Pentagon Wises Up To Risks of Defense Mergers (LMT, BA, NOC, GD, RTN, UTX)

In a major reversal from a policy promoted in the early 1990s, the US Defense Department is now warning defense contractors to beware of mergers and acquisitions in the defense industry. The Pentagon actively encouraged such mergers following the end of the Cold War as the military was downsizing. But while the Pentagon may not want to see further consolidation, there may not be a lot the generals and admirals can do to stop it.

The nation’s largest defense contractors are Lockheed Martin Corp. (NYSE: LMT), Boeing Co. (NYSE: BA), Northrop Grumman Corp. (NYSE: NOC), General Dynamics Corp. (NYSE: GD), Raytheon Co. (NYSE: RTN), and United Technologies Corp. (NYSE: UTX). What the Pentagon fears, of course, is that consolidation will reduce competition and drive up prices for weapons and materials at a time of declining budgets. The Pentagon appears to be calling for more patriotism and reduced attention to the bottom line.

The Defense Department is also not thrilled with the announced intention of Northrop Grumman to spin-off its shipbuilding business following the Navy’s decision to lower its targeted fleet growth. As The Wall Street Journal points out, Northrop’s Newport News shipyard is the sole maker of US nuclear-powered aircraft carriers.  It’s not likely that the Pentagon will let a contract to a Korean or Chinese shipbuilder to build the country’s defense fleet.

And while there have been no reports of mergers within the industry, a rumor floated around last year that Boeing may merger with Northrop. Boeing denied the rumor, saying the company was focused on organic growth.

What the Pentagon claims to be seeking with its new comments on mergers is transparency in the event a merger is proposed. That’s a pretty vague requirement. After all, how much transparency does the Pentagon really want above and beyond that already required by the SEC? Probably not much, but what the Pentagon might be angling for is some more active role in reviewing just what effects might come from a big merger.

For example, in the absence of a competitive bidder for a particular item, might the Pentagon want to enforce a fuller disclosure of the cost to build the item, thus limiting the margin to the contractor? Perhaps more detailed information on bids would be a good thing, but if there is no US-based competitor, what’s the alternative? Either the Pentagon wants the item or it doesn’t? Outsourcing a new radar system to China is out of the question.

What the Pentagon wants to avoid is consolidation at the top of the defense contractor list. It would welcome transactions that make defense firms more efficient. Falling budgets mean that the Pentagon will need to get more for what it spends. That, in itself, will be a difficult transition.

Paul Ausick