Economies of Scale: Analysts Predict New Wave of Industry Consolidation

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Expectations of declining budgets for Pentagon big-ticket weapons and an overall uncertainty about future military spending priorities may set off new rounds of industry mergers and acquisitions, economists say.

But any forthcoming consolidation is not likely to mirror the massive wave of mergers and acquisitions that swept the industry during the early and mid-1990s. Because the industry already has shrunk significantly and is currently dominated by a handful of conglomerates, any future consolidation is expected to involve mostly medium and small companies. Large companies, however, could be participants in what analysts describe as a corporate game of gin rummy as they buy and sell parts of their businesses in order to bolster their cash flow.

A rapid post-Cold War reduction in military budgets and a resulting excess capacity in the defense industry contributed to a tidal wave of company mergers. The consolidation accelerated after the so-called "last supper" in 1993, when then-Deputy Defense Secretary William Perry advised the Pentagon's top contractors to merge if they wanted to survive the coming budget crash.

"Today the major surviving firms are larger than defense companies have ever been in the history of the U.S. defense industry," says Barry D. Watts in a report published by the Center for Strategic and Budgetary Assessments based in Washington.

The degree of consolidation in the mid-1990s varied across sectors. For example, there was about a 70 percent reduction in the number of contractors in the fixed-wing aircraft, tactical missiles and expendable launch vehicles sectors. Other areas, such as surface ships, strategic missiles, satellites and combat vehicles, experienced about a one-third drop in the number of contractors.

The consensus in the industry so far has been that defense firms should stick with military work and avoid diversification into civilian markets. That assumption is now being challenged as companies may seek to shore up their cash flow by changing their portfolios, says W. Alexander Vacca, an industry analyst who participated in a recent forecast study by the Government Electronics and Information Technology Association. The "last supper consensus" appears to be breaking down, he tells an industry conference hosted by GEIA. Investors are no longer convinced that defense contractors should only engage in government work and avoid non-defense customers.

"Companies are playing what Warren Buffet calls 'gin rummy' mergers and acquisitions," Vacca says. "They sit down and swap assets."

New buyers are emerging, including players from non-defense sectors and foreign firms. "Big deals are being done with unusual buyers," he says. Examples include the $4.8 billion acquisition of Smiths Aero by General Electric Co., the $3.9 billion acquisition of DRS Technologies Inc. by Italy's Finmeccanica, the $1.1 billion takeover of AAI Corp. by Textron Inc. and the $1.8 billion purchase of EDO Corp. by ITT Corp.

Investors are willing to consider mergers and acquisition outside defense, Vacca says. "That used to be a scary thing ... they would tell you, 'you're crazy.'" Given the industry's past failures to successfully diversify into commercial markets, he says, analysts recommend that companies avoid the pitfalls of so-called corporate "synergies." An aerospace company, for instance, should not try to turn space-age polymers into the next best automobile interior fabric.

Analysts are suggesting that defense contractors should consider buying unrelated companies to generate cash flow--a portfolio approach versus a defense-only strategy, Vacca says. "This was a shock to us on the GEIA team."

Some experts remain skeptical that defense contractors can transition into civilian work successfully.

"If diversification is again tried, defense companies would be wise to focus on complementary businesses that are not too far afield from their core business," writes Stephen Blanchette Jr. …