The largest defense contractors are conglomerates, and excessive conglomeration may not be helping the customers.


Last month I argued that the rumored spinoff of Oshkosh’s military trucks business wouldn’t be good for either the company or its customers. But anti-mergers are in the air, as evidenced by the Wall Street Journal’s almost simultaneous article “Smucker, Oracle, IBM Among Credit Suisse’s 35 Firms Ripe for a Spinoff,” (24 November). The list didn’t headline the defense contractors, but did include Lockheed Martin, Raytheon, and L-3 Communications in its set of “large companies that could tap into the spinoff trend, which has seen companies shed unwanted or slower-growing divisions at a feverish pace.” Why? As the article points out, “companies with narrower footprints are easier to manage,” and by the well-known conglomerate discount, are “more fairly valued by the market.”


All three contractors have similar cash flow return on investment (CFROI, Credit Suisse’s preferred measure of performance), and similar numbers of operating segments. By my count, though, the number of actual operating business units across those segments is quite different:
  Lines of Business  
A quick glance shows that L-3 is indeed a different matter structurally. As Antoine Gelain wrote recently in Aviation Week (25 August),
     It took the creation of L-3 Communications in 1997 to show that another value proposition was possible, namely one that consisted in creating a “Sears catalog” of the defense sector (as co-founder Frank Lanza once put it), positioning the new company as a horizontal aggregator of products and services. This represented a complete break with the traditional “vertical integrator” model of the top defense primes.
That’s a novel idea, but from where did it come? Back in October 2000, the late Lanza related to Forbes the story of his new project in this way:
     In 1996 Lockheed Martin bought Loral for $9 billion. [Loral CEO Bernie] Schwartz moved on to run Loral Space & Communications, spun out of Loral just prior to the takeover. But Lanza stayed on, trying to integrate Loral into Lockheed. He soon grew frustrated dealing with the bureaucracy at the $27 billion company. “I didn’t need the money,” he says. (He had pocketed $41 million from the Loral deal.) But he didn’t quit or retire. Instead he proposed splitting off ten small companies from Lockheed Martin, nine of them former Loral properties, to create L-3 Communications.
The intertwined histories of these companies does make one wonder is it time again? Fairly, there’s reason not to rush to conclusions. Recent research by Jim McTaggart and Ron Langford, of the management consultancy Marakon, indicates that the conglomerate discount may no longer be as sharp as it once was, and that the best conglomerates are doing a fine job of leveraging their multi-industrial synergies. Ellen Lord, CEO of Textron Systems, often makes a strong case for her company in that regard. But there are limits to the model. As McTaggart and Langford write (p. 5), administrative lethargy is one of the major problems of the more sprawling conglomerates:
     The management teams of pure plays can typically make much larger decisions much faster since they don’t have to navigate the control systems set up by the much larger diversified companies. Years ago when Duracell was spun out of Kraft, Bob Kidder, Duracell’s CEO at the time, said that the biggest advantage was not having to get capital approvals in excess of $500k from the “cheese people” so that the quality and pace of decision-making improved significantly.
Today, L-3 is itself a $12 billion company, composed of 91 little companies, at least one of which makes batteries—actually quite sophisticated ones for NASA. Even if control is more financial than operational, that’s still a far-flung empire to govern, and financial control is better left to investors in financial markets. Thus, as I wrote in October, conglomeration is still “a Third World organizational strategy,” for companies in countries with poor governance and thin financial markets. And even Sears doesn’t have a Sears Catalog anymore. L-3 is not Grainger, which earns its living by lowering corporate purchasers’ search costs for frequently needed, low-margin products. Batteries for the International Space Station—at $2.5 million each—aren’t catalog items.
Why should government care? Outgoing Defense Secretary Hagel and Deputy Secretary Work have been talking a lot lately about industry’s need to innovate more quickly and differently. The commercial cost controls and manageable portfolios of companies like Oshkosh and Textron may very well support those goals. But as with the Defense Department’s own echelons of headquarters, it’s not clear how the levels of management above the battery makers are raising the game.
James Hasík is a senior fellow at the Brent Scowcroft Center for International Security.