NEW YORK (The Deal) -- Lockheed Martin's (LMT - Get Report) deal to acquire Sikorsky Aircraft from United Technologies (UTX - Get Report) for $9 billion highlights the increasing scarcity of large defense hardware platforms, and offers hints about what to expect in future deals in the industry.
Bethesda, Md.-based Lockheed beat rival bidders and a potential tax-free spinoff to win Sikorsky, a maker of defense and commercial helicopters including the Army Black Hawk and Marine King Stallion rotorcrafts. Sikorsky ranked as the least profitable business inside industrial conglomerate UTC. The helicopter maker has been stung by military program delays, a post-war slowdown in sales and issues in the energy market, but was still able to attract considerable attention and a substantial premium.
Analysts had valued Sikorsky at just $5 billion to $6 billion prior to the announcement. The higher price is in part attributable to the favorable tax structure that Lockheed and UTC were able to put together, but it also highlights the value defense contractors are putting on hardware platforms at a time when defense budgets continue to shrink.
Contractors for years turned to information-technology and government services to offset post-war declines in hardware sales, but competition has eaten into margins in those businesses. With few new major defense hardware contract awards expected to be handed out by the Pentagon in the foreseeable future, companies such as Sikorsky that have a strong book of business have scarcity value.
The competition between Boeing (BA - Get Report) and Northrop Grumman (NOC - Get Report) to produce the Pentagon's next long-range strike bomber is being closely watched by defense deal makers. If Boeing is victorious, many expect Northrop, which would be left without a large warplane contract, to divest much of its aero business or even seek a buyer for the entire company.
Even if Northrop is successful, deal making could follow. Boeing has a substantial commercial-aircraft unit, but without the new fighter, it would largely make last-generation and support aircraft for the military. The company could test the Pentagon's tolerance for a large-scale defense merger and acquisition by making a bid for Northrop.
"There's probably only enough business for two warplane manufacturers, and Lockheed with its F-35 has one of the slots filled," a defense banker said. "The bomber outcome is going to force someone into making some very difficult choices."
IBISWorld defense analyst Maksim Soshkin also sees the potential for overcrowding in the armored-vehicle sector, where there are five major manufacturers but only one large contract on the horizon. Two of those vendors, General Dynamics (GD - Get Report) and BAE Systems (BAESY), likely have the scale needed to stay in the market, but others including Navistar International (NAV - Get Report), Oshkosh Corp. (OSK - Get Report) and Textron (TXT - Get Report) are prime candidates to divest defense businesses.
Those smaller vendors "might be interested in selling off their defense businesses in light of plunging industry sales," Soshkin said.
Soshkin doubts the Pentagon would allow a major deal between two prime contractors like Boeing and Northrop, but said to expect M&A among mid- to lower-tier companies. And the bigger defense contractors will continue to manage their portfolios, either adding to areas of strength or divesting businesses that are not considered core competencies.
The bottom line is that for all of the money spent on the nation's defense, high-margin contracts are becoming scarcer. Expect portfolio reshuffling, and M&A, to follow.