Crunched by defense cutbacks and global competition, the aerospace industry has undergone radical consolidation in the 1990s, most recently highlighted by the announced merger of Los Angeles-based Northrop Grumman Corp. with Bethesda, Md.-based Lockheed Martin Corp.
While such marriages of giants have probably ended because there simply aren't any left, analysts predict a second wave of subcontractor consolidation is about to crest. And much of that will be in L.A.
"Defense and aerospace contractors are adapting to a new world order: not enough work," said George Pedrasky, credit analyst with Duff & Phelps Credit Rating Co.
The aerospace industry is not only being hammered by a two-thirds reduction in defense procurement since the end of the Cold War, but by the same forces that are confronting many other American enterprises pressures to generate profits while competing in global markets, said Robert Paulson, former McKinsey & Co. aerospace adviser, who now heads his own firm, Aerostar Capital Inc., in Santa Monica.
In aerospace today, economies of scale rule, and size has become king. "Bigness has become good, in aerospace as with elsewhere," said Stephen Koffler, president of Koffler & Co., an L.A. boutique investment bank. "Boeing, McDonnell Douglas, Lockheed-Northrop are coming against the European Consortium (Airbus Industrie), and each other. I can't imagine a lot of small aerospace manufacturers competing in world markets (as happened in the past)."
Koffler noted that the combined Lockheed-Northrop would have annual revenues of $37 billion, with 230,000 employees.
In addition, all the major aircraft manufacturers are publicly held. Managers of such enterprises are under the same pressure that other public chieftains face the incessant demand for higher profits.
"Institutional shareholders want higher returns on equity, and to do that you have to be capable of winning bids. The bigger one is, the more competitive one is to win bids, defense or commercial," said Koffler.
Indeed, when announcing their merger, top executives of Northrop and Lockheed made frequent reference to shareholders as one driving force behind the deal.
"I have been very clear that shareholder value is a very important element," said Kent Kresa, Northrop chairman and chief executive.
The belated drive for efficiency after decades in a government-sponsored economic otherworld will continue to push the aerospace industry to slash costs and look for efficiencies, said Jon Kutler, president of Santa Monica-based Quarterdeck Investment Partners Inc.
The big airplane makers have long operated in a "cost-plus" environment when building Pentagon projects in the Cold War.
In general, big Pentagon contractors in the past merely toted up costs, added on a percentage for profit, and presented a bill. That led to less scrutiny on costs than one would find in other, free-market industries.
"I would characterize the (aerospace) defense industry as being in the Stone Age in 1992, in regard to efficient production," said Kutler. "Simple things that a commercial manufacturer did to make production efficient were unheard-of in a cost-plus industry."
Indeed, the aerospace industry standard for maintaining of production-related inventories has gone from "just-in-case" to "just-in-time," said Paulson, of Aerostar Capital.
Under the "just-in-case" system, production inventories were piled high in factories; now suppliers deliver much closer to the time at which components are inserted into aircraft.
In the past, major aerospace consolidations have led to plant closings, and the combining and shuttering of research and development labs.
So far, Lockheed and Northrop officials have downplayed concerns about job cuts following the merger, and have even spoken of increasing payrolls as they enter world markets.
But John Montague, Lockheed Martin vice president in charge of mergers and acquisitions, has justified the merger by pointing to $1 billion in annual savings once the merger is completed and most experts expect the savings to reflect reduced employment, at least relatively.
Experts say that the merger wave among major aerospace giants, also called prime contractors, has just about run its course because there are no more big partners left to marry.
Still, the consolidation wave is not over; and for Los Angeles it may not even be mostly over.
A whole second level of subcontractors, large and small, now must look at each other as marriage partners if they want to compete, said observers. "The prime contractors have realized that working with three subcontractors is a lot easier than working with 12," said Paulson.
With larger production runs, the remaining suppliers will be able to drive down costs as well, said experts.
Kutler, who acts both as merger adviser and investor in small or medium-sized aerospace companies, sees plenty of action in the near future as suppliers combine to survive.
"The mergers of prime contractors have left the subcontractor base pretty much in the dust. You will see an unprecedented amount of consolidation among subcontractors," said Kutler. "The smaller mergers won't grab as many headlines, but on a local level they will probably be even more significant than what the big boys did."
Some say the second wave of consolidations will probably result in continuing softness in aerospace payrolls in Los Angeles, as merging subcontractors lay off duplicative workforces. But Paulson said defense procurement spending has about bottomed out, while commercial aircraft orders are rising at 109 percent yearly which should result in lots of production work for local companies.
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