Defense Deal Will Pose an Early Test for Biden Administration -- Heard on the Street

By Jon Sindreu 

The trend toward concentration in the U.S. defense industry remains unstoppable -- except, potentially, by the incoming Biden administration.

Shares in Aerojet Rocketdyne surged this week after the maker of the rocket engines that took people to the moon in 1969 agreed to a $4.4 billion takeover by Lockheed Martin, the world's largest military contractor by sales. Aerojet has been seen as a target ever since its only direct competitor, Orbital ATK, was bought by Northrop Grumman in 2018.

The Biden administration will need to decide whether to greenlight yet another defense deal, after the megamerger of Raytheon and United Technologies last year.

In the early 1990s there were dozens of major players in the industry; now there are just a handful. Yet military budgets will likely stop growing, and the Pentagon needs to retire the remnants of Cold War defense technology to keep pace with China and Russia. It may benefit from larger contractors that can bid more aggressively on risky contracts. Thanks to its purchase of Orbital, Northrop became the sole bidder for the government's new $85 billion intercontinental ballistic system.

The latest deal would be more a case of vertical integration than elimination of the competition. Aerojet already gets more than a third of its revenue from Lockheed by, for example, powering the Atlas space rockets. Aerojet's chief business is supplying rocket motors for missiles, including the hypersonic weapons that are now a Pentagon priority.

But securing the antitrust green light may not be as simple as many analysts believe. Aerojet also services many of Lockheed's competitors, especially Raytheon. They may well raise a challenge, alleging potential price discrimination. The Federal Trade Commission forced Northrop to "firewall" its solid-rocket motors operation after buying Orbital.

In the past, officials have disallowed such acquisitions. In 1998, under the Clinton administration, the Department of Defense blocked Lockheed's plans to buy Northrop for $8.3 billion, a deal that would have vertically integrated electronics production. And U.S. regulators recently updated 1984 guidelines on vertical mergers to make them stricter.

It isn't clear-cut what Washington should prefer. Military contractors have fattened their profit margins in recent years, but research suggests this isn't because they raised prices. With Lockheed and Aerojet, the paradox is that preventing closer integration on competition grounds could also reduce scale benefits that the government itself might enjoy.

In any case, the initial gains from integration don't seem large: Lockheed expects savings from synergies to be less than 5% of Aerojet's future sales. Its investors may question whether it is worth paying a 33% premium over the target's share price last Friday, a price implying an enterprise value of as much as 15 times 2021 earnings forecasts. Most peers trade for under 12.

To be sure, it is an affordable purchase for a company with a $97 billion market capitalization. It also may expand Lockheed's capabilities in the new space economy, where it faces competition from Elon Musk's SpaceX and Jeff Bezos's Blue Origin.

President-elect Joe Biden has suggested he will be less sympathetic to industry concentration, but it remains to be seen whether this applies to defense. Many media reports have speculated that the deputy defense secretary post could be filled by Frank Kendall, who publicly opposed the Justice Department's decision to allow Lockheed's purchase of helicopter maker Sikorsky in 2015.

There is at least a chance that the cops will end a decadeslong merger party.

Write to Jon Sindreu at [e-mail]

(END) Dow Jones Newswires

December 23, 2020 08:08 ET (13:08 GMT)

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