Industrial Consolidation

The Defense Industry in Perspective

2. Industrial Consolidation

As the Department of Defense faced the high costs of maintaining the many excess aircraft plants, shipyards, and missile plants that were languishing because of a greatly reduced demand, government defense leaders began to encourage defense- industry consolidations. The best-known call for consolidation came in 1993, when then Deputy Secretary William Perry announced (at the famous Last Supper with industry senior executives) the need for defense-industry consolidation. He also stated that the government would subsidize this behavior by allowing consolidation costs to be reimbursed as overhead costs — as long as the savings to the government could be clearly projected and as long as competition was still maintained within each sector of the industry.

Given declining DoD procurements and their negative effects on the industry, there was great rejoicing in the industry over the opportunity to consolidate. This enthusiasm was matched by Wall Street (where investors made millions on each major defense-industry merger or acquisition). The merger wave began in the late 1980s but accelerated enormously as the defense budget plummeted in the 1990s (fi gure 2.7).

Figure 2.7 shows some major acquisitions by fi ve large defense contractors, but these fi ve fi rms absorbed over fi fty previous entities. These mergers and acquisitions occurred both horizontally (such as the McDonald Douglas and Boeing combination in the aircraft industry or the Hughes and Raytheon combination in the missile industry) and also vertically (such as Lockheed ’ s acquisition of Loral and Northrop ’ s acquisition of Westinghouse). Within a decade, many major defense suppliers and many more major subcontractors had been consolidated into a handful of dominant defense fi rms. (From 1993 to 1999, the number of top defense suppliers went from thirty-six to eight, and from 1994 to 1997, the volume of defense merger and acquisition dollars increased from $2.7 billion to $31.2 billion.) ³⁷ The defense

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1993 1987 RCA1986 1986 1996 1987 1989 1990 1991 1992 1993 1995 1998 Figure 2.7 Defense-industry consolidation, 1986 to 2001. Source: Adapted from “ A Blueprint for Action, ” Aerospace Industry of America Association (AIAA), Defense Reform 2001 Conference, February 14 and 15, 2001, Washington, DC.

industry borrowed to make these acquisitions, and its debt level also rose dramat- ically — from $15 billion in 1993 to $43 billion in 1999. For example, in the second quarter of 2000, Lockheed Martin had a debt-to-equity ratio of 175 percent as a result of the large number of acquisitions that it made during the consolidation period, ³⁸ and its bond ratings were plummeting. In this same period, Lockheed Martin ’ s bond rating fell from A to BBB-, and Raytheon ’ s went from AA to BBB-.

During this consolidation orgy, a defense fi rm had several strategic choices. It could (1) buy up other fi rms to take a larger share of the shrinking market, (2) diversify by building up a commercial business along with its defense business, (3) sell off many of its defense elements (for the high cash value that they were bringing in) and focus on a narrower defense area, or (4) simply get out of the defense business (if it had a large amount of commercial business).

Considering these options in inverse order, a signifi cant number of fi rms simply exited the defense business. In the high-technology companies, these included Cali- fornia Microwave, GTE, Hughes Electronics, IBM, Lucent, Magnavox, Phillips, and Texas Instruments. In the large industrial companies, there were Allegheny, Tele- dyne, Chrysler, Eaton, Emerson, Ford, General Electric (except jet engines), Tenneco, and Westinghouse. Because of the complexity of government rules (ranging from specialized accounting to concerns about propriety rights), many technology-rich companies (such as Hewlett Packard, 3-M, and Corning) declined to participate in critical research and development projects of the Defense Department, even though they continued to sell their commercial products to the DoD. Many observers (this author included) were disappointed when the defense industrial base lost these com- mercially oriented fi rms (because of the loss of their often more advanced technolo- gies and their lower-cost design orientation), but these fi rms saw defense business as unattractive due to low profi ts, excessive regulation, and shrinking markets.

