Advice to Defense Industry: Consolidate or Die

The extent of upcoming cuts to U.S. defense spending remains tough to predict. But one thing appears certain: Budgets for new weapon systems will be heading south, and the arms-making industry still has no coping strategy, analysts warn.
Defense contractors are facing a potentially devastating 50 percent drop in U.S. military weapon buys over the next decade, and unless the industry begins to consolidate soon and shed excess capacity, it could be headed for financial disaster, says Marty Bollinger, director of Booz & Company’s aerospace and defense practice.
A substantial drop in procurement funds already has occurred, although it has been largely unnoticed, Bollinger says. During the past three years, the procurement budget has fallen by more than $40 billion — including both the base budget and war-emergency supplemental funding. “It’s only now beginning to affect industry because it takes a while for changes in the budget to work their way through the spending process,” he says.
Because the Pentagon is still spending unprecedented amounts overall, the average observer would not realize thatfunds for new weaponry has been on a downward slide. Overall, the base budget for the Defense Department has soared from $480 billion in 2008 to $553 billion requested for 2012. During that same period, procurement funds fell by $41 billion.
That trend only will accelerate as other priorities within the Pentagon’s budget continue to squeeze procurement accounts, says Bollinger. One of the rules of Pentagon budgeting is that for every dollar spent on new equipment, you need two dollars for personnel, operations and maintenance. Simple math says that if the top line does not increase, if personnel, operations and maintenance go up by 1 percent, acquisition must go down 2 percent. “We are going to see acquisition budgets go down pretty substantially as the money gets eaten up,” he says.
Under the best-case scenario, there could be a 30 to 40 percent reduction in the amount of military equipment that will be developed and purchased over the next five years, Bollinger says. That level of decline is not unlike what happened in the two previous defense downturns, when procurement spending dropped by 50 percent each time.
“The question on the table is how can industry possibly cope with a loss of half their market?” he asks. What helped the industry survive the past two cycles was a massive consolidation that wiped hundreds of companies from the sector.
Bollinger cautions that companies this time around will be in a tougher spot because the Defense Department’s industrial policy is anti-consolidation. Pentagon leaders already have announced they would oppose mergers of major contractors. According to Frank Kendall, deputy undersecretary of defense for acquisition and technology, the top tier of the industry is off-limits. “We do not believe additional consolidation would be in the interest of the department or the nation,” Kendall tells a Senate Armed Services Committee hearing in May. With regard to lower-tier suppliers, mergers would be assessed on a “case-by-case basis,” Kendall says.
Bollinger does not see how many companies will survive the coming lean times without a big wave of mergers and acquisitions. The Pentagon’s stance “worries me,” he says, because it implies that the department is willing to spend money to sustain unneeded industrial infrastructure and, as a result, is fomenting a “hollow industrial base.” On the surface, the industry would look fine, until you peel off the layers and you see that the capability has evaporated, he says. If they cannot consolidate, companies will founder because there will not be enough new programs to keep everyone in business.
Companies will have “names on the front of the building but behind it, there will be no engineers,” says Bollinger. “That is what worries me about the current industrial policy.”
Even if mergers are allowed at the lower tiers, that is not going to address the excess capacity problem of large prime contractors, which receive most of the procurement dollars. The Defense Department mistakenly believes that industry can seamlessly reduce capacity when buying falls, he says. “Capacity only gets reduced when companies rationalize and shrink corporate overhead.”
Some firms already have laid off employees in an effort to trim overhead costs, but that does not go nearly far enough, Bollinger says. To remain competitive in a smaller market, companies will need to close idle factories, unproductive operations and the infrastructure that goes along with that.
Pentagon officials’ reticence on industry mergers ignores reality, he says. The Navy, for instance, has kept two nuclear shipyards open even though there is hardly enough work to keep one alive. Over the past two decades, two parent companies, General Dynamics and Northrop Grumman, acquired two major shipyards each, but did not shed excess capacity, and the sector is now due for major downsizing, Bollinger says. “We have not had a shipyard leave the business in about three decades. … since Lockheed Martin closed one in 1988,” he says. “Competition is a very useful thing if you have frequency of programs and sufficient business to allow multiple competitors to stay alive.”
Given the budget outlook, the Pentagon will not be able to subsidize multiple competitors, and may have to resort to the arsenal model of single suppliers, which is already how many weapon systems are being bought, he says.
