With Defense Downturn Looming, Cash-Rich Firms Are Ready to Make Acquisitions
“There is tremendous cash on the balance sheets of strategic players in the market,” said John Allen, CEO of Bluestone Capital Partners, based in Washington, D.C. The top 15 U.S.-domiciled defense firms have $35 billion in cash — not including debt capacity. In addition, private equity has become a “viable participant in the U.S. marketplace, and in fact has been outbidding strategic buyers for businesses of all shapes and sizes over the last year,” Allen said.
“It’s a great time to be a seller if you want to take advantage of the capital that’s out there,” said Allen. For buyers, the market now affords a mix of bargains and overpriced offerings. Some “growth oriented” sectors of the industry such as cybersecurity, intelligence and healthcare-related information technology are pricey, but still sought-after by investors, Allen said, in part because of the role of private equity. “That has been a shift in the market,” he said.
A recent report by market research firm AlixPartners noted that “private equity firms already are showing an increased interest in aerospace and defense bids, especially seeking opportunities in the businesses that the larger, strategic companies want to exit, and on firms with technology expertise."
Another trend in the defense sector has been greater caution on the part of European firms that have aggressively pursued U.S.-based companies as Pentagon spending soared over the past decade.
“With the support of the Pentagon, European defense companies have established a strong presence in the United States through acquisitions,” Allen said. “Yet, as defense budgets tighten, many of these companies are re-evaluating their U.S. presence.”
Despite an anticipated slowdown, European defense giants such as BAE Systems and EADS will not cease to be strong players in the market, Allen said. “EADS has more than $10 billion in cash on its balance sheet and could be expected to ramp up its acquisition activity in the United States.” But outside of the top multinationals, Allen said, “We are seeing less consistent activity from European buyers in the U.S. marketplace, where they had been strong acquirers for quite some time.”
A case in point is Cobham plc, an international defense conglomerate that had been a consistent buyer of service companies but has been less active in the last 18 months, Allen said. Non-U.S. firms such as Cobham are “looking for a strategy,” said Allen. “Do we want to continue to be a consolidator, or focus on smaller areas where there may be more growth potential?” One possible target for buyers is commercial aerospace, he said. “Companies are starting to get more pro-active about placing their bets where they believe there is going to be growth potential.”
Information-technology providers with hot products such as cloud computing are now seen as offering such potential, he said. The Obama administration increased the IT budgets of most federal agencies in fiscal year 2012. “It’s pretty solid growth,” Allen said.
Byron Callan, aerospace and defense analyst at Capital Alpha Partners, wrote in a report to investors that BAE’s management sees U.S. growth opportunities in cybersecurity and intelligence, and possibly in ground vehicles support and services. But rather than seek expansion through acquisitions, BAE is looking to gain market share, said Callan. “In services, intelligence and electronics, the company is making more internal investments to compete and gain share. Cost reductions to reduce overhead and thereby compete more effectively were also emphasized.”
BAE executives, Callan said, “are not upbeat about the broader U.S. defense market environment, and there remains more emphasis on cost take-out and share gain than we’ve seen in recent years when budgets were growing.” If investors are looking for an instance where spending declines have affected a major defense contractor, he noted, “BAE offers an example.” Its land armaments sector saw annual revenues peak in 2008 at $11.9 billion, and will drop to $6 billion to $6.5 billion in 2011.
Among the European firms that are actively seeking to acquire U.S. companies is Saab North America, a subsidiary of Sweden’s Saab. A projected downturn in U.S. defense spending is no deterrent for Saab. “The United States is 50 percent of the world defense market. That is fantastic,” Dan-Ake Enstedt, president of Saab North America Inc., told National Defense. Like other European firms, Saab has gradually positioned itself as a creator of jobs in the United States, which could bolster Pentagon support for Saab acquisitions of U.S. contractors. In the company’s largest military program, the Gripen fighter jet, 40 percent of the components come from U.S. firms. Expected Gripen sales of 500 aircraft between 2011 and 2020, Saab officials predict, would translate into more than $11 billion in revenues for U.S. industry.
Enstedt said Saab expects to soon announce new acquisitions of U.S. suppliers.
But even though the Pentagon remains the world’s biggest buyer of military wares and services, there is growing frustration in industry about not knowing which areas of the budget will be targeted for cuts in response to President Obama’s directive to reduce national security spending by $400 billion over the next 12 years. The only specific cue that contractors received from the Pentagon regarding industrial policy came from Ashton Carter, undersecretary of defense for acquisition, technology and logistics. He said it would be understandable for the industry to consolidate in anticipation of shrinking defense budgets. The Pentagon, he said, would seek to block mergers within the top tier of the industry but would support acquisitions of lower-tier suppliers.
“The Defense Department has no problem with the top tier buying mid-size businesses,” Allen said. In the current environment, he said, it makes sense for cash-rich companies to either gobble up their suppliers or buy back their own stock if they believe it’s undervalued.
Companies that produce traditional big-ticket weapon systems could see diminishing investor interest, analysts noted. The trends in the Pentagon’s budget point to a future where personnel and healthcare accounts will crowd out other areas such as procurement, research and development. The AlixPartners report forecasts that “platform investments will be hit hard due to the military and political priorities of the Obama administration, with personnel costs taking an increasing share of defense outlays.”
The forecast is also one of “less emphasis on complex system-of-systems integration projects, and more stress on items suitable for waging irregular warfare like rotorcraft, trucks and surveillance drones,” said the report. AlixPartners predicts that the Defense Department’s push to “insource” work that had been performed by contractors will hurt industry’s bottom line. “As the war in Iraq winds down and maintenance backlogs begin to shrink, the trend toward outsourcing of logistics functions will reverse and defense agencies will increasingly seek to in-source workloads as a way of protecting their workers and budgets.”
Second-tier defense companies that grew rapidly during the Bush years will “weaken as larger companies invade their market turf in pursuit of a more diverse business mix, leading to a wave of consolidation in the sector that eliminates many smaller firms,” the study said. U.S. defense spending, according to AlixPartners, could decrease by at least 12.2 percent by 2013 and by another 6.5 percent by 2016.