Why Defense M&A May Wake Up
Aviation Week & Space Technology
Byron Callan
Does a different backdrop foretell a revival of defense deals in 2014?
Major merger and acquisition activity in the defense sector was pretty quiet in 2013. However, there were some noteworthy trends that point to some of the different directions management teams could take in 2014 and beyond.
There were just two defense-related deals in excess of $100 million announced last year. Both involved defense services businesses. CACI completed the $820 million purchase of Six3 Systems on Nov. 15. And on Dec. 22, Engility, which was spun off by L-3 Communications in 2012, announced an agreement to purchase Dynamics Research for $120 million. The other major development was an announcement by Exelis on Dec. 11 that it is spinning off its military and government services business.
But the bigger deals involved companies moving to reduce their exposure to the defense market by pursuing acquisitions in other sectors. Just before the end of the year, Rockwell Collins closed on a $1.4 billion purchase of Arinc, which specializes in aviation-related communications, engineering and systems integration. ATK further expanded its portfolio in sporting goods with a $985 million deal to acquire Bushnell and a $315 million deal for Caliber Co., the parent company of Savage Sports. And on Dec. 26, Textron announced it would acquire Beechcraft for $1.4 billion.
As 2014 gets underway, it is tempting to assume M&A activity will see more of the same patterns. However, there are new factors to consider in a changing industrial landscape. One is the rather stunning upward equity revaluations of public defense companies last year. In January 2013, U.S. and European firms were selling at a mean of 6.3 times earnings before interest, depreciation and amortization. Based on consensus estimates for 2014, those companies are now selling at a mean of 9.1.
These boosted valuations make it easier for managements to justify the prices of acquisitions to shareholders. That was not the case during the first three quarters of 2013, when 91% of cash from operations at General Dynamics, L-3 Communications, Lockheed Martin, Northrop Grumman and Raytheon was used buy back stock or pay dividends.
Meanwhile, a clearer picture of U.S. defense spending should emerge in 2014-15, drawing buyers and sellers from the sidelines. There are bound to be different views about how defense spending in general and specific programs could fare in 2016 and beyond, but the combination of near-term stability and long-term variability in the defense outlook could contribute to more deal-making. Like ATK and Rockwell Collins, some companies could take advantage of low interest rates to finance acquisitions outside of core defense markets. Others, believing that better days lie ahead for defense, may seek to double down on their exposure.
The U.S. Defense Department is not apt to change its opposition to consolidation among the large prime contractors. But that does not preclude restructuring or divestitures by these companies, and mid-size and smaller firms could be more active in the market. Decisions by L-3 Communications, Exelis and SAIC to restructure in order to remain more competitive in services suggest other firms with diversified portfolios of services might follow suit.
Two U.K. contractors signaled strategic reviews in 2013. Qinetiq is looking hard at its U.S. services business and Chemring promised to review its portfolio. Others could do the same, particularly when anticipated critical mass in local markets was not achieved.
In an October analysis, the aerospace/defense team at Houlihan Lokey noted that a number of defense services businesses have been held for some time by private-equity firms. These investors will not hold their properties indefinitely and will seek returns, possibly through strategic action.
Finally, there are some market sectors in the U.S. that could be more sharply defined, depending on the outcome of major defense programs and competitions. Decisions on the Armored Multi-Purpose Vehicle, Ground Combat Vehicle and Joint Light Tactical Vehicle in 2014-15 could trigger losers in these competitions, or program funding decisions to look anew at their competitive positions in defense vehicle markets. The fate of Boeing's F/A-18 and C-17 programs may also spawn strategic rethinking among suppliers. Rotorcraft remains a mature sector for now, but one where changing demand and new product development spawns strategic reassessments.
Contributing columnist Byron Callan is a director at Capital Alpha Partners.
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Mark Article As: Commentary
Issue: Aviation Week & Space Technology 2014-01-20
Starting Page: 15
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