Pentagon Will Back Defense Mergers Outside Top Five Companies, Carter Says

The U.S. Defense Department welcomes mergers among U.S. defense companies provided they don’t involve the top five or six suppliers acquiring each other, the Pentagon’s top weapons buyer said.

“We expect industry to make adjustments” to a slowdown in U.S. defense spending, Ashton Carter, undersecretary of defense for acquisition, technology and logistics, told Bloomberg Television yesterday.

Still, the Pentagon will not approve transactions that lead to consolidation of the major defense contractors such as Lockheed Martin Corp., Boeing Co., Raytheon Co., Northrop Grumman Corp., or General Dynamics Corp., Carter said in an interview prior to a speech today in New York.

The growth of the base U.S. defense budget through 2016 is forecast to average no more than the rate of inflation as Defense Secretary Robert Gates works to trim costs. Overall defense spending, including war expenses, has risen 72 percent between 2000 and 2008.

Gates has targeted $78 billion in cuts through 2016 for federal deficit reduction and another $100 billion in efficiencies savings, two-thirds of which will be shifted to weapons accounts, Carter said.

‘Economic Efficiency’

As a result, there will be consolidation and spinoffs, Carter said.

“There are small businesses, there are parts suppliers which may grow in this time and that’s good,” Carter said. Those transactions “could be in the interest of economic efficiency” and the Pentagon would welcome them, he said.

Small- and medium-sized companies are “centrally important in a healthy industrial base,” he said in the speech, at the InterContinental New York Barclay hotel

“Perhaps two-thirds to three-fourths of every dollar we award at the prime level is spent for subcontracting goods and services at the so-called lower tier of the industry,” Carter said. “Their health and performance are critical to us.”

The current structure of the U.S. defense industry was shaped in 1993 when then-Defense Secretary Les Aspin told company executives the Pentagon could not sustain several suppliers in each sector and encouraged them to merge in order to better utilize capacity.

The Defense Department today is “down to about five or six very large prime contractors who bid on many, many of our jobs and, in the interest of competition, we are not interested in seeing further consolidation and reduction in that number,” Carter said in the interview. “But with that exception just about everything else is on the table.”

‘Not Desperate’

Chief executive officers of the top two U.S. defense companies have said they don’t foresee consolidations similar to the 1990s.

Lockheed, the world’s largest defense contractor, is under no pressure to make up for a projected slowdown in U.S. military spending through acquisitions, Chief Executive Officer Robert Stevens said in a November interview.

“We are ambitious and we will continue to look” for acquisitions “but we are not desperate,” Stevens said in an interview with Bloomberg News in Washington.

Boeing Co., the No. 2 defense contractor, doesn’t see large acquisitions, Dennis Muilenburg, chief executive officer of Boeing’s defense unit, said in a December interview.

Chicago-based Boeing’s 2010 defense sales of $31.9 billion are second to Bethesda, Maryland-based Lockheed Martin, which reported revenue of $45.8 billion.

Northrop Shipbuilding

The Pentagon asks for “transparency” in all mergers and spinoffs to ensure that “the spun-out entity is going to continue to serve the department in the long-term way,” Carter said.

Northrop Grumman, which is looking to spin off its shipbuilding business, is talking with the U.S. Navy to ensure the standalone unit has sufficient financial backing, two people familiar with the talks said in December. Los Angeles-based Northrop is the Navy’s largest shipbuilder.

In addition to Carter’s speech, the Pentagon has launched a review of defense suppliers that “will go sector-by-sector, and tier-by-tier, to assemble a long-term picture” of what policies will help the department fulfill its requirements, Deputy Defense Secretary William Lynn told an industry group Jan. 30.

‘Pretty Good Pace’

“This detailed review will inform our budget decisions, our acquisition decisions, and our industrial policy,” Lynn said. “It will also help us determine what stake the department has in mergers, acquisitions, and industry consolidation.”

Aerospace and defense industry acquisitions are “growing at a pretty good pace,” said Stuart McCutchan, editor of Defense Mergers and Acquisitions, an online publication based in South Riding, Virginia. He said he expects 2011 “to be a big year.”

Defense companies of all sizes completed 255 transactions totaling about $24 billion last year, the most since 2007, when the industry completed 362 deals valued at $43.4 billion, according to data compiled by McCutchan.

The high point was deals valued at $65.9 billion in 1999 as the industry responded to the Clinton administration’s direction that major consolidation was necessary as post-Cold War defense budgets dropped.

“My guess is that Mr. Carter is trying to get in front of any prospective surge in consolidation activity,” McCutchan said. “What the Pentagon fears most is financial instability caused by imprudent activity” that leaves less corporate money for expenditures on research and development and equipment, he said.

‘What We Welcome’

Carter, in a telephone interview today after the speech, said “this is a policy discussion of what it is we welcome and don’t welcome. We would like to be part of a dialogue that shapes the kind of change industry undergoes, not as part of a regulatory process.”

“That’s the reason to raise it now, before there are a whole lot of these transactions and we are reacting to them one by one,” he said.

“We will deal with them case-by-case as they come along, but what’s important is that, as people contemplate such transactions, they have some understanding of what the department outlook is,” Carter said.

Carter today reiterated that companies must be transparent in their dealings so the Pentagon will “understand the full implications of a proposed transaction will require us to look into the whole financial details of it.”

“We are working well with Northrop Grumman in that regard,” he said of the shipyard discussions.

To contact the reporters on this story: Peter Cook in Washington at pcook6@bloomberg.net; Anthony Capaccio in Washington at acapaccio@bloomberg.net; Gopal Ratnam in Washington at gratnam1@bloomberg.net

To contact the editor responsible for this story: Mark Silva at msilva34@bloomberg.net

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