Two Minute Warning Sounds

In southern California, once the engine room of America's famed "arsenal of democracy," many vestiges of the Cold War economy are slowly disappearing from the landscape. The vast hangars at the former Norton Air Force Base in San Bernardino that once housed giant air transports, for instance, now double as movie soundstages. In nearby Long Beach, the former naval station will soon be a cargo terminal for a Chinese shipping company, and the naval housing area is being converted to a new high school, research facility and federal job corps center.

As arguably the hardest hit in terms of military base closures and defense industry downsizing, southern California is at the epicenter of seismic shifts that have rocked the once mighty military-industrial complex to its foundations. Regional companies that were once synonymous with America's industrial prowess-Douglas Aircraft Co. in Long Beach, Northrop in Pica Riveria, Hughes Aircraft in El Segundo, North American-Rockwell in Seal Beach, and Lockheed's Skunk Works in Palmdale-are shrinking, merging or disappearing.

"There's no question this transformation is tinged with sadness. In recent years, it's not been uncommon to go to the local 7-Eleven store and find yourself being served by an aerospace engineer," says Stuart W. Thompson, a vice president at McDonnell Douglas Air Transport in Long Beach, where rollbacks of military aircraft purchases cost the company 30,000 high-paying aerospace jobs between 1990 and 1994. "What we're now realizing is that a lot of the journeymen aerospace workers who used to hang around California waiting for the next big aerospace contract have not only left the state, they've left the business."

Increasingly, major corporations that depended on dwindling numbers of big contracts have been forced to merge or leave the defense business altogether. Just this year, Boeing Co. announced its intended purchase of rival McDonnell Douglas for $14 billion and the defense operations of Rockwell International for $3.2 billion. Raytheon has announced plans to acquire the defense businesses of Hughes Electronics Corp. and Texas Instruments for $9.5 billion and $3 billion, respectively. Most recently, in a proposed mega-merger of already merged giants, Lockheed Martin announced in July its intention to acquire Northrop Grumman.

"I'd say the two-minute warning has just been given in the downsizing of the defense industry," says Norman Augustine, chairman of Lockheed Martin. "If you're a defense company and you're not already positioned for where you want to be in the future, you better get on it quick, because the options are running out." Viewed by many as a defense industry visionary, Augustine was one of the first executives to realize that only companies with critical mass would survive the new realities of the defense marketplace. The growing period between jackpots in terms of major contracts, and the high cost of competing for those contracts, promised to test the endurance and resources of even the strongest companies.

"When I looked at our industry in the early 1990s, I saw declining defense budgets and a lot of companies with duplicative overhead and half-full factories. It wasn't all that profound a realization that the thing to do was bundle together, so that if you had two half-full factories, you got rid of one," says Augustine.

A Smaller Industrial Base

Given the agreement between the Clinton administration and the Republican-controlled Congress for a balanced budget by 2002, some of the recently announced mega-mergers (which have yet to receive government approval), and the spring release of the Pentagon's Quadrennial Defense Review, many experts believe the basic outline of the military industrial base of the future is beginning to emerge.

Clearly, it is an industry that has successfully weaned itself from the big defense budgets of the 1980s. According to the Center for Strategic and Budgetary Assessments (CSBA), an independent think tank in Washington, overall defense spending has declined by 36 percent in inflation-adjusted dollars since 1985, the peak of the Reagan-era defense buildup. Because of a Clinton administration strategy of roughly a six-year hiatus in terms of major new weapons programs, the procurement budget has experienced an even more precipitous drop, falling 67 percent from its 1985 peak.

Under the terms of the balanced budget agreement, the defense budget will decline by 3.5 percent over the next three years in inflation-adjusted dollars, according to CSBA. The budget will remain essentially flat in fiscal 2001, and then rise slightly in 2002, when it will still be 3.1 percent below this year's funding level.

With the agreement on the contentious balanced budget plan, even supporters of greater defense spending believe the Pentagon will have to learn to live with essentially flat budgets, barring a national crisis. "What we really need is small, predictable increases in defense spending each year, but unfortunately defense is off of everyone's radar screen right now," says Rep. Ike Skelton, D-Mo., a member of the House National Security Committee. "Projected defense budgets are too small to fulfill our national security strategy."

Given continued restraints on the defense budget, a relative paucity of major new weapons programs, and the common industry strategy of mergers to produce work force reductions and facilities consolidations, the industrial base of the future will obviously be dramatically smaller. In key market niches such as aircraft, nuclear warships and armored vehicles, there are already only a few prime contractors left to compete for major programs, a development that has raised questions about future competitiveness and innovation.

