relationships, as it allows them successful bids on future contracts. If political relationships on a micro level were weaned, future profits for Raytheon could be jeopardized. Investors are also aware of this, and when word gets out that Raytheon is manufacturing its missiles intended for the US military in a foreign country, investor relations may take a fall, which would almost guarantee a blow to Raytheon’s stock.
Choice 2: Lobby US Government to File Grievance with WTO
In lieu of FDI in China, Raytheon has the option to take a more flexible and macro strategy. Because of already established ties within the US political system, lobbying for a change in WTO policy concerning US involvement may be a feasible option. Specifically, Raytheon could engage key politicians and the USTR to pressure the WTO to challenge the countries adherence to key statutes. Allowing China to be a member of the WTO dramatically enhances China’s economic stance about the rest of the world, as it has allowed China to gain substantial prominence in the global economy. If enough pressure is placed on the Chinese government, hinting that its place within the WTO may be in jeopardy, China would be inclined to have a more liberal stance in regards to its REE export policy.
While the potential risk for such a policy may be significantly less than those with FDI, the minor implications for such a strategy would entail more of a nuisance than anything else. While the plan to lobby the WTO sounds pragmatic in theory, the reality of such organizations and their internal working structures can be significantly different in practice. Merely looking at the size of the WTO and the amount of regulation it has to enforce on a daily basis, asking it to babysit China may be more complicated on a day-to-day basis. While the plan, once implemented, may work during the initial stages, continuous regulation by the WTO on China’s practices may see a decline in the proximate future. Another consideration is that of bureaucracy; while contractors have successfully passed regulation via such channels in the past, the process is not as straightforward as we would like. A significant amount of red tape exists between Raytheon and the WTO in going about such a policy, and often, such agreements could take years to fall through, which does not help Raytheon in the event of a short-term economic shock. While bureaucracy may seem to hinder economic growth for all parties involved, it is necessary to some degree in situations such as these; while it may appear red tape is creating more hurdles to jump over, it is a process that ensures the system will not be abused.
Recommendation for Raytheon
Lobby the US Government to File Complaint with WTO (Yes)
We believe that Raytheon’s best strategic option is to lobby the US government to file a complaint with the WTO against China’s protectionist legislature regarding REEs. China is a relatively new member of the WTO (joining in 2001) and this initiation has paid huge dividends financially as they have further integrated with the global economy. Raytheon’s best chance to influence Chinese policy is to challenge China’s adherence to this organization directly. As one of the top defense contractors in the United States, Raytheon should have enough clout to convince the USTR that filing against China is in their best interest. The company should also try to leverage its contacts in other industries that similarly, would benefit from lessened Chinese protectionism in the REE market.
Several of the issues with this strategy include the potential lengthy duration of the process (lobby > file > decide > sanction) and questions about the WTO’s ability to enforce their rulings. The WTO has been known to take several years to make decisions on international trade regulation, while China would continue to profit from booming prices on REE exports. With little insight into the length of this process (it ended up taking ~2 years), we suggest that Raytheon also invest in new technologies that are less reliant on REEs. Even if the WTO rules against Chinese legislature, there is little guarantee that China will follow a decision against their REE export quotas and high duties. While there is a good chance that China would appeal such a decision based on “environmental reasons,” China values its membership in the WTO over and above any single trade dispute ruling. Despite these potential setbacks, lobbying the US government, and ultimately the WTO gives Raytheon the best chance for a sustained competitive advantage in the US defense industry.
FDI in China (No)
Raytheon’s second option of investing in production facilities in China (vertical FDI) comes with too many risks that could potentially be debilitating to the firm. The benefit of this option is the immediate access to domestic REE prices once a new factory has been established. Additionally, Raytheon would no longer have to worry about the availability of these materials (particularly of the medium and heavy variety) in the future, and developing strong ties with the Chinese government could open new opportunities for company growth.
However, with these small gains in profitability and predictability comes a considerable impact on reputation and investor support. The US government, which makes up ~75% of Raytheon’s annual revenue, may begin to withdraw contracts if production facilities, which house critical US military intelligence, are offshored to China. Even without Raytheon’s support, there is a good chance that other companies that rely on REEs will lobby for the WTO to impose sanctions on China for their protectionist REE policies. Moving production to China and having to acquire a skilled workforce and high-precision manufacturing capabilities is too much of a risk for something that may be resolved within a few years. Finally, investors may fear that such a substantial change in corporate structure brings significant uncertainty and the market value of the company may begin to tumble. While investing in FDI abroad can pay off in many situations, the industry and specific circumstance for Raytheon do not warrant such an investment.
A Lesson to be Learned
Raytheon and the US Department of Defense (DoD), the end-user of defense products, can reflect upon the financial, strategic, and security risk impact of the REE crisis and derive some insights into improving their systems and processes.
Strong engineering-focused firms like Raytheon invest heavily in research and development of cutting-edge technologies. Their use of rare earth magnets in the motors for missile flight systems are technological innovations, but the essential need for the raw material sources of this product should have raised red flags regarding the sustainability of supply. Firms can learn from this case by developing systems and processes that bring together a cross-functional team including engineering, supply chain, sales, and finance, to research potential risks and to develop contingency plans to address them. The Raytheon team should have better understood its dependency on foreign components and any single-sourced supply risks. Contingency plans should have been developed to find alternative sources and to re-engineer products away from REEs.
More significant oversight by the US Department of Defense (DoD) may also be required. When the DoD procures products from defense contractors, it should fully understand the amount of foreign content and hazardous raw materials that are used in the products. The DoD currently produces an annual report that assesses “…the degree to which the United States is dependent on foreign sources of supply; and the capabilities of the United States defense industrial base to produce military systems necessary to support the national security objectives…” 16 In 2007, the report stated that just 1.48% of DoD contracts (by value) for defense items were awarded to foreign suppliers.16 This study, however, does not consider tier-2 and tier-3 suppliers of foreign components, such as manufacturers of REE magnets and motors that ultimately become part of a Raytheon missile system. Greater oversight and attention to detail by the DoD is therefore needed to understand the risks in the defense products value chain fully.
The USTR became involved in the REE crisis on March 13, 2012. As a part of the Executive Office of the President, its purpose is to develop and coordinate trade policy, resolve trade disputes, and oversee negotiations with foreign countries.6 The USTR requested a consultation with the WTO in cooperation with the EU and Japan, regarding China’s drastic export quota reduction in REEs, tungsten, and molybdenum, which caused a spike in world prices and supply chain disruptions.6 The WTO established a panel to study the claims on July 23, 2012 and released a report with its findings on March 26, 2014, a summary of which are as follows. Export Duties: The panel found that China’s imposition of export duties was inconsistent with China’s WTO obligations and that the responsibilities are not necessary to “… to protect human, animal, or plant life or health”.4
Export Quotas: The panel found that China used quotas to control the international market for natural resources with the purpose of achieving Chinese industrial goals as opposed to resource conservation.4
Trading Rights: The panel found that China had not sufficiently justified why it restricted the rights of firms to export REEs and was therefore in breach of its WTO obligations.4 China has 60 days to appeal the rulings. 15 months from the appeals ruling, the US, EU, and Japan could begin imposing sanctions proportional to the economic damage they claim to have suffered.4