Defense Consolidation Has Disappointed Shareholders.

Industry consolidation has been a perilous endeavor for defense contractors in the United Stares. On average, shareholders have experienced poor returns during the past five years, partially as a result of the problems that have arisen as firms attempted to integrate acquisitions and rationalize operations.

For many companies, including industry leaders such as the Raytheon Company and Lockheed Martin, the acquisition integration process has not gone smoothly.

From July 31, 1995, through July 31, 2000, the Standard & Poor's 500 Index has risen by more than 250 percent, while the Dow Jones Aerospace Industry Index has risen by just 21 percent. The past two years have been even more troubling for defense firm shareholders. While the S&P 500 Index has climbed 25 percent over the past two years, the Dow Jones Aerospace Industry Index has fallen by 15 percent.

Defense contractor executives may wish to consider this disappointing track record as the pace of global industry consolidation increases. Managers need to be aware of certain pitfalls that they may encounter in their acquisition decision-making processes.

Mergers and acquisitions seemed like an attractive strategic option for managers in an industry with declining demand, such as the defense industry in the 1990s.

In this context, executives pursued mergers as a vehicle for consolidating operations, eliminating excess capacity, and improving productivity. However, acquisition integration can be difficult to manage, and operating synergies can prove quite elusive. Consequently, acquiring firms may nor generate economic returns that justify the original cost of the acquisition.

Integration problems often can be traced back to the acquisition decision-making process. Many firms make faulty assumptions regarding potential cost savings, fail to perform adequate due diligence, or prematurely converge on a particular acquisition candidate rather than examine a wide range of alternatives.

These deficiencies in the decision-making process may explain why integration and consolidation do not proceed smoothly in many cases, and why some firms fail to deliver the economic returns that their shareholders expect.

Consequences of Consolidation

U.S. defense industry executives have experienced these difficulties firsthand over the past several years. As the Defense Department reduced spending dramatically in the early to mid-1990s, merger and acquisition activity increased rapidly. The industry quickly became more concentrated as a result of these mergers. In 1991, the top four firms accounted for 17 percent of the dollar volume of defense prime contract awards. By 1999, the top four firms accounted for 28 percent of these awards.

In particular sectors, the effects of this wave of merger activity have been even more dramatic. In the early 1990s, six major naval shipyards competed for U.S. Navy new ship construction contracts. Today, as a result of a series of mergers and acquisitions, three corporations (General Dynamics, Litton Industries, and Newport News Shipbuilding) own those six shipyards. Similarly, in aircraft production, the Northrop-Grumman and Boeing-McDonnell Douglas mergers, as well as Lockheed's purchase of General Dynamics' fighter jet division, have reduced the number of major competitors significantly.

Potential Flaws

Three potential flaws in the acquisition decision-making process relate to the development of alternatives, assumptions and analysis. First, executives need to avoid converging prematurely on a single alternative. Management scholars Philippe Haspelagh and David Jemison have discovered that the process of deciding to acquire another firm often is characterized by a great deal of momentum.

In this situation, managers often do not step back to consider a variety of potential acquisition candidates. Instead, they focus quickly on a single target firm, because they feel pressured to make a swift decision as to whether or nor to "do the deal."

However, the failure to consider multiple alternatives can be problematic. A great deal of research suggests that firms make better strategic decisions when they consider multiple options. In particular, decision-making expert Irving Janis has shown that strong pressures for conformity often arise when an organization converges quickly on a single alternative. In other words, people who oppose the acquisition may not feel comfortable expressing their dissenting opinion. They withhold their concerns regarding the deal, despite the fact that these concerns are quite valid.

In this situation, managers may fail to engage in an adequate level of debate regarding the pros and cons of a potential acquisition. The lack of critical evaluation causes managers to overlook key disadvantages of the proposed merger, as well as critical problems that could arise during the acquisition integration process.

In addition to not considering multiple alternatives, some decision-makers do not identify or probe key assumptions adequately. In acquisitions, managers often have to presume a great deal about a target firm, because they do nor have complete information about the company's internal operations. Moreover, managers have to project the level of cost savings and other operating synergies that they believe will occur as a result of post-merger consolidation. These assumptions have a significant impact on the attractiveness of a potential acquisition, as well as on the price that the acquirer is willing to pay for the target firm's shares.

It can become easy to take certain presumptions for granted, or to begin to treat assumptions as facts. Consequently, managers fail to test thoroughly the validity of their assumptions. In acquisitions, this means that managers can develop overly optimistic projections of the value of synergies, or they may fail to identify the obstacles and risks associated with attempting to realize savings through post-merger consolidation. In addition, managers may make faulty assumptions regarding the effect that the acquisition will have on customers, suppliers, and competitor behavior.

