Boeing aftershocks More mergers likely, but of second-tier defense companies

A shrinking industry

Northrop Grumman, Raytheon, Hughes may need partners

December 22, 1996|By Greg Schneider | Greg Schneider,SUN STAFF

Defense Secretary William J. Perry, a bookish-looking man with the public demeanor of a slightly distracted bureaucrat, walked into a Pentagon briefing room last month and set off a bomb in American industry.

His announcement of two finalists to build the fighter plane of the future drove the third-place company, McDonnell Douglas Corp. of St. Louis, into its recently announced merger with Seattle's Boeing Co.

This is something like the CBS television network surrendering itself to ABC, a dramatic reconfiguration of an edifice that seemed too big for such change.

The two remaining defense industry superpowers -- Boeing and Bethesda-based Lockheed Martin Corp. -- will square off not only over the contract for the Joint Strike Fighter, but over the major chunk of Pentagon business for the foreseeable future.

A former Clinton administration defense secretary, Les Aspin, foresaw this landscape at an infamous industry dinner in 1993 that has come to be known as "The Last Supper." Warning that the end of the Cold War would wither defense budgets, Aspin told executives that their companies would have to consolidate to survive.

Since defense spending peaked in the Reagan years, Pentagon spending on new hardware has shriveled more than 60 percent.

As a result, mergers worth more than $40 billion have taken place in the industry. Companies have cut about 700,000 jobs. The number of major military airframe builders has shrunk from about half a dozen companies to three, and only two of those are prime contractors.

On the one hand, the consolidation satisfies the goal of the Clinton administration that the industry position itself to compete in the global marketplace. Fewer, bigger companies can withstand business cycles and stare eye-to-eye with foreign government-sponsored competitors.

But many industry experts say the reconfiguration was inevitable even without the administration's vision. And while the gargantuan Boeing-McDonnell Douglas merger may culminate the process, it by no means completes it.

A whole second tier of large companies -- primarily Hughes, TRW, Raytheon and Northrop Grumman -- remains in flux.

Hughes Electronics and the defense operations of Texas Instruments are both on the market, soliciting bids just in the past week, according to analysts. Hughes is expected to command a price of close to $9 billion, Texas Instruments about a fourth of that.

No combination of those companies is likely to rival Boeing or Lockheed Martin, many experts agree.

"There's not enough remaining in the defense industry to form a third comparable player," said Andrew Krepinevich of the Center for Strategic and Budgetary Assessments in Washington.

But the same economies that drove the mega-mergers are dictating that more mergers take place on the junior level. And that will be hastened by Boeing's move.

"The Boeing-McDonnell Douglas earthquake has got to have aftershocks that are going to reverberate throughout the industry," said Byron Callan, a Merrill Lynch analyst. "If things were close or people were thinking they might like to do something, this should galvanize them into action."

Norman R. Augustine, chief executive officer of Lockheed Martin and one of the key architects of the remade defense industry, is a persistent cheerleader.

"I think there are two groups that really need to face reality here," Augustine said in an interview. "One is some of the U.S. companies that haven't cast their lot one way or the other. [The other] is the Europeans, which really badly need to face up to these issues -- overcapacity, the inefficient use of resources and so on."

The leading company on the second tier is California-based Northrop Grumman, itself the product of several good-size matings.

"They're sort of a mini-Lockheed Martin," said JSA Research Inc. analyst Paul Nisbet. By that he means the company is relatively diverse, with strong operations in military electronics and in aircraft subcontracting.

In fact, Northrop Grumman, with a sizable stake in McDonnell Douglas' construction of the F-18 Navy fighter, is the only other company with major airframe capability -- though it no longer takes prime contractor roles.

Analyst Stuart McCutchan, who publishes a newsletter called Defense Mergers & Acquisitions, sees little direct threat to Northrop Grumman from the Boeing-McDonnell Douglas merger. The company's subcontractor work on Boeing commercial aircraft and on electronics systems with Lockheed Martin and McDonnell Douglas should be secure, McCutchan said.

At the same time, Northrop Grumman continues to carry debt from its acquisition earlier this year of the former Westinghouse electronics and radar plant in Linthicum, and so is relatively poorly positioned to make another big purchase, McCutchan said.

Raytheon is widely said to be making an aggressive run at an acquisition, but McCutchan warned that federal regulators might look askance at Raytheon buying Hughes.

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