Electronics to determine who survives in the defense business

Feb. 1, 1997
WASHINGTON-The wave of acquisitions and mergers sweeping through the defense industry is far from over, and the prize that the surviving companies will need is the one growth area left in the Pentagon budget: electronics.

by John Rhea

WASHINGTON-The wave of acquisitions and mergers sweeping through the defense industry is far from over, and the prize that the surviving companies will need is the one growth area left in the Pentagon budget: electronics.

For the moment, dominating the industry is a duopoly consisting of the current top defense contractor, Lockheed Martin Corp. of Bethesda, Md., and Seattle-based Boeing Co., which bought McDonnell Douglas Corp. of St. Louis for $13.3 billion on Dec. 15 - just 10 days after completing a $3 billion deal to buy the defense and space operations of Rockwell International Corp. in Seal Beach, Calif.

Assuming the McDonnell Douglas acquisition gets approval from the Justice Department and the Federal Trade Commission - and the Defense Department is solidly behind it - Boeing will become the world`s largest aerospace concern, with anticipated sales of $48 billion this year. However, it will not be number-one in the critical area of military electronics because Lockheed Martin strengthened its hand with its previous purchases of the IBM and Loral operations.

The buyout/merger wave picked up momentum again on Jan. 6 as Raytheon Co. of Lexington, Mass., bought the defense electronics operations of Dallas-based Texas Instruments for $2.95 billion. That same day Raytheon and Northrop Grumman Corp. in Los Angeles, submitted their bids to buy Hughes Aircraft Co. of Los Angeles - part of the GM Hughes portion of General Motors Corp. - in a GM auction. The asking price is reported at $9 billion.

What this all boils down to is an evolution in the electronics portion of the defense industry that parallels the earlier consolidation in the airframe segment, namely a downsizing of the industrial base to match new global realities and the Pentagon`s declining budget.

As the Electronic Industries Association reported last spring, the total defense budget is projected to shrink from $253 billion to $232 billion over the next decade, but electronics content will rise slightly from $50 billion to $55 billion (all figures in constant 1997 dollars). That`s an increase in the share of defense spending from 19.7 percent to 23.7 percent.

The companies that have that strong electronics capability - at least to manage their electronics subcontractors skillfully - survive; those that don`t are absorbed. Those words easily could be the epitaph of McDonnell Douglas as an independent company, which earlier last year failed in its attempts first to buy Raytheon and then to buy Hughes.

In fact, it was the Hughes bid that forced Boeing`s hand in merger deal with McDonnell Douglas that had been in the works for three years. For Boeing it was a case of now or never; if McDonnell Douglas executives had been able to pick up Hughes or TI`s defense electronics business they would have fortified their company to where they never would have to worry about a Boeing takeover again. But the loss in the semifinal round of the Joint Strike Fighter (JSF) competition in November to Boeing and Lockheed Martin effectively sank McDonnell Douglas.

The purchase prices involved in the two most recent acquisitions reflect the value of electronics. Boeing got McDonnell Douglas for a billion dollars less than the company`s 1995 sales. But Raytheon had to pay more than a billion dollars above TI`s expected 1996 defense electronics revenues of $1.8 billion.

A third company has yet to emerge to challenge the duopoly of Boeing and Lockheed Martin, and electronics capability will determine the winner. Both of the bidders for Hughes are strong in this area - Northrop Grumman with its acquisition last year of the radar business of Westinghouse Electric Corp.`s Baltimore operations and Raytheon with its earlier purchase of E-Systems of Dallas before the TI deal. The winner should give Lockheed Martin competition in military electronics, although Boeing`s dominance of commercial aviation is assured.

As the aerospace industry continues to mature, it`s likely to resemble the Big Three auto makers, who have already undergone this process. The Defense Department can`t support a surplus industrial base. The list of shipbuilders is dwindling to one per class. There are only two fighter aircraft builders left: Lockheed Martin with the Air Force`s F-22 and F-16, and now Boeing with the Navy`s F/A-18 produced by McDonnell Douglas.

The same logic applies to military electronics. Hughes and Northrop Grumman have been the mini-duopoly in airborne radar. Hughes and Raytheon have the tactical missile business sewn up. The faster-growing military communications and computer suppliers are more widely scattered, but they have a commercial business base that`s not available to the weapons builders.

So what Wall Street really wants - and what would make life easier for the Pentagon - is yet another round of mergers putting together some combination of Hughes, Northrop Grumman, and Raytheon. The logic is compelling: the surviving firm would have the critical mass to compete with Boeing and Lockheed Martin, and the industry would achieve a degree of stability comparable to the auto industry.

The net result might actually be more competition, not less, because the surviving companies could compete on an equivalent footing. Moreover, there won`t be any more big competitions on the scale of the JSF, so there`s not that much to compete for at the system level. The fiercest competition already is at the subsystem level with the growing use of commercial off-the-shelf (COTS) technology.

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