A potential merger between McDonnell Douglas and Northrop Grumman didn't make it past the negotiating table. Phil Ponce leads a discussion on the effect of mega-mergers on business and the potential this merger had in the business world.
PHIL PONCE: In the early 90's there were a dozen major defense firms. Today there are basically four huge conglomerates.
PHIL PONCE: Raytheon Corporation now includes what had been Hughes Aircraft and Texas Instruments. It specializes in electronics and missiles. The three remaining mega corporations make military aircraft and other equipment. Boeing acquired Rockwell International and McDonnell Douglas and makes FA-18 Naval aircraft, the C-17 transport plane, and the Apache helicopter. Lockheed Martin now includes Lockheed, Martin Marietta, Loral, and parts of General Dynamics. It makes the F-16 and F-22 fighters and the C-130 cargo plane. And Northrop Grumman is made up of Grumman Aircraft and other companies it acquired. It builds the B-2 Stealth bomber and electronic components for other planes.
PHIL PONCE: Had the merger between Lockheed Martin and Northrop Grumman gone through the new company would have been the largest military supplier in the world. Two perspectives now. Lawrence Korb was an assistant secretary of defense in the Reagan administration. He's now a senior fellow at the Brookings Institution. Pierre Chao is a principal at Morgan Stanley, Dean Witter Investment Bank, where he tracks defense and aerospace companies. Gentlemen, welcome both. Mr. Korb, why did the Department of Defense oppose the merger?
LAWRENCE KORB, Brookings Institution: I think they felt it would stifle competition and lead to higher prices in the long run, as well as stifle innovation, because you wouldn't have had enough competitors to keep pushing technology.
PHIL PONCE: Specifically, how would it stifle competition?
LAWRENCE KORB: Well, if you have a situation, for example, right now, the F-16, Lockheed Martin is the prime contractor-it means they build the platform-Northrop Grumman builds the electronics for it. You've got the E2C, which is an aircraft that Northrop Grumman builds. Lockheed Martin is building the electronics. If those two companies were together, what you would have is when one got the prime, it would be pretty clear the other would get the electronics. And you would not have real competition say between Raytheon or parts of Boeing and McDonnell Douglas are in that area.
PHIL PONCE: Mr. Chao, was it a good thing or a bad thing for the merger to have been stopped?
PIERRE CHAO, Morgan Stanley, Dean Witter: I think it's a complex question to ask. I think in the end it probably was a bad thing. I think in the end you get what you pay for. We've got a defense budget that's about 40 percent the level of where it was a decade ago, and in some ways we can't afford to keep that many players in the industry, and in the end, it would have been better to have had a small handful of very strong competitors that could have lasted through this downturn period. And then when you needed more products in innovation and technology development, the industry could refragment again and you would have had a series of more healthy players after this sort of slowdown period.
PHIL PONCE: So, Mr. Chao, you're saying the country would have been better off with two aircraft manufacturers, as opposed to the three which will now continue to exist?
PIERRE CHAO: I think you're getting into sort of a fine point, and that got to the crux of the issue. You need two or do you need three? When you had eight players, there was certainly no objection that we had to get a smaller number. It's certainly a matter of opinion now that you're getting down to two versus three. My personal opinion is that we could have survived with two. You still have a very powerful customer in the form of the US Government that controls the defense budget, and if you really want to introduce competition, you have a global industry, a very competent one in Europe that could have been brought in, in order to sustain competition.
PHIL PONCE: Mr. Korb, three companies better than two?
LAWRENCE KORB: Well, I think so, because if you take a look at what happens when you have just two companies, you have what the economists call a class duopoly. We just had a competition for the joint strike fighter here a couple of years ago, and at that time we had three people compete. We had Lockheed Martin; we had McDonnell Douglas, which was then independent; and Boeing. Boeing had not been a prime contractor on a combat aircraft for nearly 40 years.
They're the ones that came in with the most innovative design. McDonnell Douglas and Lockheed, which had been building the planes for the last 30 or so years, their designs did not really push the envelope very much. In fact, they were very pedantic. And that's what's normally happened. It's the third person, the person who's outside, who really pushes the technology and leads to America being pre-eminent in those particular areas.
PHIL PONCE: Mr. Korb, why then did the Department of Defense start pushing in the early 90's for all these consolidations?
LAWRENCE KORB: Well, I mean, at that time you had too many. I mean, you had thirteen or fourteen major players, and I think what they should have done is got it down to maybe five or six. But if you had allowed this, you would have allowed number one and number three to merger, and you really would have a situation that would have gone too far. My feeling is that the department, when they started this, lost control of it. I don't think they ever intended it to go this far, and then they were powerless to stop it until you got a new set of players in the Pentagon and in the Justice Department.
