Defense contractors on offensive

By Marjorie Censer
Capital Business Staff Writer
Monday, September 27, 2010

Washington area defense contractors are buying and selling companies at an increasingly high rate as they seek to position themselves for a realignment in Pentagon spending priorities.

BAE Systems, which bases its U.S. operations in Arlington County, is the latest to make some changes. The company recently picked up Stamford, Conn.-based L-1 Identity Solutions's intelligence services business for $295.8 million, just as its parent company confirmed that it is considering selling the U.S.-based "platform solutions" business, which builds aircraft and buses, among other equipment.

For defense contractors - whose budgets have surged since Sept. 11, 2001, allowing them to invest in a broad range of technologies - now is the first time they're expecting a flattened defense budget, said William Farmer, co-head of Lazard's U.S. aerospace and defense group.

Consequently, these firms are being forced to reexamine their portfolios and decide "long-term what makes strategic sense," Farmer said.

In BAE's case, the moves reflect the company's continued focus on beefing up its services business - which includes such areas as cybersecurity - rather than its equipment work. John Gannon, president of BAE's intelligence and security business, said the purchase advances BAE in areas the company has identified as "sweet spots," such as analyzing intelligence data.

BAE "is in transition from being a metal bender to a services provider," said Loren Thompson, a defense industry consultant at the Lexington Institute.

He said contractors are trying to anticipate the government's moves.

"The changes are most noticeable among smaller firms, where the rate of strategic change has reached a fever pitch," Thompson said. "But even at the top of the defense pyramid, you find many of the companies buying or selling assets."

As an example, Boeing earlier this year bought both cybersecurity firm Narus of Sunnyvale, Calif., and Fairfax-based Argon ST, which had lingered on the market for about six months, while Northrop Grumman announced it may sell or spin off its entire naval business.

Fairfax-based SRA International this month sold its airport operations division to ITT, which bases its defense group in McLean. The terms of the sale were not disclosed, and both companies declined to comment.

"If a company is number two or number three in a growing area, they may want to make an acquisition so they are number one," Thompson said. But if they're number six, they may want to "get out of the business where they can't hope to compete."

Another factor is new rules from the Pentagon that would limit companies from providing multiple services that could have conflicting interests, such as building a system and then testing it.

Although the regulations have not been finalized, Bethesda-based Lockheed Martin has announced it is divesting its Enterprise Integration Group, which provides systems engineering and integration services, and ITT has sold off CAS, its systems engineering and technical assistance business.

John Hagan, managing director and co-head of the defense and government services unit of BB&T Capital Markets/Windsor Group, said he expects the pace of mergers and acquisitions to remain brisk through the end of the year.

The release of the defense budget early next year will be a key factor in determining whether the tempo stays high in 2011, he said.

"Once that defense budget comes out, [companies will] either have been right or wrong in their estimations," Hagan said.

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