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New Threats Disrupt the Defense Industry

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War has been great business for America's defense contractors. Following a period of intense consolidation in the '90s, a handful of big aeronautics and technology companies have enjoyed a largely stagnant competitive landscape, high barriers to entry, and a major customer with bottomless pockets for more than a decade. Now, all of that is changing.

America's merchants of war face three major disruptions to their industry. A giant is forming in Europe as a merger is set to create the world's largest defense and aerospace company. Innovators from Silicon Valley are edging in on the defense market. Finally, deep budget cuts at the Department of Defense and beyond signal the end of the era of limitless money and bloated contracts. The future of the defense establishment, and their shareholders' investments, depend entirely on how each company responds and adapts to these threats.

Old rivals getting bigger
Last week, British defense contractor BAE Systems and the European conglomerate EADS, maker of the Airbus line of passenger planes, announced a plan to merge. The combined entity would balance the high-growth, volatile commercial-aviation segment with the reliable but declining defense-contracting business. The result would look a lot like Boeing (NYSE: BA  ) , which gets about half of revenue from defense and half from its passenger planes.

The major difference is that the European company would be bigger: The two companies brought in nearly $100 billion in combined revenue last year, while Boeing brought in just under $70 billion -- other American defense contractors brought in even less. If the merged company could leverage purchasing power and economies of scale to offer cheaper bids on government contracts, it would find itself with a huge advantage in winning business away from its American competitors.

Lockheed Martin (NYSE: LMT  ) CEO Robert Stevens seemed to hint that his company would try to fend off the new competition with legal challenges, telling investors that he expects a "very public review" of the deal by American regulators and that "by policy, [he doesn't] see the prospects for any consolidation opportunities at the top tier."

Ultimately, however, I expect the deal to pass muster with regulators. Contrary to Stevens' claims, the merger wouldn't represent significant consolidation in the defense business specifically. EADS' primary defense program, the Eurofighter Typhoon, is already run in partnership with BAE Systems. Further, though foreign government ownership in EADS and BAE Systems is an issue, BAE Systems is already one of the largest contractors to the American government and so has a successful track record of "ring-fencing" its activities within the company to comply with security demands.

Rather than employing lobbying tactics to stop competition, a better strategy is to take advantage of the period of internal integration the merger would require. Raytheon (NYSE: RTN  ) boss William Swanson claimed his company would gain market share in the short term, saying that during the merger, his competitors would be "trying to figure out how to make things work [internally] rather than looking up and figuring out how to make an opportunity out of the situation."

Young upstarts getting quicker
On the 21st-century battlefield, information is becoming more critical than bombs. This trend toward high-tech information and communications systems has been apparent for some time: Since Lockheed spun off its "undesirable" electronics segment in 1997 into L-3 Communications (NYSE: LLL  ) , that business has outperformed its former parent by a factor of six.

Even L-3, though, seems unprepared for today's new competitors. For example, Peter Thiel -- a tech tycoon better known for founding PayPal and bankrolling Facebook -- is now positioned to be a major figure in defense. His firm Palantir Technologies (yes, that's a Lord of the Rings reference) sells an off-the-shelf product, Palantir Government, that can be used to analyze battlefield data. The program competes directly with the military's in-house data-analytics platform, DCGS, a $2.3 billion program developed and serviced by the likes of Raytheon, Lockheed, L-3, and Northrop Grumman (NYSE: NOC  ) .

Despite the lobbying clout of the traditional defense contractors, Palantir has some powerful proponents, including multiple members of Congress and the head of the Defense Intelligence Agency. As defense becomes more about data, the traditional contractors are going to have to think and act less like manufacturers and more like tech companies: nimbler, more innovative, and less hidebound.

Major customer getting poorer
More than any other threat, defense contractors have to figure out how to grow their business when the U.S. government, a customer that generates between 50% and 90% of revenue for these companies, is facing steep budget cuts. Unless Congress and the president act soon, the defense budget is in line to shrink by more than 9% next year. While contractors are working quickly to cut costs and diversify their revenue streams, ultimately the political situation is more dependent on who wins this year's election than anything the companies can do.

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Fool contributor Daniel Ferry has no position in any of the companies mentioned above. The Motley Fool owns shares of Raytheon, Lockheed Martin, L-3 Communications Holdings, and Northrop Grumman. Motley Fool newsletter services have recommended buying shares of L-3 Communications Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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