For fi rms that countered the defense-budget declines by shifting their resources into the commercial world, the record is spotty. ³⁹ Because of the signifi cant differ- ences in the cultures of the defense and commercial environments (particularly in marketing, fi nance, and the defense engineering emphasis on maximum performance at any cost), diversifying into the commercial world has proven diffi cult and largely unsuccessful (although several fi rms have been successful at converting). ⁴⁰ In general, the overall success rate (of both commercial and military mergers and acquisitions) appears to average around 35 percent, but it has been signifi cantly higher (around 70 percent) when a few fi rms attempted conversion in areas that were closely related to their mainstream businesses. For many defense fi rms, as William Frickes, head of Newport News Shipbuilding, told the author in March 1998, “ Quite bluntly, [commercial diversifi cation] has not worked! ”

Most fi rms chose the mergers and acquisitions route as either the acquirer or the acquiree. Although the rationales for this approach (including synergism, greater

capital availability, more market power, and greater economies of scale) seem appealing, the empirical data on mergers and acquisitions demonstrate are that they have been largely unsuccessful. ⁴¹ The diffi culty of absorbing different corporate cultures and the lack of management knowledge of the new businesses have proven to be extreme barriers to the desired twenty-fi rst-century characteristics of the con- solidated defense fi rms. (In fact, a McKenzie study ⁴² of mergers and acquisitions by defense fi rms showed an 80 percent “ unsuccessful acquisitions ” record.) Nonethe- less, the Government Accountability Offi ce (GAO) found that, as a result of the defense industry consolidations that took place, the Department of Defense saved more than $2 billion in three years. ⁴³

Consolidating plant activities (both within a fi rm and across acquired fi rms in the same business) was an obvious area for potential savings. But most fi rms chose not to make the plant-consolidation moves — for political reasons (they wanted to satisfy local employment issues), for reasons of optimism (they hoped that budgets would return to high levels and their plants could again operate at full capacity), and for reasons of pessimism (they feared that they would incur signifi cant costs in moving and consolidating the facilities, even though many costs would have been covered in allowable overhead expenses against their defense contracts). Most fi rms chose not to make the plant-consolidation moves. Lockheed Martin continued to build its new F-22 fi ghter aircraft in Georgia while building its new F-35 fi ghter aircraft in Texas; Boeing continued to build aircraft in Missouri, Washington, and California; Northrop Grumman built ships in Mississippi and Virginia; and General Dynamics built ships in Maine and Connecticut. Keeping these plants running at low volume was not as effi cient as integrating these operations, but consolidation was politically diffi cult and was usually not done. There were some exceptions, however, in which the benefi ts to the government were realized. For example, Ray- theon consolidated its missile production in its facility in Tucson, Arizona, and the Defense Department saw weapons ’ price reductions of up to 25 percent, thus saving the Department of Defense over $2 billion on long-term missile productions. ⁴⁴ Because the prices paid to the producer are based on their costs for each year, the fi rms shared very little in the benefi ts realized from these savings and therefore had inadequate incentives to achieve the benefi ts from the consolidations.

One adverse affect of consolidation was the restructuring of the industry by size — a few large fi rms and a signifi cant number of small fi rms (which were being supported largely by mandated set-asides for small businesses). The increasing dis- appearance of the midsized fi rms was notable because formerly they often repre- sented competition for some of the larger fi rms. The industry was being bifurcated by the acquisition or loss of the midsized fi rms, which were absorbed by the few remaining large fi rms or which left the defense sector because they were unable to compete. This was particularly true in the service sector. From 1995 to 2004, the

value of the federal service-industry contracts going to midsized fi rms shrank from 44 percent to 29 percent, and those contracts going to midsize fi rms in the critical information and communications technology services sector shrank from 29 percent to 13 percent. In both cases, the shrinkage occurred primarily when large fi rms took over that share of the business. ⁴⁵

The defense-industry consolidations had a major negative effect on employment.

From 1990 to 1995, defense-industry employment fell by a half million people. ⁴⁶ These large layoffs in the defense sector and the growing technology boom in the civilian sector (particularly in information-technology areas) led to severe declines in the numbers of graduating engineers seeking employment in defense. In 1990, graduating technology students listed aerospace and defense as their third most popular career discipline, but by 1998, this choice had slipped to number seven in their rankings, being replaced by telecommunications, Internet, biotechnology, and other similar disciplines in the commercial fi eld. ⁴⁷ In addition to losing new tech- nologists, many skilled workers from the defense industry were leaving to join the growth industries of the commercial market.