Given decisions in the Quadrennial Defense Review to scale back purchases of major weapons such as the F-22 and F-18 E/F fighters, it's also an industrial base that will be weighted more toward research and development and low-rate production, in contrast to the mass production of yore. As a result of advances in computer and communications technology, which some experts believe are heralding a revolution in military operations, defense and industry leaders have also pledged to break down the firewalls that long separated the commercial and defense sectors.

All of these realities of the new defense marketplace are transforming the relationship between the Pentagon and its suppliers. The change is already apparent in a host of recent acquisition reforms that have forced Defense Department program managers to drop many of their military-specific requirements and maximize commercial products and practices.

In the process, the largely adversarial relationship between Pentagon managers and contractors throughout the 1980s and early 1990s-characterized by armies of government regulators and plant inspectors, fractious lawsuits and extremely high-risk, fixed-price development contracts that often left even program winners badly bloodied-is being replaced by a teamwork approach in which declining budgets and program instability are viewed as the common enemy.

"I think that both sides now realize that to ensure we get the most bang for our buck during this great competition for dollars in the federal budget, we have to act as a team," says Harry C. Stonecipher, chairman of McDonnell Douglas. "We've all heard the phrase 'acquisition reform' bandied about as a buzzword for years, but you have to give [former Defense Secretary William] Perry and [former undersecretary of Defense for Acquisition and Technology Paul] Kaminski a great deal of credit for establishing a foundation of mutual trust and respect between the Pentagon and its suppliers. If you had an idea to speed up the process and save money, they let you lay it on the table and gave it fair consideration."

Defense Secretary William Cohen has promised not only to continue those reforms toward more commercially oriented practices, but to accelerate them.

"I was involved in many of these acquisition reform issues on the Senate Armed Services Committee, and a lot of the reforms of the past three years have been very positive, and promise to save us billions of dollars," Cohen said earlier this year in an interview with defense reporters. "We need more of that, and I will be inviting top corporate executives into the Pentagon to give me their recommendations. I will do my level best to foment a revolution in business affairs in the Office of the Secretary of Defense, which I think will pay big dividends."

Merger Mania

Though long predicted, the extent of the contraction of the defense industrial base in the last year has taken many observers by surprise. According to The Wall Street Journal, merger and acquisition activity in the U.S. defense industry ballooned from less than $5 billion in 1991 to nearly $40 billion in 1996, a year that saw no fewer than 25 announced mergers.

"All this merger and acquisition activity is simply the result of an efficient market right-sizing itself to reflect more than a 50 percent drop in the defense procurement account," says Kent Kresa, chief executive officer of Northrop Grumman, which earlier this year announced the closing of four plants and the consolidation of other facilities as part of an ongoing streamlining effort. "The important thing is not how big you are, however, but whether or not you have the critical mass in those particular markets you choose to compete in."

Concerned that too many defense companies would be left chasing too few programs-leading to inefficiencies and an anemic defense industrial base-Pentagon officials, led by Perry, actively encouraged mergers. As an enticement toward consolidation, for instance, DoD officials allowed merging defense companies to charge some of the costs of the reorganization as overhead in existing Pentagon contracts, including the costs of severance pay for terminated employees, early retirement incentives and relocation expenses.

Though the restructuring payments were dubbed "payoffs for layoffs" by critics, DoD officials insist that the mergers reap savings for the Pentagon far in excess of their costs. "The whole subject of restructuring costs gets played off as subsidizing mergers, but we audit a company's savings projections using normal audit procedures, and it's very clear to me that this program is encouraging efficiency in the defense industry," said Kaminski in an interview shortly before leaving office last spring. According to DoD figures, the Pentagon has reaped $3.95 billion in savings from efficiencies resulting from industry mergers.

Though earlier this year the Pentagon was reportedly considering whether to ask for major divestitures before approving the Raytheon-Hughes merger, in general DoD officials have been key supporters of mergers in deliberations with the Justice Department and the Federal Trade Commission.

Even in a defense landscape dominated by mergers and industry consolidations in recent years, however, the announced pairings of Boeing and McDonnell Douglas, and Lockheed Martin and Northrop Grumman are breathtaking. The European Union has voiced concerns that the former merger will unfairly threaten Europe's Airbus.

