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Consolidating Defense
by Jim Surowiecki (Surowiecki)

And then there were three. With the July 3 announcement of LOCKHEED MARTIN's (NYSE: LMT) proposed $11 billion acquisition of fellow defense contractor NORTHROP GRUMMAN (NYSE: NOC), the Pentagon may very well find itself in a situation where it only ever does aerospace business with three companies: BOEING (NYSE: BA), which is in the process of merging with McDONNELL DOUGLAS (NYSE: MD); RAYTHEON (NYSE: RTN), which is putting the final touches on the acquisition of the defense operations of HUGHES ELECTRONICS (NYSE: GMH) and just closed the acquisition of the defense unit of TEXAS INSTRUMENTS (NYSE: TXN); and the new, improved Lockheed Martin. If officials at the Justice Department and the Federal Trade Commission were concerned about the absence of competition in the industry before, one can only imagine what they're thinking now.

Nonetheless, early indications are that the Lockheed-Northrop deal will ultimately be approved, although it seems likely that regulators may demand that the companies divest themselves of certain sections in which their businesses overlap. Raytheon, for example, was ordered to sell an important chip-making operation in order to gain Justice Department approval for its acquisition of TI's defense unit. And Northrop CEO Ken Kresa has already acknowledged that the new company may have to sell its electronic countermeasures -- radar jammers, warning devices, etc. -- business in order to satisfy antitrust concerns. Lockheed-Northrop will have a dominant position in the defense electronics business.

Certainly investors seem confident that the deal will go through. After the agreement was announced, Northrop shares rose $21 to $110, up 24%. Lockheed, on the other hand, saw its stock drop nearly five points to $99 1/8. The deal was structured as a straight stock swap plus assumption of debt. Northrop shareholders will receive 1.1923 shares of Lockheed stock for each share of Northrop. (Lockheed will also assume Northrop's $3.3 billion debt burden.) Oddly, this means that as Lockheed's share price drops, the deal becomes worth less to Northrop shareholders, even as Northrop's price rises.

The deal will create one of the world's largest defense manufacturers, and will culminate a succession of deals by both companies. Lockheed acquired the military jets division of GENERAL DYNAMICS (NYSE: GD) in 1993, merged with Martin Marietta in 1995, and then acquired Loral 1996. Northrop, meanwhile, bought LOGICON, INC. (NYSE: LGN)just three months ago, and acquired the defense unit of WESTINGHOUSE (NYSE: WX)last year, two years after buying Grumman. The new company will have more than $37 billion in revenues and more than 230,000 employees.

In many respects, this merger seems as much the product of necessity as of desire. Northrop Grumman had done its best to remain independent, and the company had repeatedly expressed its determination not to be bought out. But Northrop lost out to Raytheon in bids for both Hughes and Texas Instruments, and the Boeing-McDonnell Douglas merger promised to make Northrop's size even more of a competitive disadvantage. In addition, its largest single project, the B-2 Stealth Bomber, has come under intense scrutiny from Congressional budget-cutters, and it's not clear how many more B-2s the Pentagon will be ordering.

Some industry watchers thought Lockheed Martin might have been better off waiting to finish digesting Loral before embarking on yet another high-priced acquisition. Still, the Northrop deal was one that was next to impossible to turn down, particularly in light of Boeing's newfound strength. Acquiring Northrop allows Lockheed to broaden its business, most notably by beefing up its radar, missile electronics, and aerospace subcontracting operations. (Northrop actually works on many Boeing and McDonnell Douglas planes.) That may help cushion the blow if Lockheed were to lose the contract for the Joint Strike Fighter, a $170 billion project that is the last important defense contract of the century. Its lone competitor is, of course, Boeing.

While companies would almost always rather buy a competitor than have to fight, the recent flood of mergers in the defense industry are as much the product of new economic realities and state policy as they are of a coherent strategy on the part of the industry giants. Although the U.S. military budget remains astonishingly large relative to the rest of the world -- we spend more than four times as much on defense as any other country -- the end of the Cold War did bring about a dramatic reduction in the amount of money the Pentagon spent on the procurement of new weapons. By 1995, weapons spending had dropped to levels not seen since the Korean War, levels some 60% below those of the Reagan years.

The Pentagon had always encouraged defense companies to merge in order to eliminate overlap and the unnecessary duplication of efforts, but the reality of a much smaller procurement budget led the Defense Department to be more explicit about its attitude toward mergers. At a meeting in 1993, William Perry, who was then Deputy Secretary of Defense, told a group of defense industry executives that unless they joined with competitors, some of them would be driven out of business. While the Pentagon is almost the definitive captive market, it is a market that has shrunk considerably -- at least for contractors -- over the last five years.

The most notable changes include the decline in the number of different weapons systems the U.S. military uses and the growing standardization of U.S. jets. Over the next three decades, the Pentagon has said it will buy just three new fighter aircraft. One of those is the F-18A, built by McDonnell Douglas. One of them is the Air Force's new F-22, which Lockheed builds. And the third is the Joint Strike Fighter. By contrast, between 1950 and 1980, the Pentagon bought more than twenty different jets. It's not that the military has fewer planes. But it has fewer kinds of planes. And that means that there are fewer small contracts, the kind that can keep a company like Northrop or Martin Marietta in business, available.

Were the Pentagon to recommend, then, that the Lockheed-Northrop merger be rejected because of antitrust concerns, it would represent a startling turnabout in policy. While the Defense Department presumably wants some measure of competition in the bidding for its contracts, a desire that will keep Boeing and Lockheed Martin from merging, it clearly does not feel the need to deal with the 26 different aircraft companies it dealt with at the end of World War II. And while some have raised concerns about possible technological stagnation as a result of the reduction of the number of contractors, there's actually very little evidence to suggest that smaller companies are necessarily more technologically innovative. The persistently tenuous nature of military contracts -- which are subject to cancellation if policy changes -- means that even the largest companies have an incentive to deliver technologically sophisticated products.

At the same time, the Lockheed-Northrop deal fits into a pattern of recent mergers -- including Boeing/MD and British Telecom/MCI -- that have passed antitrust scrutiny because they have a greater impact on the global market than on the domestic market. While Lockheed Martin does most of its business at home, it's already aggressively lobbying to win contracts in Eastern Europe where it has a plethora of European competitors. Up to this point, antitrust regulators have seemed more interested in ensuring that there are strong American players in the global marketplace than in ensuring there are many different American companies. By that standard, this new merger qualifies.

In any case, while the antitrust laws remain crucial instruments to prevent the concentration of corporate power in areas that are essential either to democracy -- like the press -- or to consumer freedom, it's not clear what interest would be served by blocking a deal like Lockheed-Northrop, other than a general bias against bigness. The U.S. government, after all, is the only consumer in its market, and as such it has much more leverage than any individual consumer.

It's far from obvious that Lockheed Martin's future is now paved with gold. Boeing, with the addition of McDonnell Douglas, is a serious threat to Lockheed's core business. And it's not especially clear how the acquisition of Northrop helps Lockheed Martin deal with that threat directly. Before jumping on the Lockheed-Northrop bandwagon, it would make sense to replace merger mania with real analysis.

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