PHIL PONCE: Mr. Chao, why do you think they stopped it? Do you think it had to do with a new set of players or other forces?
PIERRE CHAO: I think it had to do with other forces. I mean, clearly, like Lawrence said, when you're getting thirteen or fifteen players, it was obvious, you had to go through a certain process to reduce the number. Whether this management team at the Pentagon would have had a different answer from the prior one and two or three would have been the result, this management team decided that they wanted to have-that three was going to be better than two and that they wanted to make sure that the competition stayed here.
So I think it was very much a judgment call. The only comment that I would make, however, as we go on to the next decade and you look at the defense budget, you'll only have one new fighter being developed. How many companies can survive on just one new aircraft program? We only have a handful of small missile programs. How many players do you really need to do two or three? You're only going to be building a handful of ships. So it really boils down to a matter of how much are the American people willing to pay for defense, and how many companies does that realistically support in a healthy fashion?
PHIL PONCE: Mr. Korb, how about that, is the pie big enough to support the players that are currently in place?
LAWRENCE KORB: Well, I think so. I think the downturn has been exaggerated. Pierre made a comment about it's dropped by 40 percent since the mid 80's. That was the height of the Reagan build-up. But if you look at what we're spending on investment now, which is production and research and development, we're back to the level of the late 70's and early 80's. And we're pretty near the average that we were during the Cold War, and we had many more companies at that particular time. So I think if-depending on where you compare it to-it looks bigger than it, in fact, is. I think right now we're in a situation where we could support more companies than actually exist. I would not have allowed them to go down as far as they are. I probably would have stopped it at five or six, but certainly I think if you had let this go down, then you would have begun to have real problems.
PHIL PONCE: So, Mr. Korb, the four major players that were in place right now, is this going to be the landscape pretty much for the next-for the foreseeable future?
LAWRENCE KORB: I think what you'll see is Northrop Grumman may try and buy something like a Lyons or a TRW space division or Litton, some of the second and third-tier players, which is what Sec. Cohen said today, he would encourage some second- and third-tier players to join with Northrop. And Northrop Grumman is about $9 billion. They probably want to get up to 10 or 11 billion dollars.
PHIL PONCE: Mr. Chao, it's been said that Northrop is not big enough to compete with the three really big companies and that they're too big to be a niche player. What's the future of the Northrop, from your standpoint?
PIERRE CHAO: From my standpoint I think Northrop has an intriguing possibility to act sort of as the pivot point. In other words, that wherever--in future competitions between Lockheed or Boeing, whoever Northrop decides to lend their weight behind, you could maybe get that that group will end up being the winner. So they actually have the opportunity to act as the strategic pivot between the two big boys, and that's not exactly an unenviable position.
PHIL PONCE: So you think Northrop has the ability to survive as an independent, prosperous company?
PIERRE CHAO: I think they have the ability to survive as a major or what I would call a tier one supplier to the majors and lend the pivot, and where there may be opportunities for them to develop some new technology to develop them, and Northrop Grumman-one of its great strengths is its corps technologies in stealth, in precision strike, in reconnaissance. They can lend that strength to one of the two big boys as they act as a joint venture partner for most of them. I think that's their future.
PHIL PONCE: Do you agree with that, as far as Northrop's viability?
LAWRENCE KORB: That's a good reason to keep them viable, because I think that will continue to have the competition. If they had become part of Lockheed, they wouldn't have been that pivot point. It would have been giving Lockheed too big of a share of all the future contracts.
PHIL PONCE: Mr. Korb, can you envision a scenario where the Department of Defense would have to go to the foreign companies to sort of increase the pool of competition?
LAWRENCE KORB: Well, I would like to see us do that, but I don't think it will happen for political reasons. It's very difficult for taxpayer money, for military weapons to go to a foreign country. When Americans think that we're protecting the world, we still have a lot of troops overseas. I think it will be very hard and when the foreign countries have tried to merge with US defense companies, the Department of Defense has gotten quite concerned about some of these very sensitive core technologies getting out of our hands.
PHIL PONCE: Mr. Chao, the likelihood of more foreign participation in supplying the Defense Department?
PIERRE CHAO: I think you're going to be surprised. I think it's going to be fairly high. You've had a couple of early indications: Rolls Royce, for example, buying Allison Engines about two years ago, Tracor, the Texas-based defense electronics firm that was recently acquired not only a month ago by GEC of the UK; certain countries such as the UK have proven to themselves to be very solid allies standing with America every time something has happened on a fairly consistent basis. And they've been reliable partners all along. Actually, I think, those types of countries and companies that work in those countries have had somewhat of a privileged position.
PHIL PONCE: Thank you very much. That's where we'll have to leave it. Mr. Chao, Mr. Korb, thanks.