A Decade of Defense Mergers Yields Disappointments

Almost a decade of consolidation in the defense industry has failed to deliver the benefits of lower costs for the Pentagon. And the mergers of the ‘90s that were supposed to produce stronger and more innovative defense contractors have more often caused corporate indigestion.

Raytheon last week announced more than 2,000 layoffs and $668 million in write-offs because it hasn’t been able to successfully absorb the defense businesses of Hughes Electronics and Texas Instruments, which it acquired in the last two years.

Lockheed Martin announced a month ago that it would sell off at least 10 subsidiary companies, reducing profit by about $1 billion, in an attempt to gain managerial control of scores of separate businesses the company has accumulated over years of mergers and acquisitions.

So far, bigger has not proved to be better for U.S. defense companies. Yet Europe’s industry is determined to go the U.S. route. Germany’s DaimlerChrysler has announced that its Deutsche Aerospace, or Dasa, unit would merge with France’s Aerospatiale Matra, declaring that larger corporate size would enable the Europeans to “compete with the American giants.”

The more likely result is that Dasa and Matra executives will now waste time arguing over who runs what in the new European Aeronautical, Defense & Space, or EADS, company, and competitiveness will be a forgotten issue.

Consolidation, which began in earnest when U.S. defense budgets plunged in the early ‘90s, has not delivered the expected benefits.

“The Pentagon has not seen the cost savings that Defense Department officials projected,” says Jon Kutler, defense industry consultant and head of Los Angeles-based Quarterdeck Investment Partners.

That comes as no surprise to retired Northrop Grumman Chairman Thomas Jones, who in 28 years as head of the company invested consistently in research to produce the B-2 bomber, the F-5 fighter and other planes.

Jones was always skeptical of consolidation. “As companies grew larger,” he says today, “they went from developing products that advanced the interests of their customer [the Pentagon] and tried instead to manage assets.”

Companies turned inward, trying to sort out different computer systems, methods of contracting, personnel practices.

Innovation suffered as the Defense Department sought to reduce the number of companies doing research. “I always got more new ideas when I had several companies trying to think up products to win a contract,” says a retired Pentagon official who doesn’t wish to be quoted by name.

The idea of consolidation--that reducing the number of contractors would give the U.S. more military capability at less cost--turned out to be an illusion.

The General Accounting Office, Congress’ watchdog agency, found in several studies in the last year that consolidation has brought no real cost savings. At best, defense costs grew at a lower rate, says a GAO spokesman--about what one would expect in a time of flat or falling budgets.

To be sure, a defense industry reduction was inevitable as weapons procurement outlays slid. When consolidation began in earnest in 1992, the Defense Department spent $80 billion on procurement; by last year, the amount had dropped 40% to $53 billion. Prominent firms such as General Electric and Chrysler sold their defense subsidiaries and left the business. Defense contractor General Dynamics started selling its aircraft and missile operations in 1992, and won praise from investors.

GD stock rose for most of the decade as Wall Street bought every kind of defense stock--those of companies selling assets and those acquiring them. Lately however, GD stock has fallen along with other defense issues as troubles became visible at Raytheon, Lockheed and Boeing.

And meanwhile, the government has begun taking a harsher view of mergers. The Justice Department objected to Lockheed’s proposed buyout of Northrop last year and the proposed $11-billion deal fell apart.

So now a different perspective is taking hold. Investor favor is shifting to relatively small, focused defense companies. L-3 Communications, for example, a company that has $1 billion in annual sales in telemetry, avionics and ocean systems, attracts a premium price for its stock--although its stock too has retreated in recent months. L-3 was spun off from Lockheed in 1997 and is led by former Lockheed executives.

More small companies will be coming to market as troubled big firms spin off operations, says Robert Paulson, onetime head of McKinsey & Co.’s aerospace practice and now head of Aerostar Capital, a Wilson, Wyo.-based investment company that finances defense-related small firms. Paulson is backed by a Chase Manhattan Corp. investment fund in efforts to find and organize new companies.

A more balanced view is emerging among experts and investors of how a defense industrial base should be organized. Specialized companies will drive innovation in their particular fields, while the large prime contractors will be expected to whip themselves into shape.

Casualties of consolidation get little sympathy today. “What happened to Raytheon and Lockheed was pure mismanagement,” says analyst Paul Nisbet, president of JSA Research, a Providence, R.I.-based investment firm that specializes in defense.

Nisbet cites Boeing, which has acquired Rockwell and McDonnell Douglas in the last two years, as a company that has come through troubled times and now shows how consolidation can succeed.

Boeing recently won a $5-billion Pentagon contract for a National Reconnaissance Satellite, beating out troubled Lockheed for the classified project. “Neither Boeing or Rockwell or McDonnell Douglas could have won that contract by itself,” Nisbet says. “But they were able to combine skills and come up with the winning bid.”

The moral is not that big firms are necessarily clumsy or small ones necessarily swift, but that in an era of new and different global military challenges and competition, defense companies have to focus resources and energies.

The Pentagon, too, needs to generate new ideas and focus its energies. The Cold War ended in 1989, but the Pentagon still has not fully adapted to the changes. Rather, it has lurched from one big-ticket program to another, without executing any of them very well. As the ‘90s draw to a close, the department is stuck with programs such as the F-22 fighter that are too expensive, at roughly $100 million a plane, to buy or to use.

The Pentagon must reform, just as its contractors, Raytheon, Lockheed and others, are now being forced to do. The rising defense budgets that are in prospect for the next five years must be allocated productively.

For with European companies showing ambitions in global defense markets, and nations in Europe and Asia changing their thinking on military matters, the U.S. Defense Department can’t coast on past supremacy.

Changing times demand changed thinking.

James Flanigan can be reached by e-mail at jim.flanigan@latimes.com.