Defense Dollars Prompt a Rush to Consolidate

Times Staff Writer

The business of war and counter-terrorism is fueling a multibillion-dollar spending spree as defense contractors -- many based in California -- grab up some of the nation's most secretive, sensitive and well-connected companies to compete for billions of dollars in national security initiatives.

The latest illustration came this month when El Segundo-based Computer Sciences Corp. completed its acquisition of DynCorp of Reston, Va., for nearly $1 billion, inheriting contracts that range from maintaining Air Force fighter jets in the Persian Gulf and guarding the lives of U.S. ambassadors in Israel and the Balkans to securing America's strategic oil reserves and developing anthrax and smallpox vaccines.

Meanwhile, several smaller firms have emerged as potential competitors to the defense giants by going public, then using their new capital as war chests to acquire niche enterprises that have penetrated key sectors of the booming counter-terrorism, intelligence and homeland security markets.

Taken together, at a time when the Bush administration is asking for nearly $40 billion in homeland security funding and is poised to request billions more to pay for an armed conflict with Iraq, the strategy in the war business is simple: The bigger, the better.

And in a largely stagnant American economy, it is one of few sectors that is booming.

Last year, companies in the defense and homeland security industries raised unprecedented sums in public offerings, according to Jerry Grossman, managing director of Los Angeles-based investment banking firm Houlihan, Lokey, Howard & Zukin. That, in turn, helped to fund a defense-related merger-and-acquisition binge in 2002 that saw nearly 40% more deals than in the previous year: 218 compared with 157.

The reasons go beyond the new government largess.

Increasingly, government agencies, including those in the new Homeland Security Department, are "bundling" contracts, preferring a single, diversified contractor that can provide end-to-end solutions rather than parceling out contracts to dozens of smaller firms. That requires deep corporate pockets and labor forces with broad expertise. The Bush administration, for example, signaled last week that it intends to issue just such large-scale contracts to rebuild Iraq in the event of war.

"If you're only going to plant a few daisies and tulips in your yard, you don't need a gardener. But if you're going to totally re-landscape you need ... a huge systems integrator," said Paul Cofoni, who heads the CSC group handling most of the combined companies' government work.

"We see a massive amount of consolidation in the industry."

Van Honeycutt, CSC's president and chief executive, told financial analysts that the combined companies have a "pipeline of opportunities" in federal contracts totaling about $40 billion through fiscal 2005.

The DynCorp purchase makes CSC one of America's top 10 government contractors overnight and the government's third-largest information technology supplier, with combined annual revenue of nearly $14 billion and 90,000 employees.

Executives of both companies said the deal was designed in part to better meet the government's new homeland security needs.

CSC already had broad information technology contracts to restructure entire systems at such institutions as the Internal Revenue Service and the National Security Agency. Now, the company also can take advantage of DynCorp's stable of retired law-enforcement officials, military special forces operatives and intelligence agents.

Against the backdrop of the accelerated privatization of government and military functions, fewer and fewer companies are chasing more and more taxpayer dollars.

"The consolidation of the big guys in the defense sector is to the point where there aren't a lot more big guys left to buy," Grossman said.

As a result, he added, large contractors are buying up smaller companies as well. And to compete, medium-sized companies have launched their own buying binges, often turning to Wall Street to bankroll them.

Although big may be better for business, some analysts warn that it may not be best for the customers -- the government and taxpayers.

"If you have too many mergers and you have a stranglehold on these contracts by a few companies, you lose the basic advantage of privatization, which is the cost savings by free-market competition," said P.W. Singer, a Brookings Institution fellow and author of an upcoming book, "Corporate Warriors."

"You end up with all the issues of higher cost, overbilling, over-staffing and lower quality," Singer added. "If you have dominance by a few companies, you don't have as many choices as you might think."

The biggest deal was the $7.8-billion acquisition in December of TRW Inc. by Los Angeles-based Northrop Grumman Corp., which made Northrop the second-largest Pentagon contractor in the U.S. The motive, executives of the company said, was to increase its chances of winning government work in homeland security, missile defense and electronic warfare projects.

Although the Northrop deal was by far the biggest, others among last year's 218 defense-related mergers and acquisitions were driven by the same impulse: to make a play for homeland security business.

