Should Giants Rule the Defense Biz?


By Stan Crock Think of it as the Lockheed Martinization of Northrop Grumman (NOC). That's the peril posed by Northrop's July 1 agreement to buy TRW (TRW) for $7.8 billion, plus the assumption of $4 billion in debt. The deal, which would make the Los Angeles-based giant one of the defense industry's Big Three, could replicate some of the ills that befell giant Lockheed Martin (LMT) during its buying binge. The merger also raises some serious issues about the defense industrial base that the Bush Administration, by most industry accounts, has largely ignored.

Back in the 1990s, Lockheed Martin was the defense industry's peerless predator, gobbling up company after company and growing into the nation's, indeed the world's, largest defense contractor. But the wheels fell off as soon as the merger mania stopped, when the government vetoed Lockheed Martin's 1997 proposal to buy Northrop.

Norman Augustine, the visionary Lockheed Martin CEO who had masterminded all those acquisitions, retired and wasn't around to manage what he had wrought. Blending together the companies consumed management to the point that execs lost their focus on production quality, which suffered. Result: Unpleasant earnings surprises mounted.

SUSPICIOUS MINDS. At the same time, Lockheed Martin's monopolies or dominance in many niches were a cause of growing concern. And its purchase of suppliers -- known as vertical integration -- riled its Pentagon customers, other suppliers, and competitors. The Pentagon and rival component makers felt they would not get a fair shake because Lockheed Martin was likely to buy parts or supplies it needs in-house, regardless of price or quality.

Bethesda (Md.)-based giant promised that vertical integration wouldn't be a problem and that it would continue to buy from and sell to anyone, without discrimination. But suspicions ran so deep that the Pentagon and Justice Dept. turned down Lockheed Martin's bid for Northrop.

Meanwhile, rival prime contractors were wary of buying from Lockheed Martin. They worried that they might not get the best price or quality, and in any event they didn't want to help a competitor. In the end, Lockheed Martin divested some of its suppliers, including Sanders Electronics.

INDIGESTION. Fast forward to today. The parallels between Lockheed Martin and Northrop Grumman are stunning. Northrop Chairman and CEO Kent Kresa will retire when the hard part of digesting the recent spate of acquisitions is just beginning. Those purchases include Litton Industries last year for $5.1 billion (with $1.3 billion in assumed debt) and Newport News Shipbuilding earlier this year for $2.6 billion (with $500 million in debt.

The defense industry's record for digesting other companies without burps isn't great. In addition to Lockheed Martin, Raytheon (RTN) and to a certain extent Boeing (BA) have had similar problems. And as has been all too obvious lately, American business in general hasn't been too adept at handling merger-driven growth -- or at managing companies once that growth ends.

Another similarity to Lockheed Martin is that Northrop will be a dominant force in many areas, especially shipbuilding. According to some military estimates, by 2006 or so, Northrop Grumman will control 75% of all shipbuilding and a similar percentage of the electronics that go into ships. It builds all the $5 billion aircraft carriers, dominates amphibious shipbuilding, and builds half the submarines and destroyers.

LAST OF THE INDEPENDENTS. Vertical integration will be an issue, too. TRW makes high-end military-satellite payloads, including communications and intelligence gear. Hughes, which is owned by Boeing, is the only other producer, but Boeing won't sell to other companies. If Northrop decides to merge its capabilities with TRW's and becomes another prime contractor for satellites, no independent payload vendor will be left. That would hurt companies like Lockheed Martin, which now may see the problems of vertical integration from the other side.

All of this raises the broader question of what competition in the defense industry should look like in the future. Sources say the Pentagon has set up a special panel to probe the Northrop deal, co-chaired by Douglas Larsen, a deputy general counsel, and Suzanne Patrick, Deputy Under Secretary for industrial affairs.

Defense Dept. officials have to look beyond this one deal, however. They should examine not just the supply of contractors but also the demand for hardware and services from the Pentagon. Current demand simply isn't enough demand for current supply -- and certainly not enough to support competition in many areas. That could mean consolidation in some areas but not in others.

SHARE AND SHARE ALIKE? Take submarines. Bush Administration officials have been promising to build three a year. Now it looks like that may dwindle to one. Should the two submarine-building shipyards still in operation swap the hull at midyear? What does one do while the other builds? Twiddle thumbs for six months? Such issues must be addressed.

It's still anyone's guess how the Bush Administration will come down on the Northrop-TRW deal. When General Dynamics wanted to buy Newport News Shipbuilding, the Bush team balked at the hammerlock the combined company would have over Navy programs. In the end, though, Northrop won Newport News, producing its own dominance. The government could nix this latest deal on the grounds that it would reduce competition in some key areas. That would be the legal rationale.

Fears about the management challenge of integrating so many companies so quickly -- a policy rather than legal concern -- also could play a role. So could concern that with three huge players, the middle tier of defense companies will simply fall by the wayside. Saying no to this merger would send a signal that the Administration wants to preserve these midsize players, though it could come at the cost of higher overhead expenses than would normally be justified.

BUILDING A BASE. One way or another, sooner or later, government intervention will be required. If the Bush team lets this deal go through, it will have to deal with concerns that a prime contractor will favor in-house suppliers. One option would be to go back to the way components used to be bought.

In the past, a lot of "government-furnished equipment" was used on planes, ships, and tanks. A company would win the prime contract, but the Pentagon would enter into separate contracts for components and tell the prime contractor which gizmos to put in the weapons system. More recently, the prime contractors controlled the process. But if the Pentagon fears it won't get the best price and quality, government-furnished equipment could be the nostrum. Such a level playing field also would give midsize companies an incentive to stay in the game.

The Pentagon's civilian leadership no doubt would prefer to be spending its time planning operations against Al Qaeda. But they must face these consolidation issues now, or face them later. The markets will force the Administration's hand. The Northrop-Grumman deal isn't likely to be the last to appear on the Bush team's radar screen. The sooner the Pentagon develops an approach to these basic questions, the better off the industry, the military, and the nation's security will be. Crock covers national security and foreign affairs for BusinessWeek from Washington. Follow his views in Affairs of State twice a month, only on BusinessWeek Online


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