A path that forecasters frequently take is to simply consider recent trends and then project these into the future. For defense merger and acquisition activity in 2018 and beyond, that certainly is one path to take, but it may ignore new or different forces that shape how M&A could be used by companies to improve their prospects in defense.

Defense M&A increased in 2017 compared to 2016, and it was comprised of a mix of deals whose rationale could be extrapolated into 2018 to divine what else could occur. The largest was the Northrop Grumman-Orbital ATK deal, which underscored large primes’ desires to reposition into growth markets. (There were other large deals, notably between United Technologies Corporation and Rockwell Collins as well as Safran and Zodiac, but their rationale was mainly based on commercial aerospace.) Consolidation continued in defense services as exemplified by KeyW’s purchase of Sotera and the deal between Vencore and DXC Technology. Private equity continued to be a buyer and a seller. The Vencore deal is one example of an exit, while Veritas’ purchase of Harris Corporation’s government information technology business is an example of a purchase. There were lots of smaller bolt-on acquisitions to gain access to technology, new customers or both.

Outlook 2018: Perspectives from global thought leaders

Defense sector M&A could accelerate in 2018, and deals will be struck on the same rationale evidenced in 2017. Record-high stock prices and the valuations they represent make share buybacks less impactful. There inevitably are going to be different views on the trajectory of defense budgets to the early 2020s, and managements and boards may either conclude this is as good as it’s going to get or that the best times for defense are still ahead in the future. Those dispositions are what make deals for buying or selling.

But there are other factors and issues that could alter the path of defense M&A, and they should be considered by contractors, their customers, suppliers and competitors.

The first factor is whether M&A can enable defense contractors to better ingest commercial technology. The disparity in defense versus commercial research and development has only widened in recent years, and commercial is the driver in areas such as autonomy, data analytics and machine learning that are of keen interest to militaries. Partnerships and ventures may be the better path here, as most managements seem loath to consider entering commercial markets and there are valid security, overhead and cultural issues to consider.

Second is the preference for “Buy America.” U.S. defense firms have generally not been truly multinational with globally distributed development and manufacturing operations. Supply-chain issues and potential blowback from Buy America might result in more M&A activity geared at accessing regional trade areas or individual countries.

A third factor is whether there may be another attempt to build a defense firm that is larger than Lockheed Martin, which is the No. 1 ranked firm by defense sales per Defense News’ “Top 100” rankings. Large primes might again attempt to merge, though the last time a deal like that was tabled was in 1997 when Lockheed Martin tried to buy Northrop Grumman. The U.S. Justice Department case blocking the AT&T deal to by Time Warner suggests that government remains wary of giving companies too much power over market segments and there may be a read-through for defense.

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Portfolio simplification is a fourth factor, and a related fifth factor is the culling of business segments that may spur more commercial competition. In the case of the former, managements increasingly focus on what their companies do best and divest subpar performers or businesses outside of core skills. This factor will become more important as defense investors expect growth. Commercial space and cloud services are areas where heritage defense firms will face more competition from firms with different business models, risk tolerance and cultures. This could trigger reassessment of what belongs in a defense contractor’s business portfolio.

Byron Callan is a policy research at Capital Alpha Partners, LLC and is an expert in financial and defense industry analysis.

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