WASHINGTON — While the defense industry is ripe for significant M&A activity, a combination of complicating factors, including the appreciation of the US dollar, makes valuation difficult, a panel of analysts told the audience at the ComDef 2015 conference.
Frank Finelli, the managing director of the Carlyle Group, said there exists a "tremendous capacity" for M&A deals in the defense space. as institutional investors look for
"There's over $1 trillion of dry powder out there in the private equity industry," he said. At the same time, the strength of the dollar — the euro stands at around $1.10 versus $1.40 18 months ago, and one dollar now buys over 70 rubles versus 38 over a similar period — means that US-made goods are relatively more expensive in foreign markets.
"One of the areas that concerns me a little bit is the impact of the appreciation of the US dollar on price competitiveness of US companies in the international marketplace," Finelli said. "The price of foreign goods has decreased a lot versus US goods."
At the same time, the strategy of many US businesses involves foreign sales, said Grant Rogan, founder of Blenheim Capital Partners.
"We're also seeing a rise in emerging and developing markets of non-traditional players wanting to get into a traditional industrial base here in the United States," he said. This poses a challenge for top tier US and European defense firms who want to reach those markets without diluting their share value by giving away proprietary technology to their would-be business partners.
Disruptor companies are also making their presence felt, noted Byron Callan, an analyst with Capital Alpha Partners. He pointed to yesterday's news, first reported by Reuters, that Aerojet Rocketdyne wants to acquire United Launch Alliance as an indication that while non-traditional firms won't necessarily start acquiring legacy defense contractors, they have changed the competitive landscape.
"That probably wouldn't have happened if SpaceEx hadn't come in and disrupted that market," Callan said of the Aerojet Rocketdyne offer for the rocket launch services firm.
Another unknown is if — or more likely when — the Fed will change interest rates.
Many defense firms have been using cash dividends and share buybacks to keep investors happy, based on the logic that a small dividend yield is a relatively attractive use of cash, Callan said. As interest rates rise, this strategy becomes less viable, and this may spur increased M&A activity, he said.
"Rising rates may get people re-focused back on deal making," he said.