(Illustration by Taylor Callery)

Years before the company’s legendary merger with Lockheed, Martin Marietta executives were holding secret meetings in a basement, trying to imagine what the defense industry might look like in the years ahead.

Starting in the mid-1980s — a decade before the industry-altering deal — Norman R. Augustine, the chief executive of Martin Marietta, gathered three of his top executives together every Friday. The group snuck out to his basement, only a short trip from the office, where they convened over sodas with a rotating cast of specialists in areas such as policy and Wall Street interests.

Augustine and his most senior executives suspected that the landscape for defense companies was about to change significantly, following the Reagan-era build-up in military spending.

Expenditures at their current levels at the time seemed unsustainable, Augustine reasoned. “We didn’t know what the right answer was, but one thing we knew was you were going to need money to do it,” he recalled.

So Martin Marietta started stockpiling cash, he said, saving up enough to help it survive the most significant contraction in the history of the defense industry, and merge with California-based Lockheed in a deal that not only reshaped the industry, but also shifted its center to the D.C. area.

There are noticeable similarities to the 1990s in today’s market: A major build-up has come to a stop with the end of two wars, and the industry is seeing a spending slowdown.

But analysts and experts warn that 2013 is not 1990, and industry adaptation will look very different this time around.

Rather than the mass consolidation of the largest contractors that occurred two decades ago, these observers expect more rearranging of parts and consolidation at lower levels, particularly among the services companies that have proliferated over the past decade.

“Twenty years ago, defense consolidation was mainly about getting bigger,” said Loren Thompson, an industry consultant with ties to many of the largest contractors. “Now, it’s about getting more efficient, about getting more focused.”

Looking backward

The 1990s is a storied era in defense contracting, when companies such as Lockheed Martin, Northrop Grumman and Boeing saw their prominence cemented through major acquisitions and mergers.

Simply put, Pentagon contractors went through a massive round of consolidation. By the calculation of John Dowdy, who leads McKinsey & Co.’s global aerospace and defense practice, the number of U.S.-based prime contractors dropped to six from 16.

The giants also consolidated their power; in 1991, the top 10 global defense companies made up less than 40 percent of the revenue of the top 100. By 2000, the top 10 companies controlled 60 percent of the market, according to Dowdy.

The changes were perhaps even more stark at lower levels. Of the top 100 companies in 1991, only 19 still exist today.

At the same time, the D.C. area became the center of the defense contracting industry. Even though the Lockheed Martin deal was described as a merger of equals, Martin Marietta got to keep its Bethesda headquarters.

“The vast majority of defense companies were located away from Washington, D.C., prior to the 1990s,” Thompson said. “The emergence of Lockheed Martin as the major company created pressure on all the competitors to be close to the customer.”

But the intensity of the consolidation that occurred two decades ago makes it hard for many to imagine a similarly robust round today.

“The industry is actually so consolidated ... there’s very little room for prime-level combinations that won’t run into serious anti-competitive issues,” Dowdy said.

So far, the Pentagon has made clear that it welcomes acquisitions — but not among the biggest of the big. Even abroad, those deals have been unsuccessful. London-based BAE Systems and Paris-based European Aeronautic Defence and Space’s bid to merge in 2012 ended unsuccessfully because of the concerns of their foreign government owners.

The Defense Department already has a limited number of suppliers when it comes to some weapons systems; in combat vehicles, for instance, there are just two U.S. manufacturers.

Still, some see it as inevitable, given the rapidly declining Pentagon budget. Not only is defense procurement down, but there’s little certainty that new major programs — the combat vehicles, fighter jets and missile systems that spur billions in research and manufacturing — are moving forward.

The defense industry “only has one customer that matters,” Thompson said. The “opportunity for sustaining a broad-based industrial complex in a period of declining demand is not very good.”

Budget pressures loom

Despite the potential limitations on consolidation, there are growing signs that companies are bracing for change.

Falls Church-based Northrop Grumman made what was largely considered the last deal in the previous round of consolidation, picking up TRW in 2002 to cement its spot as one of the biggest of the big. The deal capped off years of major acquisitions, including Newport News Shipbuilding.

But less than a decade later, Northrop began taking apart the massive company, first selling off its advisory services unit Tasc in 2009 to address potential inner-company conflicts of interest, and then in 2011, spinning off its shipbuilding business, which is now known as Huntington Ingalls.

Northrop’s moves predated the more recent spinoffs and separations by government contractors. McLean-based Science Applications International Corp. last year split itself into two companies: a technology business focused in areas such as national security and health, and a government services business.

More recently, Exelis announced it is spinning off its government services unit into a public company, following in the steps of L-3 Communications, which spun its government services unit off into Chantilly-based Engility in 2012.

Dowdy said many companies are taking a hard look at businesses that didn’t require as much attention in the previous decade.

“We had 10 years of year-on-year defense budget increases,” he said. “When the budget just keeps going up, up, up ... strong businesses do well, OK businesses do well and even poor businesses do well.”

These early deals are setting the stage for a defense industry reshaping. Many existing companies are simply too large and bulky to be bought, pushing them to spin off or sell units. Companies can shed divisions that are no longer profitable or fit with their portfolios and find complementary capabilities in another contractor’s unwanted units.

In particular, analysts say, the opportunity is greater for services companies, which have proliferated in the past decade as the government increasingly relied on contractors to provide federal labor.

It’s early to speculate on who might be bought, but Thompson pointed to Northrop, a leader in reshaping already, as a potential target. (Northrop declined to comment, noting that it does not participate in industry consolidation or acquisition stories).

Lessons learned

Even though reshaping this time around is likely to be quite different, there are lessons from the 1990s on how to come out on top.

Augustine, who made sure his company was a buyer, not a seller, credited preparation.

By the time it was clear to many companies consolidation was coming, “we already had a leg up because we had saved a bunch of money and we pretty well knew what we were going to do,” said Augustine, who went on to eventually serve as chief executive of Lockheed Martin.

When contractors approached the merged company about potential acquisitions, its executives already had a binder on each business with its financial data, products and leadership, he said.

“We were ready to make decisions,” Augustine said. “We could tell you tomorrow whether we were interested.”

Dowdy, too, said the aggressive movers are likely the ones who will survive a reshaped defense market.

“One of the very clear lessons is move early to win, and the opposite of that is hunker down ... You can’t just say, ‘I’m just going to last this out,’” Dowdy said. The companies working “to push their margins up and start cleaning up their portfolio are, I would argue, the ones who are going to come out the other side.”

Thompson said that those who lead the merger wave “get to pick and choose.”

“You go later, you get the leftovers,” he said.

Even though a downturn appears bleak to many contractors, Augustine contends that it provides a real opportunity to put together a better company.

“In the good times, we never could have built Lockheed Martin,” he said. “None of these companies would have been for sale.”