WASHINGTON — United Technologies will spend the next several months weighing whether to divest its Sikorsky unit, in what analysts say is a reflection of shrinking profit margins across the defense sector.

The review, which will be complete by the end of the year, is looking at the possibility of setting up Sikorsky as a stand-alone company, and the official line out of UTC is that nothing has been decided.

But during a March 12 analyst event, UTC President and CEO Gregory Hayes certainly indicated that Sikorsky is no longer a good fit for UTC.

Sikorsky is "just not quite as attractive as the rest of the businesses," Hayes said, noting the subsidiary's role "as a platform provider, as opposed to a system provider, differentiates Sikorsky from the rest of the portfolio."

Hayes called the decision "not an easy one," but said it was "the right one for Sikorsky's customers, for Sikorsky's employees, and for our shareholders."

A divestment would not be That UTC would look to divest itself of Sikorsky is not altogether surprising. Defense News reported 13 months ago that the company was considering such a move, and analysts contacted for this article all agreed it made sense, as UTC's other businesses are primarily service based. And while Sikorsky is still a profitable, $7 billion company, its profit margins are not near those of the other UTC branches.

Byron Byran Callan, an analyst with Capital Alpha Partners, said this may be part of a larger trend of companies looking at the defense sector and deciding their weaker military-based units may be ripe for pruning.

"If the military business outlook was as strong as some people make it out to be, you wouldn't be seeing these sorts of decisions," Callan said. "You wouldn't see Exelis being sold to Harris, ATK merging with Orbital.

"It's also a strong signal that to stay in this business may require more investment, and certainly further cost reduction, and some companies will make that decision and some will make the decision to just get out," he added.

Anita Antenucci, senior managing director at Houlihan Lokey, said the spinoff of defense firms is a subtle trend that is part of the larger wave of mergers and acquisitions that experts have been waiting for. She said it's an option more viable now than the 1990s, when the public was less likely to support small, independent defense firms on the market.

She called it "quite predictable" that spinoff companies become targets for either acquisition or mergers after they become stand-alone firms. Or as she put is, "It's like a halfway house, where these companies exist as stand-alone entities while the market sorts itself out."

"I think you will find many, many examples of this, but there will be more transactions without spinoffs than with," she said. of the spinoff strategy. "It won't be a majority, but it will certainly be impactful."

Steve Grundman, principal of Grundman Advisory and Lund Fellow at the Atlantic Council, sees another potential trend, one that could have negative consequences for the defense industry.

"While it's not yet the rule, UTC's announcement appears to repeat a template of multi-industrials exiting or curtailing their exposure to defense," Grundman said. "It's a playbook for the industry as a whole that I would regard as a regressive, unwelcome trend — the retreat from the defense market of multi-industrials — because I regard the participation of strong multi-industrial companies in the defense sector as improving its stability and propensity to innovate."

He points to the 2011 spinoff of Exelis Corp. from parent company ITT. as a previous example. Exelis, the defense arm of ITT, was given the chance to stand on its own, while ITT removed itself from a sector that many saw as beginning to shrink as the US prepared to draw down from Iraq and Afghanistan.

Mike Blades, an analyst with Frost & Sullivan, said it is smart for big conglomerates to begin limiting their role in the defense sector.

"Those large companies will never get out of that business, but spreading that risk will be a big concern for how they run their business from now on," Blades said.

There aren't many multi-industrials left in the defense sector. General Electric, Honeywell, and to a lesser extent Thales all fit the bill, Grundman said. But the best example may be Finmeccanica, which is Finmeccanica looking to curtail its defense exposure both in Europe and the United States. In particular, the company is looking to shed subsidiary DRS' Aviation and Logistics, as well as Training Communications and Network solutions, units.

DRS has struggled in recent years, and Finmeccanica CEO Mauro Moretti has indicated he would be willing to sell the entire unit at some point. In that way, Finmeccanica also fits the pattern of selling off weaker units as the industry slows down.

