Pentagon open to mergers, but not at very top

NEW YORK Wed Feb 9, 2011 4:36pm EST

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NEW YORK (Reuters) - The U.S. Defense Department said it would welcome defense industry mergers and acquisitions in the coming new era of tighter budgets, but did not want to see further consolidation among the biggest contractors.

Ashton Carter, the Pentagon's top weapons buyer, told a Wall Street investment conference on Wednesday that the department fully expected -- and even welcomed -- mergers, spinoffs and divestitures that led to greater efficiencies, given an expected slowdown in defense spending.

He said the Pentagon would demand great transparency about any proposed transactions to maintain a robust and competitive industrial base, avoid potential organizational conflicts of interest; and ensure full visibility into restructuring costs.

But he said the department did not want to see mergers of the biggest players in the sector like those that occurred during a wave of consolidation in the 1990s.

"The department is not likely to support further consolidation of our principal weapons systems prime contractors," Carter told an event hosted by Cowen Group.

The current structure of the industry emerged two decades ago when defense spending was scaled way back after the end of the Cold War. In 1993, then-Deputy Defense Secretary William Perry, a close friend and mentor of Carter's, told companies that they would need to merge if they wanted to survive.

That process left Lockheed Martin Corp (LMT.N), Boeing Co (BA.N), Northrop Grumman Corp (NOC.N), General Dynamics Corp (GD.N) and Raytheon Co (RTN.N) as the biggest suppliers to the Pentagon, along with Britain's BAE Systems. (BAES.L)

Carter referenced Perry's "Last Supper" during his speech, saying, "That was a very different circumstance from today. The defense industry of that era was also very different from today's industry."

But he said a dialogue with industry was just as necessary now to chart a course for the future, and said he and other Pentagon leaders were trying to cultivate better relations with industry after distanced and often-frosty relations under former Defense Secretary Donald Rumsfeld.

"A strong, technologically vibrant, and financially successful defense industry is ... in the national interest," Carter said, adding that the department planned to pursue "policies and actions that provide for long-term innovation, efficiency, profitability, and productivity growth."

Carter later told Reuters that his goal was to "get out in front of and anticipate the fact that industry is going to be making fundamental adjustments to the new era that we're in."

He said the issue of consolidation among the top tier companies had gotten a lot of attention, but he did not know if any of them were seriously considering such moves.

Carter also said the Pentagon was mindful of industrial base issues and the need to maintain specialized capabilities in some cases. The department was examining these issues in a new sector by sector review, he said.

In his speech, Carter said defense officials would focus on seven key "guideposts" in evaluating the changing structure of the industry in coming years:

* reliance on normal market forces to make the most efficient adjustments to the defense industrial base; with an eye to avoiding the creation of overly leveraged, weaker stand-alone firms that are less likely to thrive without the solid capital structure of their parent companies

* a continued focus on competition, through head-to-head competition where possible, and by offering real incentives for increased productivity in other cases

* decisions would be made on a sector by sector, case-by-case basis, trying to achieve the right size and shape for the Pentagon's changing requirements

* increased attention to the more dynamic lower tiers of the defense industry, with a big focus on encouraging the entry of smaller firms and start-ups that could "provide needed new technology, new faces, and new ideas to the defense industry."

* increased attention to the importance of service providers, which account for about half the Pentagon's annual spending of $400 billion for procurement.

* encouraging new suppliers by lowering barriers, such as needless or time consuming paperwork

* the knowledge that defense markets are increasingly global, with further moves to open the U.S. defense market to "non-heritage" suppliers while safeguarding national security

Carter told Reuters his remarks were not meant to reference any specific transaction.

Asked about the Pentagon's views of a possible spinoff by Northrop of its shipbuilding business, Carter said officials were still at an early stage in examining the possibility and both sides still had "a lot of work" to do.

The question for any possible spinoff was whether the new company would survive on its own in the long run, he said.

(Reporting by Lynn Adler in New York and Andrea Shalal-Esa in Washington; writing by Andrea Shalal-Esa in Washington, editing by Gerald E. McCormick, Matthew Lewis and Tim Dobbyn)

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