Should The Pentagon Embrace A Boeing-Northrop Merger?

The Pentagon is pushing for more power to block defense mergers and preserve competition, but analysts say any consolidation triggered by the recent contract award for a new long-range bomber might not be a bad thing after all.

Right now, the Defense Department can review one merger at a time but says this case-by-case process doesn’t give it the big picture on who controls market share. So the Pentagon is asking Congress for a bigger voice over industry deal-making.

Defense Secretary Ash Carter and the Pentagon’s chief weapons buyer, Frank Kendall, warned against further industry consolidation after Lockheed Martin (LMT) got the OK from the Justice Department for its $9 billion purchase of helicopter maker Sikorsky from United Technologies (UTX).

“With size comes power, and the department’s experience with large defense contractors is that they are not hesitant to use this power for corporate advantage,” Kendall said in September.

GD-Huntington Ingalls Duel

But Russell Solomon, a senior vice president at Moody’s, thinks a smaller industrial base would have some advantages, saying a defense sector that stays fragmented in order to keep more companies in business actually creates inefficiencies and pushes costs higher.

“We think it would be in everyone’s best interest to have consolidation at the highest level,” he said.

And going down to two major aircraft contractors from three wouldn’t hurt competition, Solomon added, citing the competitive bidding for shipbuilding contracts between the two main contractors, General Dynamics (GD) and Huntington Ingalls (HII).

But Solomon said talk of mergers at the highest levels is considered “blasphemy” right now, so most mergers in the near future will come from the tier-two or tier-three supply chain levels. He cited earlier deals like Aerojet’s 2013 acquisition of Rocketdyne and ATK’s combination with Orbital Sciences this year.

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But the Air Force’s decision in October to award the long-range strike bomber contract to Northrop Grumman (NOC) over a Boeing (BA)-Lockheed team could spark a round of consolidation at the top level.

The bomber is the main airframe project for the next 10 years and could be worth $50 billion-$80 billion.

Boeing Must Decide

“Boeing needs to think about whether or not they put in a bid for Northrop’s aircraft program,” said Teal Group analyst Richard Aboulafia. “Because that’s the only way out of this, unless they go back to being the company they were before they absorbed McDonnell Douglas and Rockwell in the ’90s and become a pure-play civil-jetliner contractor with some military work bolted on.”

Boeing is protesting the Pentagon’s decision, and the Government Accountability Office is expected to rule on it in February. Northrop Grumman was forced to stop work on the plane in the meantime.

Boeing shares are down 3.3% since the contract was awarded. Northrop shares are down 1.8%, and Lockheed’s are down 2%.

Prior to the award of the bomber contract, Boeing indicated that it would maintain the status quo afterward. In its quarterly conference call in October, CEO Dennis Muilenburg said the aerospace giant’s defense business “overall is a healthy portfolio” and that he “likes the program structures we have.”

Upcoming Drone Award

Another program, the Unmanned Carrier-Launched Airborne Surveillance and Strike drone, is up for grabs and could provide a boost to the defense business. The Navy awarded four preliminary design contracts last year to Boeing, General Atomics, Lockheed Martin and Northrop, which will compete for a final award later.

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But that may not go Boeing’s way either. While it has made innovations in its commercial aerospace segment, innovation on the defense side has been stagnant, with Boeing and other manufacturers “coasting on derivatives for so long,” Aboulafia said.

Delays and budget issues could also put that program in jeopardy, even though it is strategically important, according to Solomon.

As the Pentagon weighs the prospect of having only two main aircraft contractors, the recent history of the space-launch market may offer a sign of what’s to come.

Boeing and Lockheed once competed to provide launch services for military payloads. But 10 years ago, they merged their launch operations into a joint venture called United Launch Alliance (ULA), which had a virtual monopoly on Pentagon business.

Earlier this year, the Air Force certified SpaceX, founded by Tesla Motors (TSLA) CEO Elon Musk, for military launches, allowing it to compete for Pentagon contracts against ULA. But U.S. sanctions meant to punish Russia for its invasion of Ukraine limited ULA’s ability to use Russian-made rocket engines for its boosters.

So in November, ULA dropped out of a launch contest due to engine availability, leaving SpaceX as the lone bidder. ULA is developing a new rocket, the Vulcan, with a U.S.-made engine, but it won’t be ready until 2023.

In April, Air Force Secretary Deborah Lee James warned that the sanctions may produce such a scenario. “What we may be doing is trading one monopoly situation for another,” she said.

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