Blockage of the proposed Lockheed Martin/Northrop Grumman merger in 1998 was viewed by many as the end of the era of U.S. domestic megamergers in the defense industry. But it also heralded the start of a new round of smaller acquisitions that picked up steam in 2000 and appears have been precursor to a wave of global megamergers.

Both the U.S. and Europe are involved in an overall mergers and acquisitions (M&A) boom involving traditionally non-defense companies as well as second tier and below defense contractors. These activities also have begun to reflect the increased blurring of the line between commercial and defense operations as commercial-off-the-shelf (COTS) components become standard military fare.

The number of mergers involving defense-oriented companies was up in 2000 from the previous year, as were both the overall valuation and the general size of the companies acquired. These deals also tended to reflect an increased diversification of major defense contractors into information technology and electronics.

Examples include Northrop Grumman's purchase of Comptek Research ($145 million in annual revenues), Federal Data ($600 million), and Sterling Software ($159 million); Titan's acquisition of Avistar ($184 million) and Advanced Communications Systems ($218 million) and AT&T's take-over of GRC Intl. ($164 million).

"Northrop Grumman's acquisition of Federal Data in mid-September 2000 is the quintessential example of what's happening," according to Rick Knop, partner in the invest ment bank of Boles Knop & Company LLC )Middleburg. Virginia). "It takes Logicon (acquired by Northrop Grumman in 1997) to more than $2 billion in revenue and fleshes out what they offer to DoD. It brought in a larger sales force, crit ical mass, and IT capability in outsourcing.

"There are lots of pure IT and telecom companies that are significant suppliers of products and services to the defense and intelligence communities. That's why the major defense contractors involved in platform business have been actively acquiring information technology, telecommunications, and electronics firms, because they see that is where the defense budget is rapidly moving."

Not that sizable U.S. acquisitions have ceased, as evidenced by Boeing's $3.75 billion purchase of Hughes Electronics Corporation's space and communications division, making Boeing a major player in satellite communications.

In and of itself, defense is not a growth activity, and, despite pledges of increased budgets by the next U.S. administration, it is still losing ground in terms of share of overall government spending. This daily diet of diminishing resources has been a powerful force motivating consolidations in the U.S., Western Europe, and Russia.

It creates pressures on the entire industry in terms of how to survive and thrive in an environment where the top line is limited, and expenses, in terms of employees and main taining equipment and facilities, rise steadily. The solution most have chosen is consolidation, according to R. Jerry Grossman, managing director of Houlihan Lokey Howard & Zukin, investment bankers (Washington, D.C.).

"There is a degree of refinement in the industry, the obvious sorting out that Lockheed Martin is clearly doing together together an aggregate of assets running across almost every discipline of aerospace and defense," he says. "Those activities still have some distance to run at that level. But if you move down to second tier suppliers and systems companies, I suspect we will see some continuing refinement and combining of business."

Acquisition as it was practiced in the past is not a viable solution, however, Grossman continued, because the nature of the customer and his requirements also have changed. As a result, merely acquiring facilities and employees without care and Pruning can lead to higher overhead and reduced net earnings.

The new approach is not so much a prime contractor with large production capability, but an integration specialist with lots of niche capabilities, either in-house or subcontracted.

"And cycle times have to be much shorter, so fixed assets, such as facilities, are less important," Grossman said. "It's more of an intellectual power issue now. The aerospace and defense industry is beginning to learn how to use those smaller-faster-cheaper components to lower the relative cost of their systems and platforms and keep them more technologically current. The overall effect of that trend is to keep the top line growth of the industry at a modest pace."

Filling niche gaps in technologies and capabilities through acquisition is enabling the survivors, especially in Europe, to consolidate competitive elements to better compete on global markets. This has been especially evident among companies below $1 billion in annual revenues, both as tar gets and as buyers.

"Outsourcing is requiring a broader capability, so companies need to be able to service an entire agency nationwide or even worldwide and be able to perform," Knop said. "The contractors are filling holes in terms of skill sets, agency relationships and overall capability. Bigger is definitely perceived as being better. General Dynamics, SAIC, Northrop Grumman, TRW and others are really bulking up to be able to perform.

"The government also now has brought commercial practice to the defense establishment, which means they are going to government-wide acquisition contract vehicles. That means, for the most part, when major contractors are winning new contracts, they still have to compete and there are multiple winners, with little real exclusivity. In the past, you knew what you had for several years with a new contact. Now, you don't."

Another trend in recent acquisitions has been the emergence of new players such as private equity groups acquiring smaller middle market defense companies, either to sell to a major contractor or to take public. One such example cited by industry analysts is privately owned Veridian Corp., which is backed by a large equity partner and has gone from $100 million to almost $1 billion in revenues in recent years.

