Should Investors Worry About Defense-Industry Consolidation?

The government advocated mergers in years past, but that push makes it harder for companies to get deals done today like United Technologies/Raytheon.

Lou Whiteman
Lou Whiteman
Jun 16, 2019 at 11:31AM
Industrials

The surprise announcement that United Technologies (NYSE:UTX) intends to combine its aerospace assets with Raytheon (NYSE:RTN) to create a new, $75 billion sales behemoth has put the entire aerospace industry on notice and has turned heads both on Wall Street and in Washington, D.C. The deal marks the return of the megamerger to the defense sector after a 20-year lull and raised questions about whether that return is a welcome development.

President Trump is among the skeptics. In comments made on CNBC shortly after the deal was announced, he said he's "a little concerned" about the combination, complaining about the lack of competition on key weapons-development programs.

A Patriot missile battery launches.

Raytheon Patriot Missile launch. Image source: Raytheon.

Expect to hear a lot of similar comments in the months to come, as well as a broader discussion about the impact of consolidation on the defense sector and what can be done about it. With that in mind, here's a brief history of how we got here and what to expect next.

The last supper, then a feeding frenzy

The president is correct in saying the number of U.S. defense contractors shrunk dramatically in a short period of time. And at the time, the changes were exactly what the government ordered.

In the early 1990s, the Cold War was over and Washington was eager to shift spending away from defense and toward domestic priorities. The Pentagon, however, was concerned it would end up starving its industrial base. In 1993, Secretary of Defense Les Aspin convened a dinner meeting with more than a dozen CEOs that became known as the "Last Supper" and told the gathering that he saw a need for only half the number of existing contractors.

With the Pentagon giving the green light, the industry reacted. During a five-year period, more than $55 billion in acquisitions involving more than 50 targets were announced, and storied aerospace names including McDonnell Douglas, Rockwell, Hughes, Allied Signal, Loral, and Vought were folded into the five primes still in business today.

A summary of the companies that now comprise the five defense primes.

A sampling of the companies that were combined to create the five remaining defense primes. Image source: Lou Whiteman, from company documents.

The Pentagon finally hit the breaks in 1998, when regulators rejected Lockheed Martin's attempt to acquire Northrop Grumman. Smaller deals were still allowed: Northrop, in particular, was allowed to assemble a strong shipbuilding business, eventually spun out as Huntington Ingalls through a series of purchases in the early 2000s. But the industry's top titans, a list that also includes Boeing and General Dynamics, have largely looked the same for the last 20 years prior to the UTC/Raytheon announcement.

So what does this all mean for Raytheon and UTC?

The Last Supper was 25 years ago, but the ramifications still resonate throughout the defense sector today. The remaining primes, unable to buy each other, turned their focus to bolt-on deals and divestitures that made them specialists in specific areas. That, in turn, has led to the situation Trump was describing: Though there are five primes and a range of second-tier companies, often there are only two or three with the capabilities to bid on large-scale programs.

Raytheon and UTC are different enough that blocking the merger wouldn't fix the status quo, but approving the deal is unlikely to help the situation, either. Both companies are focused on supplying components and systems for large platforms instead of building the tanks, bombers, or ships themselves, and neither has expressed an interest in jumping into the equipment game.

Viewed from a traditional anti-competitive standpoint, there's little justification to block UTC/Raytheon. The two companies overlap somewhat in communications and electronics businesses, but if those are concerns, small divestitures that wouldn't impact the overall rationale behind the deal can be done.

The threat is if Trump and the Pentagon believe the size and scale of Raytheon Technologies will lead to copycat acquisitions that could do real harm to the diversity of the supply chain. That's a real possibility, and could be reason enough for the government to take a hard look at Raytheon/UTC, even if there is only limited overlap.

Change is coming

The most likely outcome is for this merger to be approved with divestitures. It's officially in compliance with guidelines forbidding defense primes from combining, and there's no clear, articulated policy that would forbid it. Investors should expect some volatility during what's likely to be a lively approval process -- including the potential for some spirited Congressional hearings -- but ultimately, the deal should happen.

What follows will be fascinating and of interest to investors in all defense names. The Navy has pushed increased investment as a way to reverse a drastic decline in shipyards and spur new competition, and throughout the supply base, the Pentagon could use commitments to higher spending levels to entice new competition. If so, the entire sector could benefit.

One controversial avenue to broaden the supplier base is to allow more mergers -- namely, crossborder transactions. A combination involving British defense giant BAE Systems (NASDAQOTH:BAESY) (LSE:BA) and a U.S. prime would create a more diversified powerhouse without a significant decrease in competition. There are a number of smaller European companies that could add to U.S. contractor capabilities should the Pentagon warm to such transactions.

LMT Chart

Defense primes vs. the S&P 500 since 2000, data by YCharts.

U.S. defense stocks have enjoyed a solid run in recent years, fueled largely by organic growth and tied to the defense budget. The Raytheon/UTC deal feels like an inflection point, similar to the Last Supper in 1993 and the failure of the Lockheed/Northrop deal in the late 1990s.

It's hard to say what comes next, with possibilities ranging from "me too" deals, an expansion of mergers and acquisitions to crossborder deals, or even calls to break up large companies. What does seem clear is that today's industry is unlikely to resemble the defense sector a decade from now.

What happens next should be of great interest, not just to Raytheon and United Technologies shareholders, but for investors in the entire industry, as well.