The U.S. and international defense industries are undergoing a period of rapid and large-scale consolidation that could result in a handful of traditional contractors that build major weapon systems but leave technological development to a more populated and competitive commercial market.
“There is a lot of consolidation happening on the platform side,” William Lynn, chief executive of Finmeccanica North America, said Nov. 16 at the Center for Strategic and International Studies’ Global Security Forum in Washington, D.C. “With aircraft carriers, we only have one builder. With submarines, we have two builders, but they combine. It’s not a competition…Aircraft aren’t quite there yet, but at some point, the F-35 will probably be the only tactical aircraft in production, so by definition there will only be one builder.”
Northrop Grumman [NOC] was recently awarded the $85 billion-plus contract for the Air Force’s Long Range Strike Bomber (LRSB) which will position it as the only strategic aircraft manufacturer for decades, unless Lockheed Martin [LMT] and Boeing [BA] convince the Government Accountability Office that their offering was superior. That award could be seen as a move to conserve the three big aerospace giants as separate firms by giving Northrop Grumman the bomber contract while Lockheed builds the F-35 and Boeing makes the KC-46 tanker.
There remain several combat vehicle manufacturers, but the award of the massive Joint Light Tactical Vehicle and the upcoming Marine Corps amphibious combat vehicle, among other programs, could force consolidation in that industry sector.
“On the platform side, whether or not the companies consolidate isn’t really the main issue,” Lynn said. “The issue is going to be how is DoD going to manage a much smaller competitive base?”
The driver of consolidation is the Defense Department’s procurement cycle, which contracts for a major vehicle program in each sector, about once every decade or 15 years, he added. Companies that fail to secure major long-term contracts, must either diversify away from the defense market or look to merge with larger firms. Larger firms take those opportunities to acquire new businesses and diversify themselves.
Andre Gudger, acting deputy assistant secretary of defense for manufacturing and industrial base policy, said the U.S. and international defense industries have undergone more consolidation in the past 12 months than they had in the previous two decades. The trend toward consolidation is not necessarily a bad thing if defense primes continue to also diversify with acquisition of commercial companies, as the Big Six–Lockheed Martin, Boeing, Northrop, General Dynamics [GD] and BAE SYSTEMS–-have done. Lockheed Martin’s recent acquisition of Sikorsky, which builds both military and commercial rotorcraft, for $9 billion, is a perfect example.
“All of those defense firms have a commercial component to them and one is truly half-commercial, half government,” Gudger said.
In other industry sectors that are increasingly becoming the focus of Defense Department procurement, there is less consolidation and more competition. Firms that sell electronics, communications equipment and systems and cyber security products are numerous, Lynn said.
“There is no visible move toward a much-reduced competitive base and that won’t change that much even if different companies merge with others,” Lynn said. “Consolidation is something that needs to be managed on the platform side. You need to maintain the robustness on the electronics, communications, cyber side, but that’s happening somewhat naturally.”
Still, commercial companies in those sectors outweigh defense-focused firms in both size and number. The value of the entire defense industrial base is smaller than Apple [AAPL], Google [GOOG] or Exxon Mobil [XOM], said Denis Bovin, a senior adviser with Evercore Partners, an investment banking advisory firm. Google has enough cash on hand–about $65 billion–to buy Lockheed Martin outright, he said.
“Profit margins and return on assets in the defense industrial base are much, much less than they are in lots of other somewhat comparable industries,” Bovin said. “The bad news that the market is telling us is that the…defense industrial base is largely composed of companies that are mature, low-growth and…cyclical. They are viewed as selling declining volumes of products to a unique and frankly difficult customer.”
Since the Cold War, the Defense Department has fancied itself a net exporter of technology to the commercial sector. The Internet, GPS and the Boeing 707 airliner, for instance, all were defense programs that gained traction in the commercial market. That dynamic is rapidly changing with the exponential progression of commercial technology. The U.S. military can maintain its technological edge over adversaries if commercial firms are given more opportunity to do business with the government, Gudger said.
“Are we going to be more successful at opening more commercial company opportunities inside the industrial base? I think the future of our technological edge hangs on that,” he said.