Defense Secretary William J. Perry, a bookish-looking man with the public demeanor of a slightly distracted bureaucrat, walked into a Pentagon briefing room last month and set off a bomb in American industry.
His announcement of two finalists to build the fighter plane of the future drove the third-place company, McDonnell Douglas Corp. of St. Louis, into its recently announced merger with Seattle's Boeing Co.
This is something like the CBS television network surrendering itself to ABC, a dramatic reconfiguration of an edifice that seemed too big for such change.
The two remaining defense industry superpowers -- Boeing and Bethesda-based Lockheed Martin Corp. -- will square off not only over the contract for the Joint Strike Fighter, but over the major chunk of Pentagon business for the foreseeable future.
A former Clinton administration defense secretary, Les Aspin, foresaw this landscape at an infamous industry dinner in 1993 that has come to be known as "The Last Supper." Warning that the end of the Cold War would wither defense budgets, Aspin told executives that their companies would have to consolidate to survive.
Since defense spending peaked in the Reagan years, Pentagon spending on new hardware has shriveled more than 60 percent.
As a result, mergers worth more than $40 billion have taken place in the industry. Companies have cut about 700,000 jobs. The number of major military airframe builders has shrunk from about half a dozen companies to three, and only two of those are prime contractors.
On the one hand, the consolidation satisfies the goal of the Clinton administration that the industry position itself to compete in the global marketplace. Fewer, bigger companies can withstand business cycles and stare eye-to-eye with foreign government-sponsored competitors.
But many industry experts say the reconfiguration was inevitable even without the administration's vision. And while the gargantuan Boeing-McDonnell Douglas merger may culminate the process, it by no means completes it.
A whole second tier of large companies -- primarily Hughes, TRW, Raytheon and Northrop Grumman -- remains in flux.
Hughes Electronics and the defense operations of Texas Instruments are both on the market, soliciting bids just in the past week, according to analysts. Hughes is expected to command a price of close to $9 billion, Texas Instruments about a fourth of that.
No combination of those companies is likely to rival Boeing or Lockheed Martin, many experts agree.
"There's not enough remaining in the defense industry to form a third comparable player," said Andrew Krepinevich of the Center for Strategic and Budgetary Assessments in Washington.
But the same economies that drove the mega-mergers are dictating that more mergers take place on the junior level. And that will be hastened by Boeing's move.
"The Boeing-McDonnell Douglas earthquake has got to have aftershocks that are going to reverberate throughout the industry," said Byron Callan, a Merrill Lynch analyst. "If things were close or people were thinking they might like to do something, this should galvanize them into action."
Norman R. Augustine, chief executive officer of Lockheed Martin and one of the key architects of the remade defense industry, is a persistent cheerleader.
"I think there are two groups that really need to face reality here," Augustine said in an interview. "One is some of the U.S. companies that haven't cast their lot one way or the other. [The other] is the Europeans, which really badly need to face up to these issues -- overcapacity, the inefficient use of resources and so on."
The leading company on the second tier is California-based Northrop Grumman, itself the product of several good-size matings.
"They're sort of a mini-Lockheed Martin," said JSA Research Inc. analyst Paul Nisbet. By that he means the company is relatively diverse, with strong operations in military electronics and in aircraft subcontracting.
In fact, Northrop Grumman, with a sizable stake in McDonnell Douglas' construction of the F-18 Navy fighter, is the only other company with major airframe capability -- though it no longer takes prime contractor roles.
Analyst Stuart McCutchan, who publishes a newsletter called Defense Mergers & Acquisitions, sees little direct threat to Northrop Grumman from the Boeing-McDonnell Douglas merger. The company's subcontractor work on Boeing commercial aircraft and on electronics systems with Lockheed Martin and McDonnell Douglas should be secure, McCutchan said.
At the same time, Northrop Grumman continues to carry debt from its acquisition earlier this year of the former Westinghouse electronics and radar plant in Linthicum, and so is relatively poorly positioned to make another big purchase, McCutchan said.
Raytheon is widely said to be making an aggressive run at an acquisition, but McCutchan warned that federal regulators might look askance at Raytheon buying Hughes.
