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Strategies & Market Trends : Speculating in Takeover Targets
ULBI 9.980-1.2%Jun 20 3:59 PM EDT

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From: richardred12/29/2013 4:53:45 PM
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IMO 2014 cuts in the Pentagon will make consolidation a priority among big Defense players. A good refresher piece. Textron just recently in the civilian area..

Defense Consolidation: Who Gets Bought First?

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Credit: Clemens Vasters

The biggest defense companies have been planning a long time for this day, cutting costs and streamlining operations. Now they are buying back stock and trying to keep dividend yields above 3% so that investors stay engaged. But if interest rates on ultra-safe Treasuries keep rising and sequestration forces the military to carve another $50 billion out of next year’s budget request, then companies may have to do something more strategic. Like merging.

The Washington Post reported this morning that defense merger activity was actually down in the first quarter, but that is just the calm before the storm. The way sector consolidation has unfolded in the past, one big player decides to take the plunge by selling or buying, and the other players then get drawn in because of the need to protect their market positions. Eventually everybody is contemplating big strategic moves, and knowledge of that fact keeps investors interested even though demand for military goods and services is softening.

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Five Reasons The Defense Industry Is Still A Better Investment Than Other Sectors Loren Thompson Contributor
Defense Contractors Are Going To Go For The Civilian Market Loren Thompson Contributor
So the question you’re probably asking yourself is where the first big transaction will occur. I don’t mean private equity buying into the sector, because that too is just a prelude to consolidation. Real rationalization of the sector only occurs when contractors buy and sell each other, in the process integrating previously independent operations and reducing the number of suppliers. Private equity typically buys in with the hope it can flip one supplier to another for a higher price than it paid, thereby making a killing.

If you know the defense sector’s past and current circumstances, it isn’t hard to predict where the first sizable consolidation move will happen. It will involve one of the big six contractors buying a mid-tier equipment firm with complimentary product lines. The big system integrators like Lockheed Martin LMT -0.48% and Raytheon RTN -0.21% aren’t interested in buying technical services companies unless they occupy special niches like cybersecurity, because the margins on services are well below those on military hardware, and low barriers to entry in services make it hard to know the long-term value of what you’re buying.

So what the big players with lots of financial resources want are military technology companies with well-positioned franchises — in other words, business lines that are likely to keep generating cash flow for a long time to bolster results as demand flags. But the biggest players were told years ago by Pentagon policymakers that they wouldn’t be allowed to merge with each other because there were so few that competition would be undermined. So demand would have to decline for a long time before the government approved, say, a Boeing BA -0.99% proposal to acquire Northrop Grumman NOC -0.54%‘s military aircraft and space operations. (By the way, most of the companies mentioned here give money to my think tank).

Obviously, if the big boys (and girls) can’t bid for a first-tier military hardware company like General Dynamics because the government won’t allow it, and they’re not interested in getting any deeper into services than they already are, then most of the near-term action in sector consolidation will involve smaller equipment firms. But they must have significant revenues to move the needle on corporate returns for the buyer, otherwise there’s not much point in doing a deal with valuations still relatively rich. So the logic of the situation dictates that the first big wave of consolidation involves first-tier system integrators bidding for second-tier equipment makers.

By second-tier, I mean companies with market capitalizations well above $1 billion, but well below $10 billion. Those are the thresholds that separate the small caps and the large caps in the defense sector from the folks in the middle. If you’re a Northrop Grumman or Raytheon at the top of the food chain with a market cap in the vicinity of $20 billion, then you have all sorts of financial options for acquiring a company in the middle range of players like Alliant Techsystems, which has a market cap around $2.5 billion. Even with the inevitable premium, it would be an eminently manageable transaction adding significantly to the buyer’s cash flow and product diversity.

But here’s the thing about the middle tier of the U.S. defense industry: there are only a handful of equipment makers because most of the medium-size players were snapped up in the last round of consolidation, and precious few pure plays. Pure plays, in the vernacular of the defense sector, are companies that only do business with the Pentagon and related federal agencies, rather than having a diverse array of customers and products. Wall Street prizes pure plays because they are easy to model and understand. Big military contractors looking to get bigger like them because they don’t confuse investors with business lines outside the buyer’s traditional markets.

Let’s look at a few examples of mid-tier companies that aren’t pure plays. Harris Corporation has been a focus of much speculation concerning defense-sector consolidation, but only about a third of its sales in advanced electronics and communications comes from the federal government, so a defense buyer would have to take on a sizable chunk of commercial business to get at its military franchises. Rockwell Collins is a similarly well-positioned supplier of airborne electronics and communications for the military, but nearly half of its sales come from commercial customers like Boeing. And Alliant Techsystems is a dominant supplier of solid rocket engines and ammunition to the military, but much of its recent growth has come from commercial ammo sales.

There may be compelling reasons for why a Northrop Grumman or Raytheon would want to acquire any one of these very well-managed companies, not the least of which is diversification away from heavy reliance on the Pentagon customer. But the path of least resistance during the early stages of sector consolidation will be to acquire well-positioned equipment makers that do nearly all of their business with the military. Two examples would be Huntington Ingalls, the nation’s largest maker of warships that was spun off from Northrop Grumman a few years back, and L3, a $12 billion manufacturer of military electronics, communications and networking products that typically is the number-one or number-two supplier in the product areas it addresses.

Huntington Ingalls and L3 really are pure plays, and both of them have been performing nicely despite the downturn in defense spending (I wrote a piece for on May 20 calling Huntington Ingalls the “safest bet” in the defense business). But Huntington Ingalls is all about warships, so companies would have to be comfortable with shipbuilding to buy it. Northrop Grumman owned the operation for a decade before giving up on trying to make it perform like the company’s other units. L3 would probably be an easier fit for companies that are already in the military electronics business, but it’s just about the biggest of the mid-tiers. In fact, Byron Callan of Capital Alpha Partners rates it as a first-tier player, even though its market cap is less than $8 billion.

And then there is Exelis, the $5 billion military electronics, information systems and technical services company that was spun off from ITT in 2011. Exelis is a near pure play, with 69% of sales last year derived from domestic military and intelligence business, and much of the remainder tracing to the federal government’s civil agencies (NASA, FAA, etc.). The company is a gem in terms of its market positioning and competencies, but it probably is too small to thrive as an independent entity in a shrinking military marketplace despite the fact that it is prime contractor on 80% of its programs.

One reason Exelis would have trouble doing well as a stand-alone going forward is that its competencies are spread across so many different missions, from electronic warfare to force protection to space-based imaging to GPS navigation to air traffic management. Frankly, it’s amazing that a company with a market cap of only $2.5 billion is able to compete successfully in so many areas. In any other country, it would be considered a national treasure. Which is why, to my way of thinking, Exelis is likely to be an early focus of defense-sector consolidation. It is so well-endowed with attractive technology franchises that if and when it decides to put itself on the block, a bidding war might well ensue.

Considering how strong its underlying businesses are, a case can be made that it is Exelis that should be looking for acquisitions in any consolidation wave. However, its relatively small size — it has barely a quarter of Northrop’s or Raytheon’s revenues — plus the circumstances surrounding its separation from ITT leave it at a disadvantage in trying to bid against first-tier firms for attractive properties. So when defense consolidation begins in earnest, Exelis looks to me like the most attractive target for big hardware companies that have been told they can’t buy each other. Maybe that’s why its stock has run up significantly over the last two months.
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