Will big also be beautiful, as consolidation creates American aerospace giants?
Kevin O'Toole/LONDON
Revolutions, it seems, can often start from surprisingly low-key beginnings. In the case of the Lockheed Martin merger, it began with a telephone call. In March 1994, Lockheed chairman Dan Tellep rang Norman Augustine, his opposite number at Martin Marietta and also an old friend.
Augustine, something of a policy guru for the US aerospace industry, had just backed out of a bid for Grumman after what he considered an overpriced rival offer from Northrop. Instead, Augustine and Tellep started a series of clandestine meetings and secret studies. Less than six months later, they sprang on to a largely unsuspecting public the news that the two great consolidators of the US aerospace industry were themselves to consolidate in a "merger of equals".
If the world aerospace community was not more startled, then it is only a sign that it has learned to expect the unexpected. Even the most jaded executive would have to concede, however, that this merger has the makings of a revolution. As the two companies complete their deal this year, they will begin to find out just how big.
The apparent ease and speed of the merger should not deflect from the fact that this is an alliance on an enormous scale. Annual sales of $23 billion should ensure that Lockheed Martin is the world's largest defence contractor, dwarfing McDonnell Douglas (MDC) and British Aerospace, among others. The new company may also have some chance of staking a claim, as the world's largest aerospace company, as Boeing's sales shrink again.
One leading US aerospace consultant comments, that aerospace defence companies, which had hoped to gain critical mass, by breaking through the $1 billion sales barrier, now find, that the stakes have been raised. Today the hurdle looks more like $10-15 billion, he adds.
Augustine agrees that the Lockheed Martin merger is more likely to be the first shot in a new phase of mega-mergers, rather than the parting shot from the last round of US consolidation.
Its implications are already sending ripples across the Atlantic as the European national champions begin to feel uncomfortably sub-scale. Concerns over the gathering pace of US restructuring were never far from the surface as the good and the great of Europe's industry met at Flight International's European Aerospace Forum 94 at Paris in November 1994.
"The re-organisation of the American aerospace industry is spectacular...We are witnessing a process of radical reshaping of an entire industry," says Aerospatiale chairman Louis Gallois, summing up much of the feeling within the region. "Our real challenge is to cope with cost structures and size, which are being imposed on us, by the new US mega-firm," he adds in a plea for Europe to speed up the process of rationalisation.
In fact, Augustine has suggested that his merger only achieves the sort of consolidation which took place in European industries as long ago as the 1950s, when national industries slimmed down to just a couple of major players. "In many ways, Europe was ahead of us," he says. His re-assurance is probably underselling the achievement of the USA.
Gallois points out that Europe's aerospace groups may be large, but they lack the kind of market dominance now being cultivated by the emerging US giants. While Lockheed Martin is a broad group on any measure, it is a potential world leader in its core activities of combat aircraft, space systems and defence electronics.
Hughes has similarly focused on acquiring a lead in missiles. The equivalent European group is likely to be spread more thinly across everything from tactical missiles to regional turboprops.
European concern could be valid. A renewed drive in the USA to build scale also raises the spectre of the new giants turning their attention across the Atlantic for the next round of alliances and threatening to destroy Europe's fragile consensus in the process.
Despite the inherent difficulties, the idea of transatlantic mergers is already gaining ground with many of the same aerospace and defence analysts who helped to drive the last round of US consolidation. Corporate boardrooms on both sides of the Atlantic are taking note.
ECONOMIES OF SCALE
All of this begs the question of whether size on the scale of a Lockheed Martin is necessarily desirable. "We took a hard look at whether size matters and came to the conclusion that it did," says Martin Bollinger, a leading aerospace and defence consultant at Booz-Allen & Hamilton.
Some of the arguments for economies of scale are clear enough in any industry. In a world aerospace market where the volume of sales and new-programme opportunities are almost universally under pressure, the economic gains to be made from rationalisation become compelling, argues Bollinger. For many, it will be a simple matter of survival.
The number of competitors in some sectors, especially in defence, may have to fall by up to half if existing cost levels are to be maintained, warns Bollinger.
To illustrate the point, Booz-Allen has created an industry model which weighs up the potential cost benefits which could accrue from consolidation in each of the main aerospace sectors (see graphics). The figures indicate that areas such as tactical aircraft, helicopters and missiles could cut costs by between one-third and one-half.