A more sensible option would be to allow existing prime contractors to consolidate so they can compete against new non-traditional suppliers, says Bollinger. Already there has been a surge of participation by foreign suppliers and by companies that a few years ago didn’t consider themselves traditional defense contractors, he points out. Most of the armored trucks that the Pentagon has bought for the Iraq and Afghanistan wars were foreign designs. The last helicopter the Army bought is a French design. The last aircraft bought by the Air Force is Italian. The last three trainers the U.S. military bought were foreign models. Both variants of the Navy’s littoral combat ship are being made by shipyards owned by foreign parent companies. Commercial truck manufacturer Navistar now has a $4 billion defense business.
The government tends to focus on the “legacy” supply base and on maintaining competition there, he says. That is unrealistic, he adds. The more new entries into the market, the easier it will be for the traditional defense suppliers to make the case to the Pentagon that they should be allowed to consolidate so they can survive and grow, he says. The defense industry “is going have difficulty attracting risk capital and attracting talent unless there’s a mechanism that allows them to grown,” Bollinger says. “In a down market, that would be consolidation.” During the last downturn, between 1988 and 1995, the industry managed to provide 16 percent annual return to shareholders because of aggressive mergers and acquisitions, he says. “The ones that didn’t do anything had negative returns.”
The Pentagon’s anti-mergers industrial policy assumes that top tier suppliers are in no financial danger. Although these firms might be in solid shape today, in the absence of new programs, they will wither, Bollinger says. He suggests the Pentagon should call for a BRAC-like base closure process for industrial facilities. That would help companies sidestep the political landmines associated with shutting down facilities. “They’re terrified of losing support from their congressional delegations,” he says. If all the unneeded facilities were put on one list, Congress would have to vote aye or nay on the whole thing.
Aerospace and defense industry analyst Scott Thompson, of PricewaterhouseCoopers LLP, anticipates a wave of consolidation sometime in the near future, although not as quicklyas other experts had predicted.
According to PwC’s quarterly mergers and acquisitions report, in the second quarter of 2011 there were 13 deals worth $5.3 billion, compared to nearly $10 billion in deals for the first quarter.
“Deal activity during the second quarter declined somewhat from the first quarter of 2011, but this appears to be more of a result of the robust nature ofM&A activity during the first quarter than the start of a long-term trend,” said Thompson. “Defense companies continuing to reshape their portfolios, ongoing appetite from investors in the booming commercial aerospace sector and the growing stockpiles of cash on corporate balance sheets are all factors contributing to our M&A growth expectations in aerospace and defense.”
The consolidation tidal wave that many analysts had forecast probably hasn’t happened yet in the defense sector because companies are still shedding unwanted businesses. Just in the past two to three years, for example, Northrop Grumman sold off its TASC defense consulting firm and its shipyards. L-3 in July announced it would spin off its government contracting business, although not the cybersecurity and defense intelligence divisions. ITT also divested its defense segment.
“What we’re seeing is a lot of breakups” rather than mergers, Thompson says.
But he sees mergers on the horizon. “A fundamental economic law is that in a period of contraction, you are going to have consolidation. You haven’t seen it yet because defense companies are now focusing on rebalancing their portfolios,” Thompson says. Whereas the commercial aerospace sector has seen far more corporate takeovers as a result of aggressive revenue growth, the defense segment has been moving slower because investors see revenue contraction.
Many potential buyers are holding back until the current budget dust storm settles. “There is a lot of talk about reductions in the defense budget. But what does that really mean?” Thompson asks. “Some of this uncertainty has caused companies to delay consolidation.
Analysts’ wary forecast for the industry contrasts with Pentagon officials’ rather upbeat rhetoric. Undersecretary of Defense Ashton Carter said in numerous public speeches and briefings to defense contractors that he expects industry to carry on and to continue to make profits even in a downturn. At the Senate hearing, Kendall reassured lawmakers that the industrial base is not going to collapse. “It should be clear that while we anticipate significant change from the environment of the last decade or so, the sky will not fall on our defense industry. … Even given the reductions that the president has asked us to examine, we believe that there will still be large and fairly stable markets available for the defense industry. We do not foresee a precipitous decline, like the one that the department and industry experienced at the end of the Cold War.”

Topics: Business Trends, Mergers and Acquisitions, Defense Department, DOD Budget