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Has Defense Merger Frenzy Gone Too Far?

Tue., Dec. 17, 1996

The Clinton administration’s controversial vision of an aerospace industry dominated by three or four titans is finally coming close to reality with Boeing Co.’s planned acquisition of McDonnell Douglas Corp.

Boeing and Lockheed Martin Corp. will be two of the industry behemoths, competing on a vast scale for billions of dollars of federal contracts and earning massive profits that will fuel further penetration of the government market. Lockheed Martin now controls as much as a fourth of total defense production and research spending, with a combined Boeing/McDonnell Douglas not far behind. A decade ago, no single defense contractor took in more than 5 percent of the Pentagon weapons budget.

But although the industry consolidation is not yet complete - with a third giant expected to emerge soon, possibly Los Angeles-based Northrop Grumman Corp. - the growing clout of the big aerospace players is causing many experts to question whether the merger frenzy has gone too far.

“It is hard to know what we are getting into or what the outcome will be,” said Derek Vander Schaaf, former Pentagon inspector general. “We have yet to see if we are really going to save any money.”

Vander Schaaf questions the ability of a relatively small group of big integrated prime contractors to maintain the intellectual diversity that formerly provided the Pentagon with innovative weapons. With fewer design staffs working on military problems, the solutions are likely to be less varied, he says.

“These behemoths may not be able to react quickly to innovation in the commercial economy,” added Dan Goure, a defense expert at the Center for Strategic and International Studies in Washington. “We are going to have a very limited industrial base. That makes us very shallow.”

Although the U.S. military faces no threat that could challenge it in the short term, the situation is bound to change in 20 years when the United States is likely to face far more capable adversaries.

“It is fairly easy to screw up,” Goure added.

But even if anybody wanted to stop the consolidation process now, it is probably too late. That’s because it would leave the industry unbalanced, with two dominant firms and three or four comparatively weaker companies.

The remaining pieces of the puzzle are expected to fall into place shortly, creating the third pole of the U.S. aerospace industry. Hughes Electronics, Raytheon, TRW and Northrop Grumman are the key players whose fate is hanging in the balance.

It seems likely that Los Angeles-based Northrop Grumman will emerge as the third giant in a deal that involves at least one of the other firms, very possibly Los Angeles-based Hughes Electronics.

Meanwhile, the commercial jetliner industry is also sharply contracting, with the recent exit of Dutch concern Fokker and Boeing’s expected acquisition of McDonnell Douglas following earlier exits of Lockheed and Convair.

The Pentagon’s rationale behind the consolidation is that a smaller and more tightly organized defense industry can operate at technological parity with the commercial sector and with greater efficiency than weapons makers have ever achieved in history.

Defense Secretary William Perry set this consolidation process into motion three years ago, asserting that the Pentagon could not afford to support the industrial capacity that was sitting idle in the aftermath of the Cold War.

Loren Thompson, a defense expert at the de Tocqueville Institution, says the driving force in the consolidation is the rapid drop in defense spending and the dim prospect that sales will grow any time soon.

“The defense industry was long overdue for a consolidation,” he said. “The Reagan administration defense build-up only forestalled the exit of many companies that had long run out of steam.”

Indeed, few experts argue that the defense industry earned an exemplary record in the 1980s when dozens of major contractors competed. The Reagan build-up was accompanied by horrendous cost overruns, technical problems and ethical breakdowns that sent dozens of defense executives to prison.

But critics of the consolidation say that even with all its warts, the old aerospace structure served the nation well ever since World War II, producing the weapons that won the Cold War.

Many critics also are dubious about claims that the consolidation will save money, particularly if the Pentagon needs to suddenly increase weapons purchases as occurred during the Korean, Vietnam and gulf wars.

In addition, contractors often team up to share major weapons programs, meaning that everybody owns a piece of the action. In the Air Force’s new airborne laser program, for example, Lockheed, Boeing and TRW are all on board. Such a structure minimizes any competition.

Critics also fear that the big aerospace players may amass too much political and economic power. Although President Eisenhower warned of the political power of the modern defense industry, the Pentagon has never before dealt with an arms industry that has the political and economic clout that the new titans will be able to exert, according to Lawrence Korb, a Brooking Institution military specialist.

Both Boeing and Lockheed Martin have thousands of employees in states that make up a majority of the House of Representatives. The firms routinely hire retiring senior government officials and have moved aggressively into a wide variety of government work beyond pure defense. Lockheed, for example, is the largest supplier of information technology and computer systems to the federal government.

Whether the Pentagon actually saves money and avoids the costly management errors that have long characterized defense will take years to know. The idea that the Pentagon would put the brakes on consolidation now may be the worst outcome, since it would leave the industry out of balance with a combination of exceptionally powerful and relatively weak ones. Most likely, the Pentagon can’t act soon enough to stop the action even if it wanted.

Lehman Bros. aerospace analyst Joe Campbell expects possibly two additional mergers to take place relatively quickly, involving Hughes Electronics and Texas Instruments, both of which are considering a sale.

A deal that would combine Northrop Grumman with either Hughes or Texas Instruments is a strong possibility, industry sources say, putting Northrop Grumman on a par with Boeing and Lockheed in the new industrial structure.

“The logic of the situation is clear,” Thompson said. “If Northrop Grumman buys Hughes, it becomes No. 3 of the Big Three that are without peer.”

Northrop Grumman spokesman Tony Cantafio said the firm would not comment on mergers, as a matter of corporate policy.

Although Northrop Grumman has acquired both Grumman and the defense operations of Westinghouse, the company’s financing capacity is not tapped out. The Los Angeles-based firm this year issued new stock that was oversubscribed by investors, indicating it has plenty of financial muscle for another deal.

A deal involving Hughes or Texas Instrument could occur within weeks.

The following fields overflowed: CREDIT = Ralph Vartabedian Los Angeles Times

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