Defense Gets Defensive

NEW YORK (TheStreet) -- For defense contractors, war has been hell.

Not traditional wars like the ones raging in the Middle East, which have spurred increased demand for high-tech weaponry and re-supplied arsenals. But rather the endless budget battle in Washington, which has made rubble of consolidation plans, paralyzed markets and left both executives and bankers eager for signs of an eventual armistice.

Sequestration, for all of its hype, has so far been a mixed event for defense companies. On the surface, it appears politics has done little damage to the quarterly earnings of Pentagon titans and has only modestly affected the results of midtier players and government services companies. The long duration of typical federal contracts to some extent has shielded earnings, though the gridlock has delayed new awards and at times has slowed implementation of existing contracts.

But defense spending is undeniably on the decline. Real gross domestic product increased at 2.5% in the first quarter of 2013, below economist expectations, with Goldman, Sachs & Co. economist Jan Hatzius saying that part of the blame came from "the unexpectedly large drag from defense spending."

Spending on defense contracted at an 11.5% rate in the quarter, and at a rate of 22% in the last three months of 2012. According to JPMorgan Chase & Co. economist Michael Feroli, those results marked the weakest two-quarter run for defense spending since the end of the Korean War.

Though sequestration is a U.S. phenomenon, the size of the U.S. defense market relative to the rest of the world, coupled with the push for austerity in Europe and elsewhere, means the chill is being felt across the globe.

With defense spending falling and future Pentagon funding unclear, it is no wonder defense dealmakers have mostly moved to the sidelines. It is notable that the last $1 billion-plus transaction in the defense sector, a 3.4 billion pounds ($4.46 billion) takeover of Tognum AG by Rolls-Royce plc and Daimler AG, came together just weeks before the original sequestration legislation was passed in August 2011.

Things have been quiet in the months since: According to PricewaterhouseCoopers LLP data, 2012 aerospace and defense deal volume was off 23% from the 10-year average of about $20 billion annually, and that number was propped up by a flurry of commercial aerospace transactions. Commercial aerospace has held up much better than defense, fueled by strong demand for new jets from airlines with increasingly healthy balance sheets and a desire for greater fuel savings.

"While the commercial aerospace M&A market has been active, the defense M&A market has essentially been frozen since sequestration first became a possibility," said Scott Thompson, PwC's U.S. aerospace and defense practice leader. "Until the Department of Defense provides specific guidelines regarding the defense budget, it appears as though maybe these A&D companies are not quite ready for dealmaking."

Though the timing of a resurgence in dealmaking is far from clear, people throughout the industry are confident it will return. Defense sources said that any sort of clarity from Washington on Pentagon funding levels and future priorities, even if no grand political bargain is reached, could be enough to get buyers and sellers active again.

"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) 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) and Raytheon Co. ( RTN) 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.

"Looking ahead, we're closely monitoring the industry for acquisition candidates that may become available and, as always, we're mindful for price," L-3 chairman and CEO Michael Strianese said during his company's earnings call. Multiple defense sources said they believe that if one company announces a substantial deal, it could prompt others to quickly get serious about M&A.

When the ice does thaw, look for security -- both physical and cyber -- to be an area of particular focus. Analysts expect spending on software that can lock down networks, spy on rivals and assess threats and high-tech sensors that can peer around corners or provide clearer views from the air to grow faster than spending on big-ticket items such as new jets and warships.

"Technology is the new arms race, and some of the best research is being done in small to midsized firms," one defense banker said. "Prime contractors traditionally have been more than willing to invest to bring new intelligence in-house."

Rogers of Harris Williams said he expects to see a lot of portfolio reshaping. He sees a trend toward large contractors, many of whom are under new leadership in the past 12 to 18 months, moving away from previous efforts to be a one-stop shop in favor of more specialization, and he expects to see some large-scale divestitures as a result.

"Over the course of the next 12 to 24 months, as new leaders are getting settled in and there is hopefully better guidance from Congress and the administration on spending priorities and the budgets, pressure will build and I think you will see a resumption in carve-outs and other forms of dealmaking," he said.

Some of that carve-out work had already begun prior to the sequestration, most notably Northrop Grumman Corp.'s ( NOC) 2008 spinoff of shipbuilder Huntington Ingalls Industries Inc., but Rogers said there is plenty more work to be done. "If you are fourth of four in an area it might make sense to carve that out and focus on what you are good at," he said.

Among more traditional armament categories, industry watchers point to ground and tactical systems, a segment that is very fragmented and where there is significant innovation coming from small to midsized companies, as an area that appears ripe for dealmaking.

PwC's Thompson expects defense companies to increasingly look to adjacent markets outside of defense for new growth opportunities. Government contractors have a mixed history of success trying to expand commercial businesses, but Thompson points to industries including energy and healthcare, where some of the companies' research into security and data processing can easily be applied without overreaching.

Hewson, Lockheed Martin's CEO, during her company's recent earnings call talked about the massive amount of R&D Lockheed does in a range of topics and said she believes some of that research could be applied to the private sector. "As a company, we're a technology leader," she said. "We often talk about saying that we do hard stuff, we do difficult things and try to work on big things that are affecting the global environment -- the global security environment."

Security is an area of obvious concern not just for the Pentagon but for corporate America, and a natural avenue for defense contractors seeking to open new fronts away from future sequestration headaches.

Given the anxiety defense companies have experienced in recent quarters watching politicians bicker, buying some exposure to those new markets might seem the best path forward.

-- Written by Lou Whiteman in New York.

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