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Defense Gets Defensive

"We are not demanding a solid roadmap," said a senior executive at a large defense contractor who asked not to be named. "What we need is some assurance that if we make a decision and open our wallets we won't later be blindsided by politics."

Indeed, absent political gridlock there is ample evidence that there should be a surge of deals in the defense sector.

Chris Rogers, a managing director at PNC Financial Services Group Inc. unit Harris Williams & Co., noted that cash balances among the five largest, or prime, defense contractors stand at a combined $26 billion today, up from just $5 billion in the early 1990s. Meanwhile, investors are pushing companies for guidance on where future growth and profitability will come from.

"M&A should absolutely be front of mind for everyone in the defense and government services sector," Rogers said. "Given the environment, there is almost no choice but for it to happen eventually."

The executive from the defense company said that he expects that over the coming quarters political gridlock will slowly ease, while contractors will continue to get over the sequestration rhetoric shock and become more comfortable with the current environment. And as companies adjust to the new normal, declining Pentagon spending should actually further prime the pump for increased consolidation.

"I think as the spending contracts we would expect that there would be more consolidation," Lockheed Martin (LMT - Get Report) CEO Marillyn A. Hewson said recently. The government is unlikely to encourage combinations among the few remaining prime contractors, she said, but second-tier and smaller suppliers should be able to move. "I certainly expect that because the economics will dictate that with the contraction of the budgets."

Thompson said PwC is seeing an increase in interest among private equity and other financial investors as well. "They also have healthy balance sheets and are facing less corporate competitive pressure, but are still pursuing deals in a cautious way," he said.

Barclays plc analyst Carter Copeland in a research note wrote that during first-quarter earnings calls large defense contractors focused on capital deployment, noting that "companies remain focused on 'controlling what they can control' by taking actions to appropriately size cost structures, focusing on execution and aligning their portfolios to meet the future needs of their customers."

Executives at L-3 Communications Holdings Inc. (LLL - Get Report) and Raytheon Co. (RTN - Get Report) specifically mentioned they were keeping an eye out for M&A opportunities to offset defense spending cuts, while Lockheed Martin officials discussed the potential for joint ventures or acquisitions as a way to move into new areas.
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