The U.S. Department of Defense budget request is increasing year over year, providing a significant tailwind for the defense industry. While companies are positioning to capitalize on the DoD’s high-level priorities, including the development of next-generation strike and sensing technologies, these same firms are having to communicate shifts in their capital allocation policies to shareholders.

During the last administration, cash-rich defense companies focused primarily on returning capital to shareholders, mostly through share repurchases.

However, as valuations have increased and stock prices have climbed, defense CEOs recognize that capital return strategies pose the threat of undermining future growth. Major defense companies have begun to shift away from share repurchases and more toward investment and now mergers and acquisitions.

Michael Richter is a managing director at financial advisory and asset management firm Lazard. (Courtesy of Lazard)
Michael Richter is a managing director at financial advisory and asset management firm Lazard. (Courtesy of Lazard)

In a rising defense budget environment — coupled with abundant capital and a focus toward growth — identifying financially attractive M&A targets can be difficult. Compounding the issue is the fact that internal and government-funded research and development has remained flat in recent years as a result of shareholder-friendly capital allocation policies.

The DoD has outlined that its highest priorities are related to technological advancements, such as missile defense, satellites and advanced payloads, hypersonics, and unmanned vehicles. Limited R&D means companies are scrambling to create or acquire the technological capabilities necessary to take advantage of these initiatives. With this in mind, defense companies have sought out inorganic investments, which has resulted in the targeting of mid-tier companies in order for large defense companies to swiftly and significantly augment their capabilities. Some examples include Northrop Grumman’s acquisition of Orbital ATK, and Boeing’s acquisition of Aurora.

Not surprisingly, mid-tier companies are themselves on the prowl. L3 Technologies acquired a minority stake in Peak Nano and more recently acquired Applied Defense Solutions.

With so much focus on growth and new technologies, defense companies are finding it increasingly challenging to identify acquisition targets that strengthen their capabilities while meeting their financial criteria. Identifiable assets are trading at premium multiples, while unique, under-the-radar businesses are challenging to find. Given the current market dynamic, it is possible established defense companies will look increasingly to less common sources for opportunities.

This may have interesting implications for company portfolios as nondefense participants with a defense-focused business unit or defense companies with a sub-scale or non-core business consider their alternatives. The defense industry is shifting faster than ever, and its ability to successfully navigate the current landscape to capture and position for growth has never been more important.

Michael Richter is a managing director at Lazard, an independent investment bank, where he heads the U.S. financial advisory aerospace and defense practice. This commentary does not necessarily represent the opinion of Lazard.