Veridian Inc., an Arlington, Va.-based defense contractor specializing in security programs for the intelligence community, the Pentagon and law enforcement, raised $175 million in capital when it went public a year ago. In September, it bought privately held Signal Corp. for $227 million in a "growth strategy to broaden its national security footprint and expand its presence into homeland security markets," the company noted in its Securities and Exchange Commission filings.

ManTech International Corp., a Fairfax, Va., information technology company, has acquired two similar intelligence-community contractors since it raised $110 million by going public in February 2002, according to its SEC filings. In another stock offering in December to help pay for its acquisitions, ManTech cited the Pentagon's ballooning budget and its focus on homeland security programs as key selling points.

"We have extensive experience with military intelligence operations and frequently deploy personnel overseas to support priority national security programs, particularly where U.S. troops are engaged in operations," the prospectus for the offering said.

Now, thanks to its purchase of DynCorp, so does CSC.

The industry's latest acquisition, analysts say, is a case study of the big-is-better phenomenon that is changing the landscape of the defense-services industries.

A closer look at just what CSC has acquired from DynCorp also underscores how much of America's defense and intelligence operations have been privatized since the trend started growing exponentially in the early 1990s.

Founded in 1946 by returning World War II pilots as California Eastern Airways Inc., a Flying Tigers-style air cargo company, DynCorp has so vastly expanded its missions and operations for the U.S. government and military in recent years that it has become the envy of the industry -- and a lightning rod for critics who deride it as emblematic of the evils of America's military-industrial complex.

The company, which was employee-owned after it went private in 1987, has been labeled a mercenary, a war profiteer and worse by activists; at least one Web site was created solely to target DynCorp.

CEO Paul Lombardi, under whose leadership DynCorp's annual revenue grew from $500 million to $2.3 billion in the last decade, bristles at such criticism.

"We're an ethical company," Lombardi said. "We're tremendously proud of what we do."

He acknowledged, however, that "we are involved in sensitive issues."

Among the contracts that have made DynCorp so controversial -- and successful, according to the company's SEC filings and interviews with its top executives:

* A State Department aerial-spraying contract to eradicate coca crops in South America that brought in more than $80 million in 2001. A labor-rights group sued DynCorp in federal court in Washington in 2001 on behalf of up to 10,000 Ecuadoreans, alleging that the herbicides drifted across Colombia's border and caused crop damage, illness and death in Ecuador. The company denies the charges, asserting that it strictly follows State Department standards.

* An FBI contract to help build a nationwide computer network of desktops, workstations and peripherals called Trilogy, which generated tens of millions of dollars in revenue last year when the program was accelerated after the Sept. 11 attacks. Several congressmen have sharply criticized Trilogy's soaring costs, but DynCorp's Lombardi attributed them to "requirements creep" -- the FBI's adding needs beyond the original specifications.

* A fast-growing Defense Department contract to maintain U.S. Air Force assets in southwest Asia and the Persian Gulf, which generated $116 million in revenue in 2001 -- as much as $20 million "higher than expected ... due to increased activities resulting from the war in Afghanistan," according to the company. DynCorp also maintains the entire U.S. presidential air fleet, other than Air Force One, under a separate contract at Andrews Air Force Base.

* A State Department contract to build a police academy and recruit and train a new police force for Afghanistan. The contract includes guarding the life of Afghan President Hamid Karzai, a job Lombardi said is done by retired U.S. special-forces commandos. The company also provides security for U.S. ambassadors in Israel and the Balkans, he said.

Much of DynCorp's revenue comes from less controversial contracts, such as maintaining military aircraft in the U.S. and running military training programs. But top CSC officers and independent financial analysts say it is the sensitive service contracts that make the two companies such a good fit in today's war economy.

"We're proud of all that," said CSC's Cofoni. "We don't view them in a negative way at all." Those DynCorp services, he added, "are critical to ... the interests of our country."

Besides, folding thousands of employees with hands-on experience in the military and intelligence communities into an information technology giant that serves those same sectors greatly enhances CSC's chances for future contracts, he said.

Grossman, the investment banker, agreed.

"It is a beefing up of a segment of CSC that was there before but is now strengthened," he said. "And they have the size and muscle of what is now a $13-billion company."

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