Contractors spinning off divisions as Defense budget ax falls

April 14, 2013

Pentagon budget cuts were supposed to herald a wave of consolidation in the defense industry. Instead, they’re prompting contractors to shrink by spinning off divisions.

McLean-based Science Applications International Corp. plans to split into two companies by February, and L-3 Communications Holdings last year spun off a $1.7 billion unit that provides government services. Bethesda’s Lockheed Martin and Northrop Grumman of Falls Church also have sold divisions to private investors, as Pentagon spending on contracts declined from its 2009 peak.

Such moves contrast with the wave of mergers during the 1990s, when military spending fell following the Cold War’s end. No acquisitions have been announced this year by the top 10 defense contractors.

“When the crystal ball is cloudier than it’s ever been, everybody’s driving slower,’’ Cameron Hamilton, a principal at the McLean Group, a McLean-based investment bank, said in a phone interview.

The Pentagon is absorbing $41 billion in automatic reductions this year under the process known as sequestration. That’s contributing to the largest single-year decline in the defense budget since 1955, according to a report published this month by Todd Harrison, a budget analyst with the nonpartisan Center for Strategic and Budgetary Assessments in Washington.

The top 10 contractors have announced five divestitures this year, according to data compiled by Bloomberg. Last year, the group had the lowest ratio of announced acquisitions to divestitures since 2001, with 11 acquisitions disclosed, 23 divestitures and one spinoff.

By comparison, the top 10 firms, including No. 4 Raytheon and No. 3. General Dynamics, announced 35 acquisitions and 23 divestitures in 2006, as the Pentagon budget was increasing to support wars in Iraq and Afghanistan. There were no spinoffs.

The automatic cuts that began March 1 came out of deal between President Obama and congressional Republicans to create a penalty for failing to agree on a deficit-reduction strategy. The cuts would strip $1.2 trillion from defense and nondefense programs over a decade. They would be on top of $487 billion in defense cuts already planned over 10 years.

Weapons systems

One reason for the divestitures and spinoffs in recent years has been the Pentagon’s rule against companies advising agencies on weapons systems while also bidding on contracts to build them.

Lockheed, the top U.S. defense contractor, in 2011 sold Pacific Architects and Engineers to New York-based Lindsay Goldberg without disclosing terms of the deal. No. 5 Northrop in 2009 sold TASC, its government consulting unit, to a partnership of Kohlberg Kravis Roberts and General Atlantic for $1.65 billion.

“When you’re in a down market cycle, it’s a perfect time to divest,’’ said Jean Stack, a McLean-based managing director at investment bank Houlihan Lokey. “That trend is going to continue this year.’’

The Pentagon’s resistance to mergers among the biggest weapon-makers is another reason there hasn’t been a wave of those deals. In contrast with the 1990s, the Pentagon isn’t interested in further consolidation among the top five or six suppliers, Ashton Carter said in 2011 when he was the Defense Department’s top weapons buyer.

The proposed merger of London-based BAE and Toulouse, France-based European Aeronautic, Defence & Space failed last year because of opposition from European governments. The union would have created the world’s largest aerospace and defense company.

While the industry’s consolidation hasn’t taken off, the deals may come later, after military cutbacks begin to take their toll.

The trend hasn’t begun in earnest because there’s still uncertainty about which programs will be affected the most by the automatic cuts and whether the reductions will stay in effect next year, the McLean Group’s Hamilton said.

“Following the disassembling efforts, we think it could spur aggressive consolidation across the sector,’’ said Michael Lewis, managing director of the Silverline Group, a consulting firm in McLean.

Acquisition targets

Companies such as L-3 spinoff Engility, Booz Allen Hamilton, CACI International and ManTech International may become acquisition targets as military spending declines, Lewis said.

ManTech expects that defense contractors will continue “to look at their business portfolios and spin out pieces,’’ Sally Sullivan, a spokeswoman for the Fairfax-based contractor, said in an e-mail. “We believe this offers an excellent opportunity for services firms like ManTech to acquire and grow and be able to offer our customers greater capability at a lower cost.’’

William Loomis, a Baltimore-based equity analyst at Stifel Nicolaus, said contractors will probably attract higher valuations as investors speculate that some of them will be acquired.

“I do think you’ll see some of those larger companies get bought,’’ he said in a phone interview. “When we see consolidation, it’s going to attract new investors to the space.’’

— Bloomberg Government

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