The Future Industrial Base With Declining Defense Budgets

(MoneyWatch)  One of the trends that might play out if there is a significant reduction in defense spending is Merger and Acquisition (M&A) activity. In the last major downturn in the Nineties this was significant. Some of it was encouraged by the Defense Department at that time as a way to maintain some core capability of each company. Now there are signs that this sort of activity might be picking up.

Northrop Grumman discussed this at a recent investor conference hosted by Morgan Stanley. The company is looking to invest in smaller corporations that offer new technologies and solutions. Unfortunately they are finding that those companies are expensive and this has dissuaded them so far from making deals.

One way for a larger company to expand its business base or enter a new geographical market is to purchase smaller ones that already do that kind of business or are active in the target area. Many of these smaller companies are ready to be bought as the founders want to either cash in or move on to another project. There are also companies that use this to try and seal up one type of product or market by acquiring smaller competitors. Either way over the last ten years there has been significant activity in this arena.

Both General Dynamics and Lockheed Martin have made major acquisitions in the last few months. EADS has discussed doing this in the American market after buying several companies in 2007 and 2008. Lockheed purchased Gyrocam which makes surveillance equipment used for bases in Iraq and Afghanistan. General Dynamics acquired Axsys Technologies a developer and producer of electro-optical/Infrared (EO/IR) systems.

The Defense Department recognizes that there may be consolidation in the industry beyond what has already occurred. Due to this there have been concerns expressed about the lack of U.S. companies capable of competing on major contracts. This has led to the penetration of the traditional U.S. market by European companies as they can provide the necessary competition. Ashton Carter the Undersecretary of Defense (Acquisition, Technology & Logistics) at a recent meeting realized that preserving a U.S. industrial base and capability is still important. This may require some restructuring of funding a programs by the Pentagon. The goal is not to preserve jobs necessarily but some core competencies and production capability in key areas.

As it is with limited major acquisition programs in some areas such as aviation it may be hard to maintain two American sources for those types of systems. If the Pentagon dual sources a product of limited quantity that increases the price greatly. At the same time as expressing this concern the Gate's Defense Department is fighting keeping two different engines for the Joint Strike Fighter (JSF). The cost of developing, integrating and producing two different engines is expensive. Yet without some kind of program like this GE and Pratt and Whitney may not have the necessary market to maintain an expertise in tactical aircraft engines.

With less funding it becomes a balancing act. This is especially true when America is actually conducting combat operations on what will be a reduced budget. In a war like World War II the country could afford to throw billions at a problem and maintain multiple systems to conduct the same missions such as both the B-17 and B-24 strategic bomber. It cannot afford to do that today at least not with the funding recommended by the Obama Administration.