After McDonnell Douglas lost out in its bid for the Joint Strike Fighter program, many experts assumed it would have to seek a major merger or acquisition. "We certainly didn't feel like we had to make that deal, but the reality of a declining defense business around the world is that if you're going to grow the top and bottom lines, you have to do it through acquisitions or internal developments that will take market share from someone else," says McDonnell Douglas' Stonecipher.

The synergy between a McDonnell Douglas focused primarily on defense programs and commercially oriented Boeing, he says, was a key inducement. "One of the reasons I always wanted this deal is that it creates a company that has great balance," says Stonecipher. "About two-thirds of our business was in defense and space, and Boeing reflects similar strengths in the commercial market. The combined company will also have great balance in terms of current production programs and new programs for the future."

Industry leaders and defense experts know, however, that deciding on a merger that looks good on paper is the easy part of the equation. Future success will rely on their ability to integrate disparate corporate cultures and streamline operations in a way that makes their bulk an asset, rather than a burden, to innovation.

"If you look at the track record of mergers, the data overwhelmingly indicates that most don't live up to their expectations," says Phil Condit, chairman of Boeing. "The reason is usually that corporate culture issues don't get addressed." Boeing, he says, is determined to make the issue of integrating the two companies' cultures into a cohesive whole a primary focus.

"And as we reorganize, we'll be thinking a lot about how to maximize ingenuity and innovation. If we don't, the small and agile companies will take our business away," says Condit. "There's an ever-present Darwinian imperative at work in this business. Either you adapt, or you disappear."

Monopoly Concerns

While few experts have quibbled with the economics of defense mergers, a number have raised questions about innovation and competitiveness among mega-corporations. Such a rapid and fundamental restructuring of the defense industrial base, they say, carries significant risks and uncertainties.

"No one denies that there had to be some consolidation in the defense industry to rid itself of excess capacity, but we're getting to a point with these mega-companies where issues such as innovation, political power and competition become very worrisome," says Lawrence Korb, a former Pentagon official and Raytheon executive now working as a senior analyst at the Brookings Institution. "There's also a tremendous number of interlocking relationships between these companies at the subcontracting level, so that you have no real winners or losers when a final decision is made on a program, and thus no real competition."

In a time of rapid technological change and shifting market forces, a number of defense and aerospace experts also wonder whether a few massive corporations fused from disparate corporate cultures will prove sufficiently focused and agile. "There's a fascination with all things big in the defense industry right now, but in so many industry sectors we've seen that big is not the key to success. If it was, IBM would have monopolized the information technology business," says Byron Callan, a senior defense and aerospace analyst with Lehman Brothers. "I'm not convinced that these defense conglomerates we're seeing built will prove sustainable in terms of building shareholder value over the next five to 10 years. You could easily see them start breaking these companies apart in a few years."

Other experts worry that competition and a robust defense industrial base could also be casualties of the mega-mergers. The pairing of Boeing and McDonnell Douglas, for example, essentially leaves it fighting for future tactical military aircraft programs with Lockheed Martin. A Lockheed Martin-Northrop Grumman pairing could dominate defense electronics. The Raytheon-Hughes merger seems certain to curtail competition in the field of missiles, and Pentagon officials say a further shakeout and consolidation in the nation's handful of shipyards is likely, despite the fact that only two remain capable of building nuclear warships.

"I believe these mergers are a survival issue for the companies involved, but my biggest concern is that America's defense industrial base is shrinking considerably, and I'm not sure anyone has really thought through the big picture in terms of what that means to our national security," says Sen. Bob Smith, R-N.H., a member of the Senate Armed Services Subcommittee on Acquisition and Technology. "I don't think it's particularly healthy to have two or three major defense contractors controlling 70 or 80 percent of the industrial base."

While Congress and the Administration study the proposed mergers, and review the impact of the dramatic consolidation of the industrial base, industry leaders say they will continue to combine forces where the market dictates. They point to increased productivity figures and record earnings for many aerospace companies.

"If I had my choice, I'd rather have six healthy companies competing for major programs rather than two or three. That would be better for competition, innovation, employment, the industry and for the nation as a whole," says Lockheed Martin's Augustine. "But those weren't the cards we were dealt. The choice was between six weak companies or three healthy, and in that case I'll take three healthy companies every time."

While he believes that at least two companies should be left to compete in every market segment, Augustine doesn't feel that industry is given enough credit for making the best of a bleak situation. "I'm proud of this industry. Rather than wringing our hands, complaining and remaining bloated when it became clear that we were too big, we made the tough choices," he says. "Today, we have strong companies, a good research and development base, and a huge piece of the international market."

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