NEW YORK — The financial outlook for defense firms is complicated, with growing defense budgets potentially counteracted by outsized growth in other government spending, industry experts said during a two-day defense forum hosted by Bank of America this week.

Pierre Chao, the founding partner of Renaissance Strategic Advisors, identified a few notable trends he currently sees in the defense industry.

First, after years of contraction, the Defense Department's budget is starting to increase, he said. But it will take time for the increased funds in the Pentagon's budget to translate into increased revenues for defense firms, he noted.

Second, with a two-year budget agreement is in place, the debates in Washington will not be over spending levels but over policy. For defense investors, the issues worth following include the debate over how much to fund social services, health care and pensions for an aging and increasingly professional military, he said. The other major policy debate will surround the Pentagon’s desire, articulated last year by the acquisitions AT&L chief Frank Kendall, for the authority to veto defense firm mergers based on national security concerns.

"I would watch that one really, really carefully, because that's a pretty open-ended term, and would have some pretty profound implications if that authority were granted," Chao said.

Third, the Pentagon's desire to bring more innovators and commercial companies into the fold will be highly visible, he said.

"The industry is watching this very carefully as well," he said. "They are trying to decide, 'Am I going to have a whole new set of competitors?' or 'Aam I going to have a whole new set of partners?' "

Fourth, defense firms, many of which have relied on share buybacks and dividends in recent years to keep stock prices high, will begin to display different business strategies, he said. Raytheon has spent on research and development, and has invested in its cybersecurity business, while professional services companies have been active players in mergers and acquisitions (M&A). Northrop Grumman has employed an organic growth strategy, which recently paid dividends with its win on the Air Force's LRS-B contract, he said.

The award is currently under protest from the losing team of Boeing and Lockheed Martin.

"The ability to demonstrate a differentiated strategy I think is going to continue to play out in 2016," he said. "It's going to become more and more stark."

Fifth, the definition of scale is being redefined, especially in the services market, where a $500 million or $1 billion company used to be considered large, Chao said.

Smaller margins in the sector require a larger scale to produce the same raw dollars needed to maintain a specialized core capability set, he said.

"This whole issue of what is the right scale is going to be a topic for 2016," he said.

Frank Finelli, a managing director at the Carlyle Group, noted that 2015 was a record-setting year globally for M&A (including non-defense deals), with $3.8 trillion in total deals closing last year. In the defense sector, activity remained relatively flat from 2014, which saw less than $35 billion of transactions.

There is $1.3 trillion worth of dry powder in private equity that could be quickly brought to bear, but "the reason it's not being put to work is primarily valuation," Finelli said. "There's tremendous capacity to do M&A, but we really don't see a lot of needle-moving deals."

Valuations are historically high in the defense sector, he said, with many companies’ price-to-earningsprice to earnings ratio at around 18 times.

Four years ago, if an investor bought a single share of the stock of each of the seven US defense firms that do more than $10 billion in sales annually, it would have cost less than $400, he said. The same seven shares cost $940 at the end of last year.

As interest rates rise, income investors will have other attractive alternatives for their capital, so companies may turn to other financial strategies besides higher dividends and share buybacks, he said.

Foreign military sales will not be a panacea for defense contractors, because a strong dollar makes US-made products comparatively more expensive, he said. But there will be FMS opportunities anyway, because global instability is creating demand.

"A lot of nations lack deployable military capacity," he said. "Peace is not breaking out around the world, and nations are going to have to increase the size of their force structures."

Domestically, the long-term outlook for US defense budgets is complicated by the government's growing debt, which is projected by the nonpartisan Congressional Budget Office to approach $40 trillion by 2039. By 2025, CBO forecasts interest expense on US debt will be larger than the defense budget, Finelli said.

John Niehaus, managing director of Avascent, said defense clients' focus is shifting, with an eye towards opportunities in international markets, as well as DoD, resulting from the dramatic changes in the global security market. The change in focus is noticeable: from cost reductions in the face of the down-cycle to opportunities for growth.

"I would say they are increasingly 'looking around the corner,'" he said. "Is there an opportunity for my company in the market, given the changing security environment? If so what is it and how do I capture the prize?"

Regional arms races, are possible – -- perhaps likely in southwest Asia due to recent events involving Iran, given Iran – -- and could drive new demand, he said. Combined with the belief that the US defense budget is rebounding from its recent bottom, with potential upside, especially post-Budget Control Act, clients are increasingly optimistic about their future sales prospects, he said.


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