Economics is not the only factor, however, and Booz-Allen has gone on to model several other political, competition and structural issues which will weigh in the consolidation equation. By mapping the potential for cost savings against these more qualitative pressures, a picture emerges of where the drive for rationalisation is becoming overwhelming. Unsurprisingly, helicopters, missiles and tactical aircraft again head the list.
Booz-Allen goes on to chart the drop in the number of competitors which consolidation would bring to each of the industry sectors. The figures are equally revealing. They imply cuts of up to 50% in the most overcrowded markets, both civil and military.
A review by the US Department of Defense (DoD) of the country's industrial base is equally stark. It outlines the need for only a couple of major competitors in most of the main platform sectors. Perhaps more significantly, the DoD has signalled that it is happy to live with a single-source supplier where economics dictate it. The situation already exists in areas such as those of aircraft carriers or tanks.
Few markets, either civil or military, will be immune from this cost-driven squeeze. The depressed state of civil markets hardly needs underlining. Jet-transport deliveries have fallen from a peak of more than 800 in 1991 to a likely output of no more than 460 in 1995.
Although there is a recovery pencilled in for 1997 and beyond, as airline finances begin to improve, that does not guarantee that there will be any easing in the drive to cut costs and whittle down supplier bases among the prime contractors.
For equipment suppliers, the battle to secure positions on the major programmes will increasingly become a case of winner-take-all. The fight for avionics contracts on the new-generation Boeing 737 is a case in point, where the losers are likely to miss out on upgrade opportunities for the 767 and 757 as well.
Defence is tougher still. Despite some brighter prospects from Asia and the Middle East, the core Western markets have plummeted. US military procurement alone has dropped by more than 40% from its peak in 1987.
Again, there is some hope that this is now the bottom of the latest 15-year cycle, with analysts looking for a modest upturn over the next three or four years. What no one is predicting is a return to the boom years of the 1980s.
Bollinger warns that any further defence cuts are likely to trigger a fresh wave of consolidation. With programmes scarce, the loss of even a single programme can cause chaos to corporate planning.
Northrop, for example, had relied on B-2 bomber work for more than half of its sales. With that programme facing a premature end, the group was forced to act. That explains the ferocity of its fight to win the bid battle for Grumman, an acquisition, which will help plug the yawning gap in sales in the next century.
The scale of the Lockheed Martin merger also provides some safety in numbers. Around 40% of its sales will be tied to ten key defence programmes. The loss of even a couple, could be weathered by the combined group, without a catastrophe. "We're not too vulnerable," says Augustine. "If we can hold our own in defence over the next five years and grow overall, then I think we will have succeeded."
Even for those, which survive the cancellations and competition, the lower volume of defence orders will still drive unit costs up and utilisation down. Consolidation provides the obvious opportunity to tackle this cost structure by squeezing out excess capacity in production and development.
John Montague, vice-president for corporate development at Martin Marietta, indicates that the merger with Lockheed will leave plenty of room for consolidation among its 38 operating companies and nearly 5 million m2 of space.
The track record of the two companies in realising such consolidation benefits is impressive. Montague says that Martin Marietta estimates savings over five years of $1.5 billion from the GE Aerospace acquisition and $300 million from the General Dynamics (GD) space business, while Lockheed's consolidation at the GD Fort Worth F-16 line is due to net around $250 million.
The Lockheed Martin deal could be better still. As Tellep is fond of pointing out, because the transaction was completed through a merger, it has none of the borrowing or goodwill write-offs associated with an acquisition. "Every dollar saved on a fixed-price contract goes straight to the bottom line," he says.
Tellep adds that the merger will produce impressive levels of free cash. He estimates the generation of $4-5 billion within the next five years. Some, at least, will be spent on acquisitions, once the basics of the merger have been put in place over the next year or two. It may come as some consolation to smaller players, however, that both Augustine and Tellep have more or less ruled out hostile bids.
BIG IS BEAUTIFUL
Bollinger detects a more subtle and fundamental shift-taking place, in the power balance between large and small players as consolidation continues.
In the past, belonging to a large parent group provided a certain degree of security, but gave no definitive advantage over smaller niche competitors, at least in areas such as defence electronics. That could change as the emerging giants begin to husband their resources, believes Bollinger. Opportunities to pool skills, programme risks, supplier bases and production processes could provide an edge which is unavailable to small competitors. In short, the giants will become smarter, more capable and, ultimately, more profitable, rather than simply larger.
