Consolidation Expected for European Industry.

Both U.S. and European defense and aerospace firms increasingly plan to outsource manufacturing work and focus on software and electronics. That strategy, however, still fails to address the excessive over-capacity in the industry today, said Jon B. Kutler, chief executive officer of Quarterdeck Investment Partners LLC, in Los Angeles.

Companies in the defense sector, particularly in Europe, will need to consolidate-via mergers and acquisitions-because there is "too much capacity in the marketplace" and not enough business for everyone, said Kutler, who spoke with National Defense while attending the 2001 Paris Air Show. His company opened a new office in London, in January, because, he said, "We see so much happening in Europe."

The European defense and aerospace sectors, according to Kutler, are five years behind the U.S. industry in consolidation efforts.

"In most industries, consolidation happens simultaneously, up and down the food chain," Kutler said. That was not the case in the defense industry. "It started with the prime contractors and is working slowly down the food chain."

The consolidation is almost over at the primecontractor level, he said. "The second and third tiers is where it needs to take place. There is too much capacity and inefficient Operations."

Despite high-profile trans-Atlantic partnerships announced recently, it is unlikely that large U.S. and European firms will merge in the foreseeable future. Such partnerships include joint ventures between the Raytheon Co. and Thales, and between Northrop Grumman and EADS (European Aeronautic Defense and Space Company).

Those joint ventures help the companies market their products better, said Kutler. "But the consolidation of U.S. primes with European primes is not on the horizon for the next few years.

"This is a global industry, and prime contractors are waking up to realize that they can't be U.S. centric or European centric," said Kutler. "Ten years from now, this will be a much more seamless global industry than it is now:'

Meanwhile, the news for defense companies is not encouraging, he said, because defense budgets are not expected to increase significantly. Both U.S. and European government buy weapons systems in "a very dysfunctional manner," which keeps the costs high, he said. Companies are trying to keep their infrastructure ready for full production, but there is not enough money to do that, Kutler said.

In the United States, the Bush administration will be devoting a lot of new defense spending to missile defense. Because missile defense is "such an expensive program," Kutler said, "it will suck dollars out of other programs. That will be an overhang for the industry that builds airplanes and ships."

The Clinton administration "caused a lot of damage," said Kutler. "They didn't spend and ran the wheels off the military. The Bush administration came in with great goals. Unfortunately, it's been co-opted by the system. The system beat them back to more incremental goals."