Bigger Firms Seen in Next Defense Consolidation
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September 22, 2011
By Andrea Shalal-Esa
Reuters
9/20/2011
WASHINGTON – United Technologies Corp’s interest in acquiring Goodrich Corp. marks the start of a more active consolidation phase in the U.S. aerospace and defense industry that could ultimately winnow the current field of five or six prime contractors.
Industry executives expect more takeovers of second- and third-tier defense suppliers in coming months and say there could even be changes in the top tier, depending on the depth of defense spending cuts mandated by U.S. budget deficits.
For years, experts ruled out further consolidation among the biggest arms makers after the mega-mergers sparked by the end of the Cold War. But the prospect of deep spending cuts and continued pressure on companies to generate profits have revived the specter of bigger mergers.
Deals in recent years have been smaller, punctuated only by the $5 billion takeover of U.S. defense contractor DRS Technologies by Italy’s Finmeccanica SpA in 2008.
If United Tech prevails in its bid to acquire Goodrich — a deal likely valued at around $12 billion — that would probably be the harbinger of other large deals.
“This changes the whole spectrum,” said one senior defense industry executive. “Everything’s on the table now. I’m not saying it’s going to happen, but it’s a whole new ballgame.”
Another senior executive agreed, saying, “This feels like the early 1990s again. We’re in for some turbulent times.”
The biggest companies in the U.S. defense market are Lockheed Martin Corp., Boeing Co., Northrop Grumman Corp., General Dynamics Corp. and Raytheon Co., as well as Britain’s BAE Systems.
After a decade of sharp growth in defense spending, the U.S. Defense Department is now scrambling to cut at least $350 billion from previous spending projections, and that could rise to $900 billion unless Congress finds at least $1.2 trillion in deficit cuts by year-end.
COMMERCIAL SEEN AS HEDGE AGAINST DEFENSE DOWNTURN
Budget pressures have already scaled back new weapons programs, and lawmakers have taken aim at additional projects in recent weeks — leaving less work for defense companies to divvy up. Many companies have shifted into services, and that trend will continue. Others are looking to diversify into more commercial work to offset the drop in government orders.
“You have a lot of defense companies that are cash-rich and are looking at ways to move into adjacent areas; it’s possible that they would expand what they do in commercial aerospace,” said Philip Finnegan, director of corporate analysis for the Teal Group, an aerospace consultancy in Fairfax, Virginia.
Defense Undersecretary Ashton Carter and other officials had tried for the past year to assure industry executives that they would be able to stave off big spending cuts.
But those hopes have been overtaken by a new reality, said defense analyst Loren Thompson of the Lexington Institute. “What Secretary Carter told the defense industry about its future prospects just isn’t panning out,” he said.
Brett Lambert, deputy assistant secretary of defense, manufacturing and industrial base policy, this month acknowledged the toll that uncertainty was taking on the sector.
Given the difficult economic climate, the Defense Department fully expects more mergers, acquisitions and spinoffs in coming years, mostly in the supplier base, Lambert told the Reuters Aerospace and Defense Summit in Washington.
While the Pentagon was comfortable with the current number of prime contractors, it was not “ruling anything out,” he said.
Adam Palmer, who manages aerospace and defense investments for the Carlyle Group private equity firm, told Reuters that defense officials might rethink their opposition to big mergers if spending cuts gut the market for certain types of weapons.
Carter, nominated for the No. 2 job at the Defense Department, is no stranger to defense consolidation, having attended the 1993 “Last Supper” where his friend and mentor, then-Deputy Defense Secretary William Perry, urged arms makers to consolidate.
Carter often talks about that experience in public speeches, and he says the department has a responsibility to pay attention to the impact of its decisions on the industrial base, especially given the slowdown in defense spending.
DEFENSE ELECTRONICS LIKELY TO SEE CONTRACTION
Thompson does not expect mergers at the top tier, but he says there will clearly be contraction in defense electronics. He said companies such as Harris Corp. and ITT, which plans to spin off its defense unit, are probably more vulnerable to takeovers than bigger players such as Northrop and Raytheon.
“It’s going to be a big change, but I don’t think there’ll be a ‘Last Supper’ in the sense that the DoD (Department of Defense) will tell everybody what they expect and what needs to be done and companies will go do that,” said Norm Augustine, former chief executive of Lockheed, who attended the Perry event.
John Young, who served as the Pentagon’s chief weapons buyer before Carter, warned that further consolidation would likely increase already high prices of new weapons.
He said defense officials should adopt strict policies against any mergers that create monopolies, while easing tough auditing rules and other barriers that keep more innovative companies and nontraditional suppliers out of the market.
“The truth is that if (the bigger firms) shed some overhead and closed some plants, they would be better positioned for the next upward cycle in the defense budget,” Young said.
Jacques Gansler, who headed Pentagon procurement under former President Bill Clinton, agreed, saying the department also needs to allow more competition throughout weapons programs instead of handing contracts to one supplier.
“They don’t understand how competition works,” he said. “Monopolies tend to raise prices, not lower them.”