Telecommunications firms, such as AT&T, also have become active in the defense marketplace, reacting to DoD's outsourcing of large telecom requirements. The goal there is to acquire companies that already have a place at the table, along with their service contracts and capabilities. This trend is expected to increase as the line between IT and telecom continues to blur.

Recruitment and retention of experienced workers also has been a factor in consolidation at this level. Major defense contractors have found it increasingly difficult to compete for skilled workers in such high-demand areas as information security and electronic commerce. One way to combat raiding of high-end skills by smaller companies is to absorb them.

"A final rationale for this consolidation is that past performance is becoming more and more important in the procurement process. So some of the larger companies are acquiring niche companies with past performance track records and customer relationships in areas such as intelligence," Knop said. "We see this pace of consolidation continuing for the next several years, and the top tier defense contractors will be forced to acquire smaller companies to maintain revenue growth and get into skill sets that are hard to find."

These same elements also are being felt elsewhere in the world. FY2000 saw an increase in transnational acquisitions that some believe will become the centerpiece of a new merger mania.

Examples of this include the acquisition by Cubic Corporation ($511 million 1999 revenues) of New Zealand's Oscmar International Ltd. (terms of the deal were not released), which develops and manufactures precision instruments for use in simulation systems, instrumentation and control equipment and monitoring defense training performance.

BAE SYSTEMS North America completed its acquisition of Lockheed Martin Control Systems in a $510 million cash transaction in 2000, giving it a presence in aircraft engine controls, space controls, and hybrid-electric drive systems. At year's end, BAE SYSTEMS also was pursuing a $1.67 billion cash purchase of Lockheed Martin Aerospace Electronics Systems.

In September 2000, United Defense Industries finalized its take-over of Bofors Defence of Sweden from Saab)the value of the transaction was not disclosed). While Bolors Defence remains a Swedish corporation, headquartered in Karlskoga, the new combine is intended to establish a strong position in intelligent munitions, advanced artillery technology and naval gun design on the global defense market.

As FY2000 ended, Boeing announced plans to buy Australia's Hawker de Havilland, a designer and manufacturer of commercial and military aircraft aerostructure components, from Tenix Holdings International Pty Ltd. The acquisition would complement Boeing's subsidiary AeroSpace Technologies of Australia (ASTA Components). Tenix Group Managing Director Paul Salteri cited global consolidation in the aviation industry, saying Hawker de Havilland would have the strongest prospects as part of Boeing, the world's largest aerospace manufacturer.

FY2000 did see some significant megamergers, as well, but this time in Europe.

The joining of British Aerospace with Marconi Electronic Systems to form BAE SYSTEMS in November 1999 created the world's second largest defense contractor. It also reflected a growing European response to previous U.S. consolidations.

"BAE SYSTEMS has the size and capability to ensure it takes a lead role in the global consolidation of the aerospace and defense sector," BAE SYSTEMS' chief executive John Weston said at the time of the merger. "We are well positioned for further European and U.S. moves, and we are just one step away from our goal of being a significant part of the leading global player in our business."

In July 2000. a new European behemoth debuted on three stock exchanges (Madrid, Munich, and Paris) simultaneously. Based on 1999 combined revenues, the European Aeronautic Defence and Space Company (EADS) — comprising the activities of founding partners Aerospatiale Matra SA. (France), Construcciones Aeronauticas SA. (Spain), and DaimlerChrysler Aerospace AG (Germany) — was born as the world's third largest aerospace company.

However, integrating three extremely different management styles, cultures, and languages from three pre-existing strong companies is likely to be more difficult than was the merger of far more similar U.S. giants, which in some cases (such as McDonnell Douglas) were themselves merged into history before fully integrating their old corporate cultures.

Even so, there have been rumors of possible future trans-Atlantic mergers involving both BAE SYSTEMS and EADS.

The latter is thought to have an interest in Northrop Grumman, for example, primarily because of the American firm's electronics and software capabilities. Because Northrop Grumman is no longer a prime on aircraft manufacturing and its stealth technology is no longer a unique asset, such a combine might be acceptable to the U.S. government. There also are those who argue that prospect could have spurred some of the EU's opposition to the Lockheed Martin effort.

Ironically, a few analysts also have put forth the prospect of a future merger of Lockheed Martin and EADS, with EADS possibly emerging as the controlling entity.

BAE SYSTEMS, meanwhile, has been working closely with Boeing on several fronts, fueling speculation of a U.S./U.K. merger at some point in the future. Barring an EADS joining with one of the U.S. giants, such a combine would become the undisputed number one in aerospace and possibly defense.

