Defense: Manufacturers of high-tech defense electronics benefit from consolidation and rising spending.(A)(INDUSTRY SNAPSHOT)

Byline: Reinhardt Krause

When defense contractors talk about the "Last Supper," it has nothing to do with the Bible. They're recalling an earth-shaking event that still reverberates in the industry today. In 1993, the Pentagon told its suppliers to merge or fold. The defense budget was shrinking fast. So big defense firms bought or merged with rivals - often at high prices. Top suppliers, called primes, also tried to branch into nondefense fields. Smaller defense firms adapted to shifts in the supply chain. The industry's makeup is still in flux today. With the Bush White House rethinking military plans, defense budgets may climb - though not as fast as seen under Presidents Carter and Reagan. And takeover activity will look different in upcoming years, observers say. "There'll be more efficient consolidation, not consolidation for consolidation's sake," said Paul Miller, chairman and CEO of Alliant Techsystems Inc., a Hopkins, Minn., maker of launch vehicle systems and other defense gear.

1. BUSINESS Devising new weapons can take decades, especially for big-ticket items like ships and planes, says Standard & Poor's Corp. In addition to long lead times, defense firms spend heavily on research and development, much of which is funded by government contracts. Once the Pentagon orders weapons, production can stretch out for years. That lifts margins in the long run. The buying process is complicated by having three parties, not the usual customer-supplier ties. That's because Congress sets the defense budget and OKs programs, while the Pentagon gives out the contracts. A key fact of life for defense firms is that defense outlays are based on politics, not just price and performance. Programs may go on even though a weapon's value wanes. So defense firms lobby and give large sums of money to political action groups. It helps to have plants in key congressional districts. Name of the game: "It's all about protecting programs, winning new programs and making sure there's support on Capitol Hill," said Stuart McCutchan, editor of Defense Mergers & Acquisitions. "That helps drive consolidation, because (companies) want geographic reach and as many congressmen on their side as possible."

2. MARKET More than half of the discretionary federal budget goes to defense, says the Center for Defense Information. Not all of this is for new weapons. Much is spent on payroll and to keep up existing arms. To defense firms, procurement, research and development, and testing and evaluation are the keys. After the Carter/Reagan buildup, procurement and RDT&E spending peaked at $ 184 billion in fiscal 1985. Then it fell steadily, to $ 142.6 billion in 1990 and $ 78 billion in 1995. It ticked up slightly the last three years. Even so, spending in some fields rose at a fast clip. In the late 1990s through 2001, more ships and subs were built to upgrade the Navy. In fiscal 1999, the Navy accounted for 30% of buying and RDT&E, the Air Force 27%, the Army 24% and other agencies 19%. The current fighter jet upgrade plan will be one of the big budget areas for coming years, says the Government Electronics Industries Association. The Bush administration is now reviewing military strategy. Its aims are unclear, analysts say. And there's much uncertainty over where spending may grow. "Defense stocks rose last year because of big expectations that there'll be material increases in procurement and R&D spending, but the optimism may not be warranted," said Robert Friedman, analyst at S&P. "I don't see defense contractors making huge outsize profits."