With declining budgets and the considerable excess capacity that existed in defense plants, there were signifi cant reductions in capital expenditures by the defense industry. Perhaps even more important for the long term, there was also a signifi cant reduction in company-sponsored independent research and development (IR & D). From 1994 to 1999, for example, the percentage of sales spent on IR & D by defense fi rms dropped from 4.1 percent to 2.9 percent, and since sales were declining rapidly, total IR & D was a smaller percentage of a smaller number, i.e., an adverse “ multiplying factor. ” ⁴⁸

Perhaps surprisingly, during this period of dramatic defense budget reductions and driven by the consolidations that Wall Street tends to favor, defense stock prices actually soared. Between the last quarter of 1990 and the fi rst quarter of 1998, defense stocks produced a return of 664 percent, which compares favorably to 324 percent for that period for Standard and Poor ’ s 500 Index. ⁴⁹

By the end of this defense budget down cycle, there was growing concern within the Department of Defense about the trends that were appearing in the defense industry. ⁵⁰ First, there were growing concerns that in many sectors of the defense industry, the number of fi rms had been reduced to only two or three major fi rms in each critical area of defense needs and that there was the threat of going down to one. Second, after the period of Wall Street exuberance over the merger and acquisi- tion activities of defense fi rms, several fi rms were not meeting their earnings expec- tations (for a number of reasons), and their stock prices began to plummet. Third, many fi rms that had the choice were leaving the defense sector and going to the commercial area, thereby increasing the isolation of the defense sector from the rapid advances of commercial technology and from the exploding market growth

in the commercial technology sector. Finally, outmoded export-control policies and practices continued, and many believed that the defense sector should and could remain autarkic — a self-suffi ciency that was clearly counter to the needs and realities of the growing focus on coalition warfare and industrial globalization. Steps had to be taken to address these four areas.

First, in terms of competition, the Defense Department, the Justice Department, and the Federal Trade Commission were increasingly concerned about the declining number of fi rms that were available for competition in the defense sector. Even so, they allowed the consolidations due to the shrinkage in available business and the uniqueness of the defense market structure (a monopoly buyer and a small number of oligopoly suppliers that fought fi ercely for the few, infrequent, and declining numbers of major procurements). The regulators reasoned that if the only customer (the DoD) was satisfi ed with the limited competition and if the cost of maintaining additional potential suppliers was prohibitive, then they would not object to the consolidations on antitrust grounds. The DoD assured them (as Secretary Perry had stated) that it would allow consolidations only if they reduced costs to the DoD and if adequate competition will still exist after the mergers and acquisitions. It was noted that there had always been fi erce competition for DoD ’ s aircraft engines, even when only two suppliers (General Electric and Pratt & Whitney) dominated the U.S. defense business (and with Rolls-Royce of England available if needed). Thus, it was agreed that two or three competitors would be adequate for competition in each critical sector and that the shrunken defense market could not support more than that. As the shrinkage continued, the Department of Defense began to monitor more carefully priority, critical technologies and to create protection (or watch) lists to monitor loss of U.S. technological leadership and the adequacy of U.S. suppliers (by 2005, nine critical sectors were being tracked).

Eventually, the consolidation of defense fi rms would have to come to an end since the government would not allow consolidation from two fi rms to one (from a duopoly to a monopoly) in any critical defense sector. This was demonstrated by both the Defense Department and the Justice Department when they would not allow General Dynamics (which had already bought the Electric Boat nuclear submarine facility) to buy the Newport News Shipbuilding facility — which was the only other shipyard capable of building nuclear submarines. The remaining choice for the major defense fi rms was often to buy up lower-tier defense suppliers (the subsystem and critical-component fi rms). However, when there was a threat that two suppliers were at the point of going to only one supplier in any critical subtier sector, the government again had to step in — as when it stopped the proposed Lockheed Martin and Northrop Grumman merger (not so much because of anti- competitive considerations at the prime contractor level but because of the threat of creating monopoly suppliers at the lower tiers and because of vertical-integration

considerations). ⁵¹ This proposed merger helped to make visible a growing concern regarding vertical integration. If one prime contractor owned or acquired the only (or even the acknowledged best) supplier of a critical subsystem, then it would be at a signifi cant competitive advantage against other prime contractors, which would not (as the result of the merger or acquisition) have access to that subsystem sup- plier on future large weapon-system bids. The prime contractors that were propos- ing the merger or acquisition of the lower-tier supplier usually argued that their acquired subsystem division would be a merchant supplier to anyone bidding against their parent fi rm. This argument was not felt to be credible. Nonetheless, perhaps surprisingly, the military services often favored the merger of the two remaining suppliers since they believed that this would result in less overhead to be carried (in spite of the empirical evidence that the lack of competition results in rising prices). In the end, they argued that they “ could not afford to carry both suppliers. ” ⁵² Nonetheless, the services ’ positions on these issues often had to be overridden by the offi ce of the secretary of defense in combination with the Justice Department or Federal Trade Commission, based on long-term antitrust arguments. ⁵³

