Defense Industry Consolidation: This Time Will Be Different

The pace of merger and acquisition activity in the defense sector has quickened recently as company executives grow apprehensive about a potential downturn in military demand beginning with the 2012 budget. Because there is only one customer who matters in the defense business — the federal government — any sign of softening demand on the part of that customer raises fear that stock valuations in the sector will erode. So companies that were hoping to be acquired or selectively sell off properties are incentivized to do their transactions promptly, before the market adjusts its assessment of forward business prospects downward.

Most senior executives in the sector expect that some moderation in demand is coming. However, since that softening is not yet apparent in Pentagon budget requests, there will be a big gap in the near term between what sellers and buyers think defense properties are worth. Sellers will generally focus on recent track records demonstrating strong growth to justify seeking a premium from buyers. Buyers, on the other hand, will cite demand dampers in the near future such as the drawdown in Iraq and weapons cuts to argue for less robust valuations. It may take several quarters before sellers reconcile themselves to the kind of prices buyers are likely to be offering.

It is already clear that the coming wave of defense-sector consolidation will be radically different from what followed the Cold War. Twenty years ago, the collapse of communism brought a wholesale restructuring of the industry that resulted in two thirds of the big players exiting the business. In a few years during the mid-1990s, many of the biggest defense players sold out, leaving the sector dominated by a handful of look-alike military conglomerates. Nobody expected demand to recover the way it did in the following decade, so regulators allowed the industry to concentrate to a degree that later became controversial.

Because a half-dozen companies now dominate the defense sector and have grown with the defense budget since 9-11, there is not much room for further consolidation in the upper tier of the market. No regulator is going to let Raytheon merge with Lockheed or Boeing buy Northrop — at least, not without major divestitures — so most of the near-term consolidation activity will probably involve second-tier companies. There is already evidence that the biggest defense contractors will be selling properties to position themselves for sustained profitability in a down market. Lockheed Martin currently has both its Enterprise Integration Group and Pacific Architects & Engineers units on the market. Northrop Grumman recently sold its Analytic Sciences (TASC) unit and probably is contemplating options for selling or spinning off some shipbuilding operations.

The willingness of big companies like Lockheed Martin to reshape their portfolios in light of changing market conditions is good news for investors, because formulas that worked in the expanding-market conditions of the Bush years won’t fare as well during the coming Obama downturn. There will likely be considerable competition for the properties they sell off among private-equity players and second-tier defense contractors. The second-tier companies, like SAIC and Textron, are not as broadly based as the defense majors, so they probably will want to get bigger if they plan to stay in defense for the long term. Many second-tier firms will likely disappear in strategic transactions as the decade progresses, because scale and diversity matter more when the market becomes unpredictable.

It is possible that one of the under-performing majors will eventually elect to break itself up and sell off the pieces as Hughes and several other companies did at the end of the Cold War. However, the coming moderation in defense demand will probably be far less harsh than what followed the collapse of the Berlin Wall, and companies still have many other cards to play before they contemplate getting out. Until the depth and duration of any downturn becomes much clearer, all of the first-tier players appear committed to staying in the business.