None of those is likely to happen in the next year or two, but the emergence of truly transnational aerospace and defense giants can only be seen as a logical extension of a pattern already beginning to form in other industries, such as automobiles, consumer electronics, and pharmaceuticals.

"The utility of new technologies will bring countries closer together and create partnerships with technology multi-national corporations (TMNCs) and governments," says Ken Brown, president of the Alexis de Tocqueville Institution (Arlington, Virginia). "TMNCs will rely on governments for law enforcement, and governments will rely on TMNCs for talent and proposals for increased safety and technology inte gration. As long as TMNCs can continue to make the case for usefulness and economic growth, regulatory bodies will ultimately be 'open-minded' to their pursuit of new markets."

U.S/European combines also could be spurred by the expansion of NATO and demands by both new and old members for increased commonality in equipment. Filling the needs of an alliance involving all partners is easier from a contracting standpoint than competing for individual national military programs, where domestic contractors have obvious advantages.

"There has been some consolidation within the NATO companies and a little trans-Atlantic, but not much," Knop says. "Jacques Gansler (under secretary of defense-acquisition and technology) had indicated the U.S. might look favorably on some cross-border activity, but has backed away from that somewhat. There is a national security angle, of course, when talking about cross-border mergers."

Even so, the level of cross-Atlantic activity has been significant the past two years, with roughly 40 percent of the total value of aerospace/defense transactions involving European buyers of principally U.S.-based companies, according to Grossman.

"There has been some activity hut a lesser amount, the other way. I think that is a concern," he says. "DoD has said it would be much more global in its thinking in terms of suppliers and would recognize that the technology deployed in aerospace/defense assets is no longer just invented for those purposes. In the commercial sector, there is a lot of R&D going on that is producing system hardware and software elements that can be integrated into defense and aerospace systems. And a lot of that is coming from companies overseas or from global companies. So the idea of being more vulcanized as a buyer of aerospace/defense services and products, according to DoD, is not the way to go.

"The question for U.S. companies is, will they get the same reception from European governments when trying to buy a company in Europe? European regulators have been tougher on some of the international transactions outside of defense/aerospace where a major U.S. firm has been involved

— or U.S. mergers involving companies that do a lot of business in Europe, such as AOL/Time-Warner. The Europeans don't seem to want to give up control, although the U.S. and U.K. seem to have worked things out. But beyond that, into Europe at large, there is some concern that deals going the other way might hit some rough ground. Clearly, the com bining of U.S. and European defense/aerospace companies has been moving along most aggressively from East to West."

While its long history of government-owned assets in aerospace and defense has given Europe a tendency to look at transnational mergers more closely, Grossman says the U.S. government is finally beginning to recognize the sensitivities of globalization. Oddly, the spur to that new interest is not the old defense industry.

"Americans have tended to be more relaxed about merg ers, but now there seems to be some increasing U.S. government scrutiny of the East-to-West activity, led largely by the telecoms," Grossman says. "Besides just weapons and missiles, you have the issue of information security, cyber warfare closing down communications systems, and the amount of information that is mobilized across communications systems. The communications infrastructure globally is increasingly used to carry some of that information. So you have to look at where the threats are coming from and international ownership as a national security issue."

Meanwhile, in Russia, efforts intensified in FY2000 to restructure the old Soviet design bureaus and other elements of the military-industrial complex to create more streamlined entities capable of bringing badly needed hard currency into the beleaguered Russian economy. The Russian government has reorganized how it deals with its defense industry on an almost yearly basis since 1992.

The latest iteration, in place at the beginning of FY2000, was a new Commission on Defense-Industrial Questions, headed by the prime minister. Reporting to this commission are five government agencies: The Russian Munitions Agency the Russian Conventional Weapons Agency, the Russian Control Systems Agency, the Russian Shipbuilding Agency, and the Russian Air Space Agency. Each agency will develop, budget, and contract its own projects, as well as serving as the state contractor for research and development relative to its area of interest.

The new effort was not universally applauded. Yakov Urinson, the retired vice premier who supervised the defense industry complex, argued arms agencies are the wrong approach because there is no longer a pure defense industry, with the vast majority of enterprises primarily engaged in manufacturing consumer and export goods rather than government military production. Urinson said the economic well-being of those operations lies elsewhere, and the arms agencies will become little more than feeding grounds for bureaucrats.

Urinson's concerns for where markets actually lie for Russian industry reflects what has been happening globally. Companies that once directed all or the majority of their efforts toward military contracts now are increasingly compelled to find commercial markets. And the growing inability of the Pentagon and its counterparts to fund military specific R&D, further increasing reliance on COTS components, has forced governments to redefine both national security and what comprises a "defense" asset.

"If you project this three to five years into the future, it will be much harder to distinguish where is the defense sec tor," Grossman says.