July 4, 1997 in Nation/World

Latest Defense Merger May Be Industry’s Last Fewer Players Would Raise Prices, Cut Innovation, Analysts Agree

Paul Richter And Jube Shiver Jr. Los Angeles Times
 

The benefits of the dizzying defense consolidation of recent years still are being hotly debated, but supporters and critics seem agreed on one point: The huge proposed merger of Lockheed Martin and Northrop Grumman probably will be the trend’s last big act.

The wave of mergers that began in 1993 has winnowed the industry to three behemoth players that are expected to compete on all major defense contracts. Pentagon officials believe the mergers have given the armed forces better products at a cheaper price than would have been the case if a destructive industry shakeout had been allowed to occur.

Yet, many analysts also agree that cutting the main players to only two - or one, for that matter - could threaten innovation and price as well as create concern in Congress. While these analysts acknowledged that this judgment is partly guesswork, they say that cutting the dominant players in the defense industry to two would be too much.

On Tuesday, the Federal Trade Commission approved Boeing Co.’s $14 billion purchase of McDonnell Douglas Corp., and in January, Raytheon Co. announced that it would acquire the military business of Hughes Electronics Corp. in a $9.5 billion deal. Raytheon’s purchase of Texas Instruments’ military business recently won approval from the Justice Department.

“In the end, these mergers have been the right thing to do for competition, and for cost,” said Daniel Goure, an analyst at the Center for Strategic and International Studies in Washington. But, he added, “This ought to be the end of the road.”

The consolidation wave did not occur by accident, but was set in motion by the conscious design of the Clinton administration in its first year. Fearing that national security - and the economy - would be hurt by a wave of bankruptcies caused by defense budgets that plummeted after the Cold War ended, the administration set out in 1993 to begin a merger wave.

It pushed to ease antitrust rules and began reimbursing companies for their merger expenses. Since 1993, contractors have been entitled to one-third of what their mergers save the Pentagon - a subsidy that has cost hundreds of millions of dollars.

But in the view of defense officials, it was far better to have an orderly consolidation into a few large companies than a splintering into small companies that might not have the deep pockets, staying power or skilled staffs to finance and execute big multiyear procurement projects.

But the consolidation of the defense industry into what one analyst termed “the three gorillas” - Boeing, Raytheon and Lockheed Martin - brought warnings from some quarters of stifled competition and higher prices.

For instance, Lockheed is the prime contractor on the new Air Force F-22 fighter aircraft, and Northrop is secondary contractor on the new Navy fighter, the F/A-18 E and F.

“I think in the long term, you are going to end up with a classic duopoly that will raise the cost of procurement,” warned Lawrence Korb, a former defense official now with the Brookings Institution.

Analysts from Santa Monica, Calif., think tank Rand Corp., meanwhile, cited a new study showing that in periods of rapid innovation in air power, the smaller, hungrier rivals - rather than dominant firms - have come up with the winning designs.

There can come a point of too much consolidation; and many experts believe that with this deal, the defense world will have reached it.

With three companies competing in almost every area, there is less risk that the two firms will effectively collude to divide up the market between them in a way that raises costs and slows innovation.

Or as defense analyst Goure puts it, with three major companies, “You’ve got to be paying attention; with two, you’ve got to really watch it.”

A spokesman for Lockheed Martin was more blunt. A merger between any of the remaining three companies “would be pretty difficult to do,” said James Fetig. “I don’t think the government would allow it. It’s just not realistic.”


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