Rotorcraft Stand-Alone

If UTC divests moves ahead with divesting Sikorsky, analysts agree that a spinoff is much more likely than a sale to a rival competitor, for both market and tax reasons.

US tax law says that the sale of a company results in a gain tax; a spinoff does not need to pay that tax. But there is a wrinkle: If the spinoff is bought by another company within a two-year period, the burden of proof is on the original company to prove this wasn't a tax avoidance scheme. After two years, the burden shifts to the IRS to prove anything is amiss.

Because of how long Sikorsky has been owned by UTC, the tax bill for a sale would be huge, likely negating the possibility of another firm buying Sikorsky from UTC in the short term.

That's not a major issue for the rotorcraft unit. The analysts all agreed a stand-alone Sikorsky would be able to survive, and Hayes pledged not to cripple Sikorsky with debt if it was spun off, saying, "we want to make sure they will be a successful, stand-alone company."

The picture remains blurry about potential buyers after the two-year period has passed. While Sikorsky has a huge portfolio, it is not one that matches up well with another rotorcraft company.

According to a Teal Group analysis, military rotorcraft saw a 7.9 percent compound annual growth rate between 2004 and 2013, with an unheard of 66 percent jump from 2008-2012. That unsustainable growth has slowed and is projected to continue to decline, while the commercial market is on an upswing.

The fact Sikorsky is stronger in the military helicopter market hurts it as a potential pickup, Blades said. Notably, Hayes noted Sikorsky's reference to a "predominantly military" customer base in UTC's official announcement of the strategic review.

"If you read between the lines, it's not that they make helicopters. It's that they make military helicopters," Blades said, emphasizing the word military. "It's a business, but it's not an explosive growth business."

"All the other stuff UTC does is going to be demanded and needed, not just on the military but also on the commercial side," he added. "Their CEO is charged with growth, and while Sikorsky may have steady sales, it won't show huge growth."

Teal's Richard Aboulafia doubts Sikorsky would be absorbed by one of its rivals in the rotorcraft market, for both financial and political reasons.

"I don't think anyone has the stomach for a European firm buying Sikorsky," Aboulafia said. "Textron just doesn't have the cash to do this, so it won't be Bell Helicopter. As for Boeing, someone would kill that merger — it could be DoJ or DoD, but there would be so many knives out that there's no way."

Callan agreed that another helicopter company may not be a fit, but noted that future buyers could come from a non-rotorcraft company that sees synergies with what Sikorsky does. Antenucci, however, disagrees.

"Synergies with another helicopter company would always be much greater than with a non-helicopter company," she noted. "The helicopter industry is still a segment of defense that is less consolidated than other platform businesses, in part because the conglomerates that own some of them were not looking to add to their individual helicopter units — UTC would never go buy another helicopter company when Sikorsky has a lower return on sales than their other businesses."

Callan also questions why UTC needs to spend several months reviewing the decision, given Hayes' comments. He wonders if it is related to UTC is waiting to see what happens with sequestration before finalizing how it will divest the helicopter unit.

"You may not want to announce something now and then find out the budget coughs up a different set of answers than expected and you have to change plans," Callan said, noting that "helicopters got whacked" in previous budget discussions.

For now, the Pentagon is staying out of it. Frank Kendall, the top acquisition official at DoD, told reporters last week he was keeping an eye on the situation.

"At this point, based on what I know about that deal, I'm neutral about it," Kendall said. "It should not impact us as far as cost or rates are concerned, I think. I'd be interested in knowing the answer to that question…. I've just got to make sure it doesn't affect our prices very much."

Joe Gould in Washington contributed to this story.

Twitter: @AaronMehta

Aaron Mehta was deputy editor and senior Pentagon correspondent for Defense News, covering policy, strategy and acquisition at the highest levels of the Defense Department and its international partners.

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