Pentagon Preparing for Wave of Mergers and Acquisitions

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NEW YORK — With cash-rich U.S. defense contractors planning a new wave of mergers and acquisitions, Pentagon leaders are thinking through the kinds of deals they want to see, what they will accept and what they will not.

“We are at the very early stages of the process of defining an approach to new realities we’re facing in the defense industrial base,” the Pentagon’s industrial policy chief Brett Lambert said after a Nov. 9 address at the annual defense conference sponsored by Bank of America Merrill Lynch in association with Defense News.

Lambert said the U.S. Defense Department’s policy on mergers and acquisition deals would reflect “what’s in the best interest of the warfighter not only now, but 10 years from now, and second, what’s in the best interest of the taxpayer.”

He said the Department of Defense (DoD) needs to share its vision of the future industrial landscape with defense companies.

“Where we need to shape that vision, industry should be an important, but not sole, contributor,” he said.

U.S. Defense Secretary Robert Gates, Deputy Defense Secretary William Lynn and Pentagon acquisition chief Ashton Carter have been holding meetings to listen to top defense executives’ concerns, including on how best to meet Gates’ goal of shifting $100 billion over five years to new weapons.

Lambert said the Pentagon should help its suppliers understand what it will need. In 1993, a similar obligation prompted then-Defense Secretary William Perry to convene the “last supper” meeting. Defense spending was plunging with the end of the Cold War, and Perry urged chief executives to consolidate or perish.

“Dr. Carter was at that meeting, and knows that business needs to make decisions, so we are trying to do some of this in real time,” Lambert said.

Lambert is also looking at each U.S. defense market sector to better understand competition and supply chains, from prime contractors down to fourth-tier parts and raw materials suppliers.

 

‘Guidance, Please’

After a decade that doubled the Pentagon budget, the defense industry is reorganizing for a decline. Carter has repeatedly said that DoD does not want to see leading industrial players consolidate, nor competition wane. But senior executives, Wall Street bankers and analysts want to know what kinds of deals Pentagon leaders would encourage or accept.

They have been bruised in the past. In 1998, government antitrust authorities rejected the planned merger of Lockheed Martin and Northrop Grumman; in 2001, they nixed General Dynamics’ planned takeover of Newport News Shipbuilding. The decisions cost the companies millions of dollars in charges and fees.

Formal approval of mergers or acquisitions rests with either the Justice Department or the Federal Trade Commission. But federal antitrust authorities historically have deferred to defense officials in assessing mergers and acquisitions. Foreign acquisitions of U.S. firms face antitrust vetting, as well as review by the interagency Committee on Foreign Investment in the United States.

Lambert said lessons from 1993 would shape policy today, yet there are differences from the wave of consolidation that followed Perry’s last-supper meeting.

“It was a consolidation of stock symbols that was healthy for shareholders, but not sure it ended up saving money for the taxpayer or delivered additional benefits for the warfighter,” he said.

Lambert said laying out a DoD industrial base has grown more complicated. Once the Pentagon bought largely from U.S. companies that did only defense work; now it relies on a global and largely commercial base.

“The rationalization of that base in light of new requirements and funding realities is going to look very different than it did in the early 1990s,” Lambert said. “It’s more nuanced, it’s more complicated. It’s got more financial, private equity and foreign investors. All of those complications have to be considered because we certainly don’t want unintended consequences for our decisions.”

Moreover, the Pentagon is no longer the guide star for industry, especially high technology.

“We used to be the dog wagging the national industrial tail, but now we are increasingly the tail, with the exception of certain specific items like nuclear submarines and warships,” Lambert said. “We can no longer apply old formulas to our new realities.”

As for spending, he said, “We desperately want to avoid previous cycles that were characterized by large budget swings. Our goal is to have a steady state budget, communicate that steady state budget to industry, and I have no doubt that they will shape themselves to provide the goods and services we need. We need to be clear about our plans and programs to industry. Guessing about the future doesn’t help the warfighter, the taxpayer or the shareholder.”

 

‘Make Everybody’s Life Easier’

Bankers and analysts generally lauded the Pentagon’s effort.

“It’s the right decision in that industry desperately needs some kind of indication from DoD what deals are the realm of the possible and what they shouldn’t even think about,” said David Berteau, the defense industry analyst at the Center for Strategic and International Studies think tank in Washington.

“In a sense, everything is possible, but that’s not realistic. Nor is it responsible to say ‘let the market decide.’ The problem is, DoD is the market, so believing that there’s some third force that’s shaping the market, not DoD, is just ridiculous. But even with a downturn in spending, DoD remains a massive market that will still allow the industry and its shareholders a healthy profit.”

But Loren Thompson of the Lexington Institute said industrial-policy efforts will be wasted until the extent of defense budget cuts become clear. If the cuts are deep enough, the Pentagon may be forced to accept mergers to monopoly.

“Why would they want to have two builders of nuclear submarines if there isn’t any competition?” Thompson said. “We have two submarine builders today in name alone. So if the Pentagon has decided what they do and don’t want before demand has even begun to go down, they’re not really prepared for what’s ahead. What they want today won’t bear any resemblance to what they will have to do in a few years. They will be sending the wrong signals based on the notion that defense spending will continue to rise at 1 percent a year, which is both arithmetically and politically untenable.”

Pierre Chao, managing director of Renaissance Strategic Advisors, disagreed.

“Yes, budgets may change, but there’s a lot of work you can do in terms of base-lining and running scenarios,” Chao said. “It’s about understanding the industrial structure that exists today, for example, where you have single points of failure, and how future budgets will exacerbate your challenges.

“But identifying what the issues are can be done independently of the budgets. It’s not just the number players, but where the technology is evolving. If current technology is being superseded, then it might be fine to have one player in a field that is dying. You need to do this work now.”

Chao said that the Pentagon has tended to shy away from giving broad industrial guidance, preferring to react case by case to merger proposals.

“The clarity after Perry’s last supper was the aberration rather than the norm, so a pointed policy would make everybody’s life easier,” he said.