Shrinking Arsenal : Is Consolidation Slipping Out of Defense Industry’s Control?

Defense Secretary William Perry has said that the Pentagon wants an orderly consolidation of the defense industry in the post-Cold War era.

But what Wall Street has in mind may be something much different: a fast-paced auction of weaker contractors, in which investment bankers and major investors will be calling many of the shots.

That became apparent last week when a $1.9-billion bid by Martin Marietta Corp. for Grumman Corp. prompted a rival $2-billion offer by Northrop Corp., creating a hostile battle of prime contractors. It marked the beginning of a fight that is likely to change the insulated and clubby defense business forever.

Grumman had little apparent interest in forfeiting its independence last year when it quietly discussed a possible “merger of equals” with Northrop.

But the very discussions with Northrop put Grumman into play as an acquisition candidate, and its investment banker, Goldman Sachs, later put together the deal with Martin Marietta without any other bids.

Even Northrop officials admit they don’t understand the swift turn of events and why they were not allowed to make a bid. “We don’t know what happened,” said James G. Roche, Northrop’s vice president for advanced planning and development.

One clear winner, however, is Goldman Sachs. It stands to earn huge fees--estimated by one competitor at $20 million--a far higher profit rate than what the Defense Department would typically pay a contractor.

If the fight for Grumman and past takeovers in other industries are any indication, the defense business is likely to quickly lose some control of its destiny. If so, the Pentagon has no guarantees that the consolidation would not leave gaping holes in its weapons suppliers.

According to one investment banker knowledgeable about the current takeover battle, Grumman executives never anticipated that their talks with Northrop would lead to an unwanted bidding war.

In this case, Goldman approached Martin Marietta and negotiated a deal, without seeking a bid from Northrop--prompting Northrop’s hostile bid. A Goldman spokesman declined to comment on its role, or on its potential fees from the deal.

Meanwhile, Northrop itself is now seen as vulnerable to a hostile takeover bid, whether it gets Grumman or not. Without Grumman, it lacks the scale to compete in the collapsing defense market; with Grumman, it would be a valuable breakup target with weak defenses, according to the investment banker.

If a hostile offer is made for Northrop, it could come from an industry outsider collaborating with Martin to break up the company along with Grumman and parcel out pieces to the highest bidder.

“There is a risk that steps you take down a path in a consolidation cannot be retraced,” said John Harbison, an aerospace consultant at Booz Allen & Hamilton. “That fear has prevented a number of companies I am involved with from taking an initial step.”

The Pentagon has paid scant attention to how this consolidation process would actually work, preferring so far to keep its hands off the process. Indeed, spokesmen for the department could not identify any officials or staff with direct responsibility for merger oversight or policy.

In congressional testimony, Perry allowed that the Pentagon “has an enormous interest in maintaining this (industrial) base in some sort of a healthy way” and projected that the consolidation would take three to four years to be completed. But he offered little insight into how government interests would be protected.

Ironically, Martin Chairman Norman Augustine warned the Pentagon last year that its indifference could have grave consequences for national security.

In a lengthy speech to the American Bar Assn., Augustine said the Clinton Administration and Congress “must be involved in considering what policies should be brought to bear as we shrink America’s defense industrial base. And as tempting as it may be, the U.S. government cannot simply step back from the fray and let the forces of the free-enterprise system solve the problem for it.”

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The potential problem envisioned by Augustine was that decision makers in private industry have no obligation or incentive to preserve an adequate industrial base to serve the Pentagon and that the stakes are so high for national security that the Pentagon should not leave such matters to chance.

Some experts say that an acquisition of Grumman by Northrop would better serve the government, because Northrop Chairman Kent Kresa has placed a high value on Grumman’s aircraft operations, while Augustine does not want to be an aircraft builder.

Another crucial issue in the consolidation is antitrust policy. So far, the federal government has accommodated all but one proposed merger.

The Federal Trade Commission blocked a merger between Alliant Techsystems and Olin Ordnance in 1992 on grounds that it would leave the Pentagon with only one producer of artillery rounds.

The irony of that decision is that the Army is not procuring any artillery rounds currently and that both firms are struggling to maintain an adequate revenue base. The ammunition industry is also widely considered the weakest and most vulnerable part of the industrial base.

“One problem with allowing the market to determine the consolidation is that you reduce your ability to influence an end structure that most benefits the government,” Harbison said. “There are certainly many industries where the winner of an acquisition battle ends up with so much baggage that they are seriously hurt in their ability to serve customers.”