Defense Industry Mergers Divert Attention From 3 Key Trends

It seems that every week yet another acquisition is announced in the defense industry. Favorite targets are exciting defense electronics companies whose capabilities are the building blocks for future warfare and whose values are bid up in each successive deal to unprecedented levels. Investors may not understand the dynamics of defense procurements, but having made millions of dollars in the sector, they buy into the mantra of consolidation and anxiously await even the slightest rumor or observation which may help unearth the identity of the next target.

1996? Yes--but, if you pulled out copies of the Los Angeles Times 10 years ago, you would also observe an eerie similarity.

A conservative Lockheed Corp. battled a much smaller but aggressive Loral Corp. for one of the gems of the industry--a publicly traded defense electronics firm named Sanders Associates. The price paid by the successful Lockheed--1.3 times its revenue--surprised analysts at the time. A decade later, with the recent announcement by Lockheed Martin Corp. of the acquisition of Loral at a similarly high valuation, all three companies find themselves on the same team.

In 1986, the basis for consolidation was acquiring advanced capabilities to feed a rapidly growing defense procurement budget and its next generation of weapons. Such spending, as well as the prices paid for acquisitions, peaked shortly thereafter.

After a decade of declining spending, acquisition decisions today are based upon a more sobering outlook regarding the future. Today’s deals are driven instead by quantifying savings obtainable in consolidating facilities in an industry which still retains far too much capacity. You make money today upgrading and filling orders on existing weapon systems rather than developing new planes, tanks and ships.

As the events of recent weeks vividly demonstrate, consolidation in the defense industry continues at a feverish pace. Two acquisitions in the defense electronics sector--Northrop Grumman Corp.’s purchase of Westinghouse Electric Corp.’s defense businesses and Lockheed Martin’s acquisition of Loral’s core defense business--boost two industry giants to new levels that dwarf the size and capabilities of their predecessor companies a decade ago.

As the big get bigger, there is a perception in the industry that, like the Super Bowl, many compete but only two teams will be invited. While these two teams have locked up a playoff berth, competition among the remaining industry behemoths will heighten in the coming months. There will be new announcements of mergers and acquisitions as other teams scramble for the remaining “wild card” slots.

If observers remain focused on only the excitement and pageantry of this race, they may miss three important trends which will become apparent this year:

Lower Prices

Like this point in the cycle a decade before, the premiums paid for defense companies will begin to drop. While the titans race toward the Super Bowl, much of the rest of the league has yet to suit up. Many companies, still comforted by both the final benefits of working off their remaining Cold War production backlog and their rising stock prices, have yet to act. The realities of the inherent cyclicality of both the realities of defense procurement and Wall Street’s love affair with industry sectors will shortly force those on the sidelines to rethink their strategies. Since selling at today’s acquisition multiples will become more compelling to many than making acquisitions at those prices, an increased supply of companies for sale will lower overall values.

There will also be a shrinking base of aggressive buyers. Unlike a decade ago when it was considered a growth industry, the participants in this consolidation are exclusively companies already in the game. When two large companies combine, they reduce the number of bidders for future properties.

In addition, having already completed the deals necessary to achieve critical mass and secure market position, their next purchases become more discretionary, thus lowering the premiums they are willing to pay.

The frenetic activity has also masked an important reality--the continuing deterioration of the basic fundamentals in the defense industry, as the absolute amount of defense spending slides and more money in this shrinking pie is shifted from procurement to operating accounts. Corporate valuations are based in part upon expectation of future growth. It is impossible to shrink one’s way to such growth.

Even Wall Street has started to alter its mechanism for rewarding transactions. Until the last few months, the stock prices of both buyer and seller had typically risen upon the announcement of a transaction. In several recent transactions, the stock price of the acquirer has fallen. After three years of buying backlog cheaply and realizing the “low-hanging fruits” of consolidation savings, investors have expressed their displeasure regarding the recent shift to dilutive acquisitions brought on by ever-increasing acquisition prices and consolidation benefits that may take years to realize. They are more than willing, however, to hunt for the next target.

More, but Smaller Deals

Unlike the last cycle, the volume of transactions will remain high as interest in consolidation shifts from large defense electronics deals to other industry sectors and smaller transactions. Industry observers often assume that the frothy activity in the defense electronics sector can be applied to the whole industry.

The building blocks of the defense industry, however, are more mundane components that do not capture the imagination (and therefore justify the pricing) the way the promise of “black-box” solutions may. Although perhaps not the first choice of acquirers, the large number of these types of companies, and the compelling current valuation spread between them and more expensive electronics companies, will attract the interest of both strategic and financial investors to lead their consolidation.

More Strategies for Growth

Last, while there is no debating that these giant diversified defense contractors will remain dominant forces in the marketplace, there will also be a recognition that “bigger is better” is not the only successful approach to defense contracting for the millennium. Many focused, mid-size companies and smaller niche companies will receive market recognition for their differing strategies.

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This year, like a decade before it, promises to be an exciting one for industry observers. So, grab a comfortable seat, buy a program and try to keep score. After the high-priced and much-hyped Super Bowl is over, the international media and the fans go home, the harder and less glamorous part of the consolidation (plant closures, layoffs, joint marketing efforts, etc.) will take place during the trading, workouts and team moves of the off season.