The CH-53K Helicopter Ground Test Vehicle is being built at Sikorsky's Florida Assembly and Flight Operations facility in West Palm Beach. There was speculation Sikorsky could be sold or spun off. (Sikorsky)
WASHINGTON — Since the US Budget Control Act created the specter of sequestration in August 2011, very few deals have been struck to sell or merge defense companies. The refrain has been that budget uncertainty was leaving many risk averse and timid.
But even now that a two-year deal is in place that provides a bit of insight into future defense budgets, experts still don’t anticipate activity picking up anytime soon.
After Defense News reported last week that United Technologies Corp. (UTC) was weighing potential sale or a spinoff of its helicopter unit Sikorsky, there was some industry buzz that it could be a sign that the mergers and acquisitions (M&A) dry spell was coming to an end. The market responded positively to the news — UTC’s stock surged roughly 2 percent on a day when the wider market was down.
Still, the overall high stock prices, at record levels for many defense companies, could be a sign that change is unlikely across the industry, said Ron Epstein, a senior analyst at Bank of America Merrill Lynch.
“The stocks are working because they’re buying back shares, they’re paying a dividend and they’ve got a pension tailwind,” Epstein said. “If the stock stops working, if the market loses its appetite for what they’re doing, then they’ll do M&A. If it ain’t broken why break it? The market continues to have an appetite for what they’re doing and you can say what you want about the market, but it does tell you in the moment what people want. Right now they’re OK with it.”
For those such as UTC who might be considering what to do with a defense asset, the environment is not good for deals. By default, most companies are inclined toward selling business segments because of the influx of cash they can receive. But because the budget agreement by Rep. Paul Ryan, R-Wis., and Sen. Patty Murray, D-Wash., covers only two years, there still isn’t much long-term clarity as to where defense spending will go.
“There are a lot of people talking, but sellers are unwilling to sell at currently deflated [company] prices and buyers are unwilling to take the risk of more serious budget cuts affecting targets, so it’s creating a stalemate among these companies,” said Michael Richter, head of the aerospace and defense investment banking group at Lazard. “Even though there’s a two-year budget deal, there’s still a relative lack of visibility as to future program funding.
“And visibility is the key to M&A. It’s the forward pipeline of visibility, the forward cash flows, that drives the M&A market and the ultimate valuations that are paid,” he added. “And to the extent that there are clouds limiting visibility, deals become much tougher to effect and much tougher to value. How can you value a business, how can you agree on future cash flows, when you can’t even agree on the future funding of those programs with certainty?”
The other factor that can kill potential sales: taxes. While there’s no way to calculate a generic number given the different tax structures facing companies, most companies would expect to surrender a healthy chunk of a sale price to taxes. That in turn means that companies would need to demand a higher price to end up with the cash that they want, a difficult proposition in the deflated M&A market.
If they can’t find a buyer who will provide an adequate price, or the tax liability is just too great a concern, defense companies in turn look at tax-free spinoffs of businesses they want to get rid of. In the past several years, despite the lack of sales, spinoffs have been the big trend with companies such as Northrop Grumman, L-3 Communications, SAIC and ITT splitting. With a tax-free spinoff, shareholders are issued new shares in the newly formed company, but there isn’t a buyer to hand over major capital.
“Many of the spinoffs that we have seen may have been because they couldn’t find a buyer to pay the right price,” said Sam Pearlstein, a senior analyst at Wells Fargo.
That doesn’t mean that companies can’t find a way to profit, which they need to do to justify the divestiture.
In some cases the valuation of the entire company is dragged down by part of the business, and the simple act of separating it can add value. But most of the time companies need to engage in major stock buy-back initiatives to stabilize the stock price after the split. That’s because one of the major metrics used by investors to value stocks is earnings per share, and with the separation of the company, earnings decline. Finding the cash to buy back enough shares to keep the ratio static can be done a couple of ways, including loading up the new spun-off company with debt and then using the cash to buy back shares of the parent company.
One of the challenges facing US defense companies, which are increasingly bringing in revenue from foreign governments, is that large amounts of that cash sit offshore and can’t be used for buybacks without first paying repatriation taxes on the money, something they are loathe to do.
But if a defense company can’t find a buyer at the right price, a spinoff could be the best option available.
While there may be other targets for spinoff, the experts doubted that any wave of mergers or acquisition was coming. During the last downturn in the 1990s, industry consolidation was the order of the day and many of the largest defense companies that dominate the market today were created. But with the Defense Department telling companies that they don’t want top firms to merge, alongside issues with projecting future defense spending, this down cycle will require a different strategy.
“I can’t think of an event that would, all of a sudden, provide a catalyst where you’re going to see transactions getting announced regularly,” Pearlstein said. “It’s not like 1993 where everyday there was a different transaction.”
What may get things moving a little, even if not at the pace of the ’90s, would be changes to the margins at defense companies, Epstein said.
“We’ve seen the top lines really start to come down now, and everybody is talking about that, but margins are fine,” he said. “If margins start to crack, then investors will start to scratch their heads and say, ‘oh, there’s some risk to this cash story.’ Then you’d see a change in the valuations of the stocks, and then you’d see it in the board rooms, and then you’d see changes in strategy.” ■