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.

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