Govt. supports industrial policy, defense style

Republican policy-makers generally do not like industrial policy, that buzzphrase of
the 1980s, or any industrial policy where the government is the prime player. But look at
what's happening in the defense industry and you can see industrial policy with a
vengeance.

This new policy was created with the heartfelt approval of those in the Pentagon--which
soon may have to be renamed the Norman Augustine Building in honor of the longtime leader
of Lockheed Martin Corp. The policy has bipartisan approval.

In the early 1980s Martin Marietta Corp., begun at the inception of the age of flying
machines, was fighting for survival. It was threatened with takeover by Bendix Corp. and
its go-go chairman, William Agee. But now Lockheed Martin Corp. has become the most
exciting union of airframe, space avionics and IT business around. Others can only seek to
emulate it.

Northrop Corp., fat with cash from its B-2 program, bought faltering Grumman, and more
recently Northrop-Grumman bought Westinghouse Electric Corp.'s defense division as
Westinghouse refocuses on its CBS broadcast unit.

General Dynamics Corp., once the preeminent defense contractor, followed a liquidation
strategy, selling its aircraft manufacturing operations to Lockheed and its space systems
division to Martin Marietta, shortly before Lockheed and Martin got hitched. GD proceeded
to buy the venerable Bath Iron Works to go along with its Electric Boat holdings.

McDonnell Douglas Corp. and rival Boeing Corp. reportedly have been discussing a
merger. From seven airframe companies a few years ago, we are down to four, and soon there
may be only three.

In the meantime, Loral Corp.'s Bernard Schwartz bought some of the proudest names in
defense electronics and computing, including Ford Aerospace, Fairchild-Weston, part of
Honeywell, LTV Missiles, IBM's Federal Systems unit and Unisys' Paramax unit.

Now Lockheed Martin has agreed to acquire Loral. If the merger is permitted by the
antitrust authorities, it will lead to a single gargantuan defense contractor with $30
billion in annual sales.

The fast creation of the Loral IT conglomerate and its significant rewards for
stockholders demonstrate why mergers and acquisitions (M&A) are in fashion. Copycats
and bottom-feeders will follow the trail blazed by Schwartz and try to cobble together
unwanted or undervalued components of other businesses.

The market dynamic is such that there is likely to be a renewed round of mergers and
acquisitions in the wake of the Loral acquisition. The pu rchase of PRC, a prominent
systems integrator, by Litton, a defense shipyard and electronics company, and Magnavox's
acquisition by Hughes are examples that actually preceded this latest round of activity.

Bernard Schwartz will take home an extra $18 million this year, in addition to his
usual $6 million-plus in salary and bonuses and an additional zillion dollars in the
increased value of his Loral stock. Some Martin, Lockheed and General Dynamics executives
also have received huge payouts in the course of the mergers.

But despite the mammoth payouts to executives, the taxpayers still have benefitted from
this corporate Pacman game. Had any of these now-merged companies been forced to exit the
market through bankruptcy and simply closed down, the cost to the public and the Defense
Department might have been much greater.

The biggest defense and aerospace contractors have reorganized their industry with the
behind-the-scenes approval of the Pentagon. Instead of sitting around waiting, Augustine,
Schwartz and others have taken the defense complex in hand and created a new megamall.

In the world of DOD, companies that demonstrate their commitment to solving the
structural problems of over-capacity are likely to be rewarded. DOD will give them the
benefit of the doubt when they compete, particularly in that gray area between electronics
and computing.

And, as the recent Lockheed Martin victory in the competition for the FBI fingerprint
contract demonstrates, these companies also can win outside the DOD sphere, on a level
field with no help at all.

For those ITites that depend on government service contracts--in particular DOD,
Veterans Affairs or related agencies--for their business, the world just got more
dangerous. Old defense companies have reproduced themselves as a new class of internally
funded, experienced raptors looking for contracts to take away.

For smaller companies, particularly systems integrators that hover in the 250- to
1,500-employee range or have sales of less than $500 million, selling out may be a good
option, especially if the entrepreneurs who built them want to retire.

Besides increased competition from the big guys, the legal and political climate does
not help the small and middle-size companies. Procurement reform legislation and
best-value buying tend to vest greater discretion in procurement officials, for whom the
size and relative stability will be reassuring.

For commercial IT companies, the defense M&A trend is less of a threat. For
example, Hewlett-Packard, with its sought-after computers, its cash-cow printer division
and its test and measurement division, which has DOD customers, has a level of overall
corporate profitability and growth that exceeds that of the DOD giants, taken as a group.

In between such successful IT companies and the DOD systems integrators is not a place
for the fainthearted systems integrator.

Stephen M. Ryan is a partner in the Washington law firm of Brand, Lowell & Ryan. He
has long experience in federal information technology issues. His Internet address SMR@blrlaw.com.