"They're the two biggest missile builders in the country," he said, and the loss of competition in that field might be more than the military is willing to stomach.
The best match, he said, would be for Hughes to take down the "for sale" sign and buy the Texas Instruments division. "That's one of the best fits I've ever seen out there, in terms of radars, electro-optics and in terms of missiles," McCutchan said.
Analyst Nisbet takes a different view, rating Hughes and Raytheon a good match because of their missile heritage. And he predicted some kind of news on the merger front imminently. "It could be next week, conceivably," he said.
Because each of the smaller companies has its own niche in the industry, they are not likely to be overwhelmed by the new Boeing.
"The people that should be worrying," McCutchan said, "are Lockheed Martin, because of Joint Strike Fighter."
Observers almost universally credit Boeing with surpassing Lockheed Martin as the favorite in the scramble for that contract, which could be the most lucrative ever at about $300 billion or more.
Combining the fighter expertise of McDonnell Douglas with the innovation and commercial clout of Boeing "is an enormous boost," said Krepinevich of the strategic assessments center.
Augustine, the Lockheed Martin chief, remains undaunted. "I think the basic competition is about the same," he said.
Augustine is generally sanguine about the new Boeing rival. The two companies, he points out, have different strengths: On the defense side, Boeing will be "somewhat larger" in military aircraft, while Lockheed Martin has "a significantly larger piece of the business" in military space.
On the other hand, Boeing's undisputed nondefense crown is commercial aviation, where Lockheed Martin no longer competes. And Lockheed Martin has an all-but-insurmountable lead in the fields of electronics and information systems.
"We've stacked up our business profile against the combination of McDonnell Douglas and Boeing," Augustine said. "The overlap isn't as big as it might seem at first blush."
As for the Joint Strike Fighter, industry sources have suggested that the "fighter aircraft deal of the century," as one put it, might not turn out to be winner-take-all.
The program is the only fighter plane the Pentagon plans to purchase for three branches of the military well into the 21st century. But it could be that the government, worried about maintaining the country's industrial base, will pick a winning plane and then let the losing company build, say, 40 percent of it.
Either way, Boeing and Lockheed Martin are secure for decades because of their sheer size. That was the idea behind consolidation in the first place -- creating companies big enough to weather the dry cycles.
There are drawbacks, though.
With smaller companies absorbed or shunted aside, niche areas of technology could be abandoned -- areas that often lead to BTC bigger breakthroughs later. "You won't quite get the range of options that the Department of Defense had when there were more players competing," Krepinevich said.
With less competition, costs could rise, though both Boeing and Lockheed Martin claim they can save $1 billion or more a year through greater efficiencies.
And there is always the specter of monopoly in particular areas of defense expertise, which can limit the country's ability to respond quickly to changing global threats.
But analysts generally downplay those potential problems, applauding instead the rapid and thorough way the defense industry has reacted to a changing environment.
"I think it [mergers] very much needed to happen," Nisbet said. "And the stock market thinks so, obviously."
The Pentagon, too, is pleased with the way the business-scape is changing.
"We have made no secret about saying that [consolidation] is inevitable, and we think it makes good sense if it's going to streamline things and make economies and save the taxpayers money in the long run," said Defense Department spokesman Glenn Flood.
The Pentagon and federal antitrust officials still have to review the proposed Boeing-McDonnell Douglas deal. All indications are that the arrangement will sail through.
The European Union has recently protested the possible impact on industries there, because Boeing is such a stiff competitor to the Airbus Industrie consortium in commercial aviation. Nothing, though, appears to hold a serious threat to the deal.
The new balance of power has even had its first dry run, with the announcement Friday of two finalists to build a next generation of booster rockets for the Air Force.
The Pentagon made a predictable choice in the $2 billion program, sticking with the two companies that already build rockets for the Air Force -- Lockheed Martin and McDonnell Douglas.
Of course, by the time the Air Force picks a single winner in 1998, McDonnell Douglas Aerospace will most likely be a unit of Boeing.
Even before the merger announcement was a week old, then, Boeing had bought itself into an area where it had no prior foothold. And military space is one of Lockheed Martin's most cherished core businesses.
Pub Date: 12/22/96