Defense Industry Running out of Time; Mergers Loom
By Paul McLeary
NEW YORK — For the past several years, defense watchers in Washington have been anxiously awaiting an expected surge in merger and acquisition (M&A) activity among the big prime defense contractors as the Pentagon budget tightened.
But that hasn't happened to the level that many analysts expected.
Other than the April 2014 announcement of an agreement between Orbital Sciences Corporation and Alliant Techsystems to combine their businesses into form a $4.5 billion, 13,000-person space, defense and aviation developer and manufacturer, most of the primes major priome contractors have instead been filling niche needs and spinning off smaller business segments.
Some Wall Street analysts have said that the fiscal year 2016 budget will represent the seventh year of the current downturn in defense spending, which has been coupled with the disruption of the budget cuts and the congressionally mandated sequester cuts, which kick in if the Pentagon doesn't stick to its budget caps.
"In the absence of clarity of where the Pentagon exactly wants to go going forward, the grand strategy [for defense contractors] is a simple one" said Pierre Chao, managing partner at Renaissance Strategic Advisors, on Jan. 7.
The large primes have adopted what he descried as "a holding strategy, to make sure I can generate enough returns to the street in the forms of dividends and share buybacks until I can get that clarity, develop a strategy and move forward," he said at a conference hosted by Bank of America here.
So far that strategy has worked, been working, as the large primes have consistently posted record profits in their quarterly and yearly reports, a fact that has struck many as being incongruous with the pleas of budgetary disaster coming from the Pentagon.
That disconnect, said Todd Harrison, a senior fellow at the Center for ofStrategic and Budgetary Assessments, has come about because industry saw the budget cuts and dearth of new start development programs coming, "and did what it needed to do to prepare. Cutting people, closing facilities, and getting more efficient … industry is reaping the benefits now."
But the share buybacks and cost-cutting measures that the defense industry has used to return value to its shareholders can't last forever. "It's a somewhat temporary benefit," Harrison warned, because "you can only get more efficient and downsize to a certain point until it starts to hurt you."
Chao echoed the point, telling the audience of analysts and investors that the strategy has worked — but been working. But time may be running out.
Prime contractors' efforts to The effort of the prime contractors to lay off staff, close facilities, and conduct share buybacks has "been rewarded, it's been holding in place," he said. "There's enough cash and capital in place, there's enough running room in terms of leverage … for that to last another 12 months, maybe 14, 15 months. We're certainly in the latter innings rather than in the beginning. The success of that strategy is sowing the seeds of its own destruction — obviously the higher they push up the multiples, the less return on investment capital that share buyback scheme generates at some point."
All of the schemes undertaken by the defense industry to increase shareholder value has been a positive force for the industry's shareholders overall, said Frank Finelli, a managing director of the Carlyle Carlisle Group.
"They're doing a very effective job in running their companies," he said. observed. Still, with the budget uncertainty in Washington "it's going to be hard to get things done."
Jeffrey Bialos, a partner with Sutherland, Asbill & Brennan, LLC added that he thinks the defense industry will try to and sustain the buyback and efficacy efforts as long as they can "before they start mergers."
And once those mergers begin, he expects them to be "more in dual use and aerospace but not so much in strictly defense," since the market has become so interdependent.
Renaissance Strategic Advisors' Chao added that he sees 2015 as a year when the primes start moving on the M&A front. In 2014, he said there was about "$13 billion worth of transactions that got that close, but somebody blinked at the last minute."
"If the companies in '13 were frozen by sequestration and weren't moving, the mood last year was the beginning of 'I can't afford to be frozen, I need to start doing something or at least start thinking about it,'" he added.
It's assumed that the fiscal 2016 will be the low point for the defense budget's topline, The budget cap instituted under the 2011 Budget Control Act is slated to begin moving up in 2017 from $499 billion to $512 billion.
There is little expectation that Congress will lift the Budget Control Act's spending caps, although the White House has said that it will continue to ignore the caps in its yearly requests. Sources have told Defense News that the '16 budget request slated to be released on Feb. 2 should blow by the $499 billion budget cap by about $35 billion, which doesn't take into account the yearly supplemental wartime funding request, which it has been reported will be $51 billion in '16.
"There's enough money in the system overall to fund competitive solutions … the issue is how you allocate those funds in a constrained environment," said Jeffrey Bialos, a former deputy undersecretary of defense for Industrial Affairs in the Clinton administration.
Despite budget caps and the sequester, "there's enough money for us to do what we need to do and for industry to prosper."