Feb 5 2014, 3:46pm CST | by Forbes
With Pentagon purchases of goods and services gradually trending downward from their peak during the first Obama Administration, defense executives and Wall Street dealmakers have been waiting for sector consolidation to commence. The last time there was a big downturn in military demand — during the early 1990s – two-thirds of the top military contractors disappeared through mergers, spinoffs and various other exit strategies. Consolidation won’t be quite that dramatic this time around because procurement spending, the lifeblood of the defense industry, isn’t likely to see the 68% drop in buying power it did back then. But five years into the Obama era, it’s clear that technology outlays are taking a bigger hit than other types of military spending, so industry will have to rationalize.
One thing about the defense sector that has changed a lot during the intervening 20 years is the emergence of sizable technical-services businesses that specialize in providing high-end skills such as cybersecurity, logistics and analysis. Some of these businesses are embedded in big military-hardware companies, like the Support Solutions unit of BAE Systems, Inc. that generates $3 billion in revenues annually and employs over 12,000 personnel. But others like Booz Allen, Leidos, and SAIC are stand-alone enterprises that saw huge growth as a result of the wars in Southwest Asia. Now those wars are ending. Although many of the leading service providers such as ManTech have lucrative business lines unrelated to overseas contingencies, it is clear that the services segment currently contains more players than future levels of demand can profitably support.
(Disclosure: Many companies engaged in selling technical services to the defense department contribute to my think tank; some are consulting clients.)
As services companies gradually exhaust the standard playbook of remedies for coping with declining demand from their government customer — cutting discretionary costs, buying back stock, etc. — they are being forced to consider more strategic options. The big system integrators such as Lockheed Martin and Northrop Grumman have voted with their feet, spinning off or divesting services units that looked likely to under-perform going forward. For instance, L3 spun off its government-services unit in 2012, Raytheon eliminated its technical-services unit in 2013, and now Exelis (formerly ITT Defense) says it will be spinning off much of its own services work for the government. In general, the big hardware companies want to hold on to sustainment of the combat systems they make and niche services with growth potential like cybersecurity, while exiting low-margin work that can’t generate the kind of profits they make in weapons production.
But the growing exodus out of services hasn’t yet produced the kind of deals that can consolidate the sector into a smaller number of more robust players. The main reason consolidation has lagged is the mismatch between present valuations and future business prospects. Equity prices in the defense sector have surged to record highs over the last year, even as underlying fundamentals began to erode in response to waning military demand. Even stand-alone service companies like Booz Allen, CACI and Leidos have seen their share prices rise by 30% or more. That gives the companies financial leverage they previously lacked, but it also makes everyone involved less likely to participate in consolidation because valuations just look too rich. Even private-equity players are wary about doing deals at these levels.
However, that all is likely to change in 2014, for three reasons. First, tapering by the Federal Reserve will undermine equity prices across the board — prices that are already under pressure due to weak domestic growth and fears of contagion in emerging markets. Second, sequestration will really begin to bite for some of the biggest weapons makers, who have enjoyed a temporary reprieve up to this point because of the multiyear lag between when budget authority for procurement is cut and when the cuts are felt at the program level. Third, sequestration’s impact will bottom out in services, where the lag in sequestration effects is less lengthy, and thus the bottom is reached faster. Bottom line: valuations will fall just as the market senses the worst is over in defense services, and that sets the stage for consolidation to commence.
There will still be way too many players in defense services to be accommodated by the likely level of forward demand, but with share prices falling and sales prospects improving, executives will be able to make a more credible case for buying out their competitors. Or for selling: once companies see their stocks start sliding, they will be incentivized to get out quick before the price their property can command falls further. 2014 looks like the year that will happen. Michael Lewis of the Silverline Group suggested last year that recent sales and spinoffs of service businesses seemed to be creating conditions conducive to segment consolidation. Once valuations moderate, all it will take is a few big players intent on getting bigger to kick the dealmaking into high gear.
Source: Forbes Business
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