Defense downturn sets off mergers, and a search for Non-U.S. customers.

• Author: Erwin, Sandra I.
• Position: DEFENSEWATCH

It has only been a few weeks since Secretary Robert Gates unveiled his 23-point plan to rein in spending at the Pentagon.

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But the defense industry is wasting no time to maneuver into position for the coming downturn. Even with promises of flat or slightly higher future defense budgets--Gates said he is hoping for 1 percent annual growth--there still will not be enough work to keep every company in business, or to satisfy the demands of shareholders who have been spoiled by a decade of double-digit growth.

Even before Gates launched the current "efficiencies" campaign, the industry had seen the writing on the wall and started to consolidate. Now the pace will only accelerate. "Mergers and acquisitions are back in a big way," says Tom Captain, vice chairman of Deloitte's aerospace and defense business.

Corporate mergers and takeover deals are up in value by 300 percent from a year ago. Companies are also shaking up their portfolios as they dump what they perceive as losing sectors--shipbuilding, military hardware manufacturing--and jockey for new business in hot markets such as intelligence, cybersecurity and information technology services.

The industry also is courting new customers. More aggressively than ever, defense firms are flocking to the Middle East and Asia in search of emerging markets. Captain says he recently returned from a trip to India. "Everyone's there," he says. "Companies go where the money is." India is expected to spend $80 billion on new weapons and space systems over the next five years. It's only a small fraction of what the United States spends, but the industry still regards it as a promising region where, once you get a foot in the door, opportunities could blossom.

In this survival-of-the-fittest climate, it is only natural that firms begin to shed excess fat after a decade of bloat. Deloitte recently published a number of surveys that portray an industry that has thrived financially but started to plateau about two years ago. The average per-employee profit is up 108 percent since 1991, Captain says. U.S. defense industry has been handsomely rewarded during the post 9/11 buildup, he says, and now it is time for corporations to worry about whether they can afford their own future.

Profits and revenues have been flat for 18 months, says Captain. The only growth ahead will be from mergers, acquisitions and foreign military sales.

Interestingly, even though industry's profits swelled during...