Northrop Move Sparks Speculation About Sector Consolidation

Northrop Grumman’s disclosure this week that it may exit the naval shipbuilding business has generated a wave of speculation among investors about defense-industry consolidation. Investors have long known that demand for defense goods and services would soften as U.S. forces began to withdraw from Iraq, especially given the unprecedented budget deficits the federal government is currently incurring. Although defense secretary Robert Gates is credited with restraining Obama Administration moves to shift money from the military to domestic programs, his efforts to reduce weapons outlays and in-source services have reinforced expectations that the defense sector is entering a period of contraction and reorganization. The latest such initiative, aimed at trimming overhead costs, provoked much consternation in the sector because it was widely interpreted as a threat to profit margins.

Against that backdrop, the prospect that the Navy’s biggest shipbuilder may sell or spin off its shipyards has become a catalyst for speculation about where the sector may be headed in terms of possible divestitures and combinations. Many investors interpreted the recent decision of Lockheed Martin to sell two business units while reorganizing its service offerings as a move to position the company for coming market changes. That development was followed by CEO Linda Hudson’s decision to launch a wholesale reorganization of BAE Systems, Inc., the sprawling North American arm of BAE Systems plc. Hudson’s move wiped out an entire layer of management while arranging business lines in a manner that would make them more responsive to customers, but it also signaled an awareness that demand is trending away from some of the company’s core programs. So when Northrop Grumman said it might divest its naval shipbuilding unit — representing nearly a fifth of corporate revenues — even the dimmest investor began to realize that change was afoot in the defense sector.

Industry insiders already knew that merger and acquisition activity had begun to reach a fever pitch among the sector’s second-tier players in the spring, but with several of the biggest players now making their own strategic moves, it is clear the whole sector will be reshaped over the next several years. Companies like SAIC, ManTech and Textron could become much bigger in the defense business, or they could disappear as other companies make offers they can’t refuse. Private equity companies will undoubtedly play some role in sector consolidation, but their presence is more symptomatic than fundamental to the process. What’s really happening is that the defense industry must adjust to the fact that its main customer — the federal government — has a waning appetite for military goods and services, so some of the companies that have grown fat supplying that customer will have to go away. The Obama Administration says it wants more competition in defense contracting, but everything it is doing guarantees there will be fewer players in the business by the time President Obama departs office.

The thing many people in industry don’t understand about these consolidation waves is that once they get started, there is no way of knowing where they will end up. Pressure from investors and competitors forces every player in the sector to get involved for fear of being placed at a strategic disadvantage, and the entire landscape of the industry can change quickly. For instance, Northrop Grumman’s current plan may be to sell or spin off its shipbuilding unit as a single entity and then turn the rest of the enterprise into a lean, mean machine, but the markets could have other ideas. The market verdict may be that the shipyards are more valuable if sold off separately, and maybe the rest of Northrop Grumman is more valuable if treated the same way. In the era of program trading and hedge funds, the identity of a company’s big shareholders can change very quickly, and so can their ideas about where the enterprise should be headed. So don’t assume that today’s plan is what will really happen in the end; like military campaign plans, corporate consolidation plans sometimes do not survive contact with the real world.