Because fewer and fewer new defense programs were being initiated during this downturn, the small number of remaining fi rms in a given sector often attempted to team to ensure that they would get at least part of each program (since a com- petitive loss might mean that they might have to wait a decade or more for the next big opportunity). For example, when the navy was planning to purchase a new destroyer, ⁵⁴ Lockheed Martin Corporation, Bath Ironworks, and Ingalls Shipbuild- ing put together what they categorized as the dream team (with Lockheed being the systems integrator and the only two shipyards in the destroyer business providing their expertise). The navy favored this dream team, and it was strongly supported by the congressional delegations from each of these industry suppliers. The offi ce of the secretary of defense, however, insisted that competition between the two shipyards must take place so that the DoD would benefi t from the innovations and lower costs that come from competition. The navy subsequently agreed that it benefi ted signifi cantly from the competition.

Wall Street ’ s immediate reaction to these events — the slowing down of the merger and acquisition trend, the industry ’ s low profi ts, and the high debt problems in the industry — was a severe erosion in the defense fi rms ’ stocks. Lockheed Martin ’ s stock price declined from nearly $60 per share in mid-1998 to under $20 in the closing days of 1999; Boeing lost a third of its market value between April and September of 1998; Raytheon ’ s stock plummeted 43 percent in one day during the fall of 1999; and Northrop Grumman ended the decade trading at $59 a share, far below the $139 it reached in early 1998. ⁵⁵ By the end of the decade, the fi nan- cial condition of the defense industry was of increasing concern. As the Wall Street

Journal commented in December 1999, “ Some of the Defense Industry ’ s biggest players, including Lockheed Martin and Raytheon, are struggling. Eight years of consolidation has left these companies with large debt loads, low stock prices, and weak earnings. Pentagon and industry offi cials have questioned whether these weakened giants can make the necessary research investments to maintain a U.S.

technological edge. ” ⁵⁶

Both Congress and the DoD realized that signifi cant steps were required to slow down the mergers and acquisitions. Also of concern were the health of the industry and the growing separation of the commercial and military markets. To address the former of these issues, the DoD continued to pursue its acquisition reforms and signifi cantly stepped up its business reforms (which were aimed at ensuring a healthier defense industry while still maintaining the benefi ts of com- petition). Additionally, there was widespread recognition that the cuts in procure- ment had gone too far, so the budget began to rise. In 2000, there was a signifi cant upturn in the price of defense stocks (for example, Newport News increased 81 percent, Boeing 58 percent, Lockheed Martin 46 percent, Northrop Grumman 46 percent, General Dynamics 33 percent, and Raytheon 29 percent — in a period when the Standard and Poor ’ s 500 went down by 6 percent and the NASDAQ went down by 23 percent). Additionally, the White House, under Vice President Al Gore, conducted a review of government business (known as the National Performance Review) with an eye toward effi ciency, responsiveness, and transpar- ency. This review emphasized simplifying the government ’ s acquisition procedures and relying more on the commercial marketplace. Under DoD Secretary William Perry, these themes began to be implemented within the Pentagon (led by a new organization, created by Secretary Perry, with a deputy undersecretary of defense for acquisition reform). Congress also recognized the importance of trying to bring commercial fi rms into defense business, and it passed legislation streamlining pro- curement and the increased use of commercial products. Legislation such as the Federal Acquisitions Streamlining Act (FASA) and the Federal Acquisition Reform Act (FARA) emphasized the procurement of commercial items by the Department of Defense.

These initiatives were continued under Secretary of Defense William Cohen ’ s leadership. The “ revolution in business affairs ” emphasized the use of commercial best practices, reductions in the size of the DoD infrastructure, and increased use of contracting for DoD services (of a “ non-inherently governmental ” nature) from the private sector. These growing concerns about the structure of the defense indus- try led to a series of studies by the independent Defense Science Board, including a 1997 study of vertical integration and a 1998 study of globalization. The secretary of defense ’ s offi ce also issued a series of policy statements — for example, on an anti-competitive teaming policy (1999), a subcontractor competition policy (1999),