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Defense Dollars Prompt a Rush to Consolidate

Bigger is seen as better as firms swallow up one another in the pursuit of government contracts.

March 17, 2003|Mark Fineman | Times Staff Writer

The business of war and counter-terrorism is fueling a multibillion-dollar spending spree as defense contractors -- many based in California -- grab up some of the nation's most secretive, sensitive and well-connected companies to compete for billions of dollars in national security initiatives.

The latest illustration came this month when El Segundo-based Computer Sciences Corp. completed its acquisition of DynCorp of Reston, Va., for nearly $1 billion, inheriting contracts that range from maintaining Air Force fighter jets in the Persian Gulf and guarding the lives of U.S. ambassadors in Israel and the Balkans to securing America's strategic oil reserves and developing anthrax and smallpox vaccines.

Meanwhile, several smaller firms have emerged as potential competitors to the defense giants by going public, then using their new capital as war chests to acquire niche enterprises that have penetrated key sectors of the booming counter-terrorism, intelligence and homeland security markets.

Taken together, at a time when the Bush administration is asking for nearly $40 billion in homeland security funding and is poised to request billions more to pay for an armed conflict with Iraq, the strategy in the war business is simple: The bigger, the better.

And in a largely stagnant American economy, it is one of few sectors that is booming.

Last year, companies in the defense and homeland security industries raised unprecedented sums in public offerings, according to Jerry Grossman, managing director of Los Angeles-based investment banking firm Houlihan, Lokey, Howard & Zukin. That, in turn, helped to fund a defense-related merger-and-acquisition binge in 2002 that saw nearly 40% more deals than in the previous year: 218 compared with 157.

The reasons go beyond the new government largess.

Increasingly, government agencies, including those in the new Homeland Security Department, are "bundling" contracts, preferring a single, diversified contractor that can provide end-to-end solutions rather than parceling out contracts to dozens of smaller firms. That requires deep corporate pockets and labor forces with broad expertise. The Bush administration, for example, signaled last week that it intends to issue just such large-scale contracts to rebuild Iraq in the event of war.

"If you're only going to plant a few daisies and tulips in your yard, you don't need a gardener. But if you're going to totally re-landscape you need ... a huge systems integrator," said Paul Cofoni, who heads the CSC group handling most of the combined companies' government work.

"We see a massive amount of consolidation in the industry."

Van Honeycutt, CSC's president and chief executive, told financial analysts that the combined companies have a "pipeline of opportunities" in federal contracts totaling about $40 billion through fiscal 2005.

The DynCorp purchase makes CSC one of America's top 10 government contractors overnight and the government's third-largest information technology supplier, with combined annual revenue of nearly $14 billion and 90,000 employees.

Executives of both companies said the deal was designed in part to better meet the government's new homeland security needs.

CSC already had broad information technology contracts to restructure entire systems at such institutions as the Internal Revenue Service and the National Security Agency. Now, the company also can take advantage of DynCorp's stable of retired law-enforcement officials, military special forces operatives and intelligence agents.

Against the backdrop of the accelerated privatization of government and military functions, fewer and fewer companies are chasing more and more taxpayer dollars.

"The consolidation of the big guys in the defense sector is to the point where there aren't a lot more big guys left to buy," Grossman said.

As a result, he added, large contractors are buying up smaller companies as well. And to compete, medium-sized companies have launched their own buying binges, often turning to Wall Street to bankroll them.

Although big may be better for business, some analysts warn that it may not be best for the customers -- the government and taxpayers.

"If you have too many mergers and you have a stranglehold on these contracts by a few companies, you lose the basic advantage of privatization, which is the cost savings by free-market competition," said P.W. Singer, a Brookings Institution fellow and author of an upcoming book, "Corporate Warriors."

"You end up with all the issues of higher cost, overbilling, over-staffing and lower quality," Singer added. "If you have dominance by a few companies, you don't have as many choices as you might think."

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