Finally, acquisition decision-making processes often falter because the formal analysis of the deal is inherently biased. During many capital investment decisions, including acquisitions, managers conduct net present value" analyses. These systematic financial evaluations attempt to determine whether an investment will yield adequate returns.

Research shows that managers often employ sophisticated analysis to justify and legitimize a decision, rather than to evaluate a proposal in an objective manner. This occurs because a strong advocate for the proposal rakes control of the analytical process. Advocates know the outcome that they wish to achieve, and they steer the analysis so that the results will support the conclusion that they wish to hear.

In acquisitions, this means that managers often treat the due diligence process as a vehicle for justifying an acquisition, rather than as a means of gathering more complete information to support an objective evaluation of the deal. In other words, by the time that due diligence occurs, the decision to acquire is often pre-ordained. If managers treat due diligence in this manner, they will almost certainly fail to surface key problems and risks associated with a proposed merger.

Keys to Success

As defense firms pursue global consolidation, they can employ certain practices in order to avoid an inadequate search for alternatives, the development of flawed assumptions, and the use of biased analysis. In particular, managers can take three steps to improve acquisition decision-making.

* They should generate well-defined criteria for screening and evaluating potential acquisition candidates.

* They must encourage constructive conflict and debate while making decisions.

* They should identify key contingencies and risks that may impede the integration process.

Research demonstrates that managers make more effective strategic choices when they define their decision criteria in a clear and precise manner. Clear criteria can be especially important when screening potential acquisitions, particularly for firms that are doing many deals in a short period of time. For example, experienced acquirers such as Emerson Electric, Newell and Cisco Systems all employ a well-defined set of criteria for evaluating potential acquisition candidates. Clear screening criteria provide a structured means of evaluating alternatives for these firms, and help to develop a common managerial understanding of the rationale for a particular acquisition strategy.

Moreover, successful acquirers do not judge target firms based solely on financial criteria such as return on investment or expected impact on earnings per share. Instead, firms such as Emerson, Newell, and Cisco tend to establish strategic, organizational, and financial criteria for screening target firms. In other words, potential acquisitions must fir the corporation's well-defined competitive strategy, and they must be compatible with the organization's culture and values. In addition, the acquisition must be expected to generate attractive financial returns.

Successful organizations also tend to generate healthy conflict and debate within their senior management teams. This facilitates the generation of multiple alternatives, and insures that everyone probes assumptions in a more critical manner. For example, Kathleen Eisenhardt, of Stanford University, has shown that the managers within the more successful computer firms in Silicon Valley tend to encourage substantive debate, but they rake steps to insure that it does not become personal.

When considering acquisitions, managers can employ several strategies for insuring adequate internal debate. For example, they can appoint someone as the "devil's advocate" during the decision-making process. This person's responsibility would be to try to point out the problems and risks associated with a proposed merger. In addition, they might employ what Alfred Sloan, former chairman of General Motors, once called a "second chance meeting," in order to mitigate the negative effects of organizational momentum.

When executives appear to have arrived at a decision to acquire another firm, they might wait a short period of time, and reconvene the management team to reconsider the decision. This brief delay provides people an opportunity to consider whether they may have agreed prematurely with the proposed merger.

Finally, managers will make more effective acquisition decisions if they identify and evaluate key contingencies and risks as soon as possible. Scholars such as Edward Russo and Paul Schoemaker have shown that individuals systematically exhibit overconfidence when they make decisions.

Overconfidence can cause managers to systematically underestimate the difficulties and risks associated with acquisition integration. To enhance the effectiveness of their acquisition decisions, defense industry executives need to engage in contingency planning while they evaluate the attractiveness of an acquisition candidate, rather than waiting until the deal is done. Managers will make better acquisition decisions if they identify what might go wrong during the integration process, try to determine how significant and likely that risk may be, and then devise ways to avoid or reduce that risk. In some cases, this proactive contingency planning may cause managers to reject a proposed acquisition that is likely to fail, when they might otherwise not identify key problems until after the merger has been executed.

Now, a new wave of consolidation has begun, and it entails international mergers and acquisitions. For example, General Dynamics recently bought ENSB of Spain. Similarly, BAE Systems, a U.K.-based conglomerate, is seeking to purchase Lockheed Martin Aerospace Electronics Systems.

As firms make these acquisitions, they need to be aware that more effective decision-making processes will result in smoother integration and reduced operating costs. Flawed decision-making will lead to a poor match between acquirer and target, difficult and expensive integration efforts, and low returns for shareholders.

Michael A. Roberto is an assistant professor of competitive strategy at Harvard Business School, Boston, Mass.