Mergers Remaking Defense Industry

Mergers are as intrinsic to American business as taxes, yet few industries have seen such prolonged consolidation as defense, whose latest spree of merger activity stretches back a decade.

A nearly continuous stream of acquisitions--costing more than $80 billion--has changed the competitive dynamics of the defense industry and attracted an increasingly sharp focus by Washington regulators. Northrop Grumman Corp.’s unsolicited offer to buy TRW Inc. for $5.9 billion would further shrink the base of big defense contractors.

In the decades before the early 1990s, the defense industry had no dominant players and many of the key contractors were conglomerates that made most of their money in commercial markets. Today, the big companies operate mainly in defense or aerospace markets, and a handful of them dominate the industry.

The defense industry’s current Big 3 prime contractors: Lockheed Martin Corp., Boeing Co. and Raytheon Co. are products of the 1990s consolidation, built from dozens of deals that pieced together producers of electronics, spacecraft, airplanes, ships and weapons.

Northrop’s effort to buy TRW comes nearly four years after many thought the consolidation was mostly finished.

Ironically, it was Lockheed Martin’s 1998 decision to scrap its planned purchase of Northrop Grumman in the face of U.S. antitrust concerns that many viewed as the apex of the merger wave in the 1990s.

But Northrop’s aggressive chief executive, Kent Kresa, then went on an acquisition binge, paring the number of major defense players even further. If it buys TRW, Northrop Grumman would add to a stable of recent acquisitions that include defense-electronics maker Litton Industries Inc. and aircraft carrier builder Newport News Shipbuilding Inc.

A few other second-tier defense firms also have been merging--or at least trying to--and Richard Aboulafia, an analyst with Teal Group, an industry consulting firm in Fairfax, Va., said he has no doubt the trend will continue.

Honeywell Inc. and AlliedSignal Corp. merged in 1999. United Technologies Corp. also bought Sundstrand Corp. in 1999, and General Dynamics Corp. launched the bidding for Newport News last year before losing to Northrop Grumman. General Electric Co., a maker of jet engines, among other products , tried to buy Honeywell but was thwarted by European antitrust officials last year.

TRW, in fact, had been the subject of takeover speculation for years prior to Northrop Grumman’s bid. Others believed potential players in further consolidation are Alliant TechSystems Inc., L3 Communications Holdings Corp. and GenCorp’s Aerojet propulsion business. GenCorp sold Aerojet’s electronic information systems business to Northrop Grumman last year.

And Northrop Grumman might not be TRW’s only suitor. Despite the Pentagon’s past protests about letting the prime contractors get any bigger, Lockheed Martin and the other two might consider bidding for TRW as well because of its strong position in satellites and missile defense. Some second-tier defense firms also might view a TRW merger as a way to burnish their competitive position.

Other industries once populated with several major players also have witnessed rapid consolidations over the last decade. They include the oil business, media and entertainment companies, supermarkets, banks, brokerage firms and other financial-services concerns, and telecommunications and cable firms.

The rationale behind the mergers is usually the same: The buyers want to “augment the depth of their products and services, extend their geographic reach” and reduce excess capacity in the industry that’s eroding profits for everyone, said Michael Ervin, an analyst with RCW Mirus Inc., an investment bank in Boston.

Indeed, defense mergers were encouraged by the Pentagon in the 1990s because, amid a sharp drop in post-Cold War defense spending, too many contractors were chasing too few defense dollars. A similar trend is evident in banking, where many analysts have said for years that there are far more banks than U.S. consumers need.

The buyers in these mergers also hope to gain more control over a product’s journey from the drawing board to the customer--”vertical integration” in corporate jargon. This strategy is particularly appealing to media and entertainment companies that merge in order to tap profits from both producing and distributing programs and other content.

But critics of these industries’ mergers complain that a handful of giants has come to enjoy excessive dominance over their markets, raising potential risks for the companies’ customers, suppliers and employees. The fear: not enough competition to keep prices down and keep innovation up.

The Pentagon used that very reason to block Lockheed Martin’s purchase of Northrop Grumman. Though it wanted fewer contractors, it still sought to maintain competition for key defense programs. Even after that move, the Pentagon was criticized for having already given up too much control over weapons programs by allowing the creation of Lockheed Martin, Boeing and Raytheon.

Nonetheless, the Defense Department also said it would continue to encourage mergers among smaller aerospace and defense firms--provided they didn’t harm competition either. With that endorsement in hand, the second-tier companies have another reason to merge: To gain more bargaining clout as suppliers to the prime contractors, said Teal Group’s Aboulafia.

“They need the might to stand up to the primes, because the primes are squeezing the life out of them” in terms of putting pressure on the suppliers to keep their prices down, he said.

By broadening their lines of business using mergers, they make themselves partners with the prime contractors, he said. “In other words, you don’t just provide them with hydraulic pumps, you integrate the whole hydraulic pump system” for the major contractor, and the supplier gains that ability by acquiring other companies involved in the projects, Aboulafia said.