Consolidation Among Defense Firms Seen : Lockheed Offer for Sanders Part of Emerging Trend, Observers Say

Lockheed’s $1.2-billion bid for Sanders Associates is an early warning of what is widely expected to be a period of major consolidation and reduction of capacity in the defense industry in the years ahead.

Intense interest is being focused on about a dozen medium- and large-size defense electronics firms, such as Sanders Associates, by big prime contractors that are seeking to vertically integrate their product lines.

The net effect could be a reduction of competition in the industry.

Ironically, aggressive efforts in recent years by Congress and the Pentagon to push defense contractors toward greater competition and enterprise are major factors contributing to this industry consolidation, experts say.

“The defense business is hard right now. It is very competitive,” said Richard DeLauer, a former undersecretary of defense and TRW executive. “Competition advocacy and all these crazy rules by Congress have given companies a hard time, and they are going to do more and more aggregation.”

Procurement reform in recent years has increasingly meant a “get-tough” attitude toward contractors, but now that may turn around and haunt Congress. “Anything the Congress does usually ends up having the opposite of its intended effect,” Lockheed Vice President H. David Crowther said.

Major prime contractors gained substantial financial strength during the Reagan Administration defense buildup, and many are prepared to spend their savings to prepare for the coming lean years when defense budgets flatten out.

“This is an industry that has a lot of excess capacity in it, and with fewer programs being chased by more guys, you are going to have to do some consolidation,” said David J. Smith, an aerospace analyst at Sanford C. Bernstein & Co. “In deregulation, industry cuts costs and competes, and what is the defense industry doing right now? Power is going to get centered in four or five big guys.”

Such a prospect could spell big trouble for the Pentagon, which has historically counted on a defense industry in which no single company exercised significant market power. The largest defense contractor, McDonnell Douglas, held only 5.9% of the defense market in 1985, a far lower market share than the leader of most U.S. industries. GM, for instance, controls more than half of the U.S. auto market.

“If too much consolidation happens in the defense industry, it could reduce competition,” said Verne Orr, recently retired Air Force secretary. “I have a suspicion (that consolidation drives up Pentagon costs), but I couldn’t prove it.”

Already, a trend exists toward consolidation. In 1985, the nation’s five largest defense contractors received only 22.5% of all the defense contract dollars, but in 1982 the figure stood at only 19.6%. The top 100 contractors received 70% of total contract dollars in 1985, but they received only 65.9% in 1982.

Several big mergers in the past year have already set the stage for some consolidation in the defense electronics arena. The merger of Burroughs and Sperry combined two manufacturers who have a substantial business in computer sales to the Pentagon. The merger of General Electric and RCA combined two firms that are satellite manufacturers.

But the deals so far represent “just the tip of the iceberg in terms of merger activity in this industry,” according to one Wall Street investment banker.

A lot of the mergers will center on companies that are hardly known outside of the defense industry, but inside the Pentagon they are considered the heart of America’s technological leadership in weapons.

They include such firms as Tracor, Singer, Hazeltine, E-Systems, Watkins-Johnson, Loral, Litton Industries and even TRW, which is a major integrated defense electronics house in itself. Moreover, there are scores of smaller defense electronics firms that often make major technological advances for the Pentagon.

The integration of these firms into major prime contractors will not necessarily reduce the number of firms producing equipment, but the fact that they are captive firms in a vertically integrated industry will still reduce competition, some experts believe.

A prime contractor who needs an electronic system for an aircraft, for example, might be more inclined to award the business to its own subsidiary than to hold an open competition for the work.

“Human nature would be to give a break to your in-house company,” Orr said.

The other problem is that the Pentagon will face a new, more financially powerful middleman for many of the electronic goods that it used to purchase from small companies.

“If you start to get too much vertical integration, then when you go out to bid for electronic gear, you have to bid through the parent company,” Orr said.

Of course, the Pentagon could put a stop to virtually any merger anytime it wants, because as the lone buyer for the industry--a situation known as monopsony--it wields enormous power. Most defense contracts contain clauses that permit their cancellation “for the convenience of the government.”

Even Loral Chairman Bernard Schwartz, who has been outbid by Lockheed in his effort to acquire Sanders, is concerned about the consolidation trend.

“I am hopeful that the rationalization occurs in such a way that the entrepreneurial character of many of these small electronics firms will not be squashed out in the process,” Schwartz said in an interview Thursday. “I hope there is room in the process for a Loral-size company and that we can keep an entrepreneurial style to our business. To take these firms and put them into a large conglomerate, I think, does a disservice to the defense industry and to the security of our country.”