Lockheed Martin, for example, will emerge with a combined research-and-development budget of $750 million - a figure larger than the turnovers of most of its small rivals. Tellep has made it clear that the aim will be to maintain this level of spending, but make it more effective.
The two merger partners, have already shown themselves adept, at spreading less tangible assets, such as best practice and know-how, throughout their expanding groups. Bollinger identifies Martin Marietta's absorption of GE Aerospace as a prime example. Both companies gained, with GE managers rising through the enlarged group's ranks and bringing new ways of doing business in their wake.
Consolidators are already rewarded with enhanced margins and shareholder value. In future, the prospect is that they will increasingly set the pace on price and technology for contract competitions.
The acquisition and subsequent rationalisation of the GD missiles business by Hughes Aircraft is a case in point. That produced utilisation gains of 35% to 85% and cost savings of 35%, allowing Hughes to boast that it had paid off the $450 million acquisition price, through higher margins, within just 18 months.
The combined operation also went on to gain market share in the air-to-air sector and has become the single source for the Toma-hawk cruise missile leaving MDC in the cold.
It will be another year or two before Lockheed Martin begins to reap the full benefits of combined operations. Augustine and Tellep admit that there is little room to start serious integration on existing programmes, even where both companies have a major work-share, such as on the F-22. The next round of development programmes and contract competitions could be a different story.
TRANSATLANTIC ALLIANCES
Although this restructuring of the US defence aerospace base has until now largely been a domestic affair, as the end-game gathers pace there is a growing evidence, that it could begin to spill across the Atlantic.
"We believe that the next step is to look outside the USA," says Bollinger, although he admits that the shift to trans-national mergers may prove a longer-term trend. There is little doubt that the major US contractors have developed an appetite for consolidation, which will prove increasingly complicated to fulfil without looking beyond the USA.
The post-Cold-War shift in world politics could support the trend. Both the USA and Europe are now focused on the new threat of containing small, and often unpredictable, regional conflicts around the world. That requires new common capabilities, which will be difficult for any single country to develop in the current climate of budget cuts.
Whether transatlantic mergers and acquisitions prove to be the solution is still highly speculative, dependent in part on the intricacies of European politics.
Summing up at the European Aerospace Forum 94, Ian Godden of OC&C Strategy Consultants, painted two potential visions for the future of the European airframe primes.
"If the Governments of Europe can foster agreement within Europe, then the objective is to create two strong defence contractors of equivalent size to Lockheed Martin," he says. Despite the growing number of collaborative European programmes, that is still a big "if". The alternative, Godden believes, is a "real risk of fragmentation", as the major European aerospace nations go their own way.
The UK and Italian industries already face a choice of whether to deepen links within Europe or to secure their survival by turning to outsiders from the USA or beyond.
There is much talk around the bazaars, certainly in the USA, over the logic of future US-UK links, based around the existing defence ties between the two countries. Even then, the alliance would have to be of the order of a link between BAe and MDC to create the necessary scale to match a Lockheed Martin.
Such a deal is not impossibly large. After all, it was BAe's current chairman Bob Bauman, who, in a former role, secured the giant transatlantic pharmaceuticals merger between SmithKline and Beecham.
The UK industry appears instead to be leaning towards a more European future, but as Godden says, the issue could ultimately come down to which deals offer company shareholders the best financial rewards.
He adds that a transatlantic tie-up could create a "trojan horse" for US companies to gain a foothold in Europe, in the same way that Japanese car makers used UK plants and co-operation as springboard into the region.
If fragmentation does take hold, then Godden believes that Germany could be tempted to cultivate its neighbours in Eastern Europe and the former Soviet Union. "The German aerospace industry is and will remain embedded in the European aerospace industry," stressed Manfred Bischoff, chairman of what is now Daimler-Benz Aerospace, speaking at the Paris conference. He does add, however, that some limited co-operation with the former Soviet states could be pursued in defence and space.
Meanwhile, the French defence industry could probably muster sufficient critical mass by a consolidation within the largely state-owned national industry. Alternatively, the individual players could look outside France to join with one or other of the emerging power blocs.
Aerospatiale chairman Louis Gallois does not exclude internal French consolidation, but stresses that the real future lies with "intensified European integration" as a response to the threat of US "mega-conglomerates".
So, for the present, Europe seems temperamentally inclined to pursue consensus, but, as the industry knows only too well, situations can change radically. It only takes one telephone call.
Source: Flight International
