Mergers and spinoffs shake up the defense industry

By Marjorie Censer
Monday, February 7, 2011; 18

When Fairfax-based information technology contractor SRA International canceled on short notice its presentation at a government IT conference in Washington last month, the rumors started circulating. Was the company, which generated $1.67 billion in revenue in 2010 and has more than 4,000 local employees, considering a major change?

SRA spoke up last month, acknowledging that, after receiving multiple questions about whether it was accepting offers, the company had hired a financial adviser. It cautioned, however, against viewing the move as an indication that the company "is or should be for sale."

The firm's stock price surged nonetheless as SRA became the latest government contractor to get caught up in the swirl of merger and acquisition activity reshaping the local economy.

Companies big and small have been rethinking their portfolios and buying and selling accordingly. Locally, Boeing bought Fairfax-based Argon ST -- which had lingered on the market for about six months; Lockheed Martin decided to divest its Enterprise Integration Group, which provided systems engineering and integration services; and White Plains, N.Y.-based ITT Corp. announced it would separate into three pieces: a manufacturing business, a water technology firm and a McLean-based defense and information solutions firm.

The shake-up is likely the most significant since the early 1990s, when reductions in defense spending forced widespread consolidation. That was the era when today's contracting behemoths were formed; Lockheed Corp. and Martin Marietta became Lockheed Martin, while Northrop Aircraft and Grumman Aerospace became Northrop Grumman. The number of companies able to serve as a prime contractor for tactical missile programs, for instance, fell from 13 to three, according to a Government Accountability Office report.

This time around, the corporate moves suggest the industry is working from a different playbook.

"The previous wave of consolidation of the defense industry reflected a collapsing threat and the willingness of policymakers to lead sector consolidation," said Loren Thompson, a defense industry consultant at the Lexington Institute. Today, "threats may actually be growing and the Pentagon isn't all that eager to see further consolidation."

That helps explain why the recent flurry of buying and selling seems more strategic in nature. So far, at least, the industry has shied away from any blockbuster deals.

"This is neither the '90s nor the last decade; it's different," Pentagon acquisition chief Ashton Carter said at a June briefing. "It's an environment in which we're going to have slow real growth, and our senior managers and our partners in industry need to manage accordingly."

As a result, companies are seeking to reorient their businesses, selling off units that pose potential conflicts of interest or are not core to a company's operations and buying businesses in what are widely considered growth industries like cybersecurity, health IT and cloud computing.

Whether it's Northrop Grumman's decision to likely spin off its shipbuilding business or McLean-based ATS Corp.'s recent declaration that it is pursuing strategic alternatives, the moves have at times been unpredictable, leading to a feeling that there's little consensus in the industry on the best way to adapt.

Companies have "got to be prepared to go every direction, and that makes it very hard right now," said David Berteau, senior adviser and director of the Center for Strategic and International Studies' defense-industrial initiatives group.

Whatever the move -- breaking up a business, divesting a unit or acquiring another firm -- companies are generally trying to focus on the operations they think have the most growth potential, said Michael S. Lewis, director of equity research at Lazard Capital Markets.

"The management teams and the boards have had to take a hard look at their businesses and say, 'Is this in the strategic long-term focus of the firm?' " said Lewis. "We're seeing these types of moves from the largest firms down to smaller companies."

At AAI in Hunt Valley, Md., for instance, owner Textron Systems opted to split the company into three individual pieces: an unmanned aircraft unit; a test and training business; and a services group. Because AAI was already a subsidiary of Textron, giving it access to the company's back-office and corporate resources, the extra AAI headquarters was redundant, said Fred Strader, president and chief executive of Wilmington, Mass.-based Textron Systems.

"What became very obvious to me . . . was we had an extra layer," said Strader, adding that the business units will now be more efficient and able to make decisions more quickly.

The new focus on dealmaking has kept area law firms busy. At Venable, which worked on a high of 16 aerospace, defense and government services deals in 2007, the deal volume slowed in 2008 and 2009. In the second half of 2010, however, the practice completed seven deals.

"It really was crazy," said Joseph C. Schmelter, co-chairman of Venable's government contractor services industry group.

"We're at full capacity with the M&A lawyers" and are now relying on attorneys in other practices to pitch in, he said.

Sarah E. Kahn, a partner at Arnold & Porter who specializes in mergers and acquisitions, said she sees the uptick continuing.

"I don't see this as a particular short-lived thing," Kahn said.

Faced with a weakened commercial market, more private equity firms have thrown their hats into the ring, buying up government and defense contracting businesses.

The increased private equity interest "creates a more competitive market than in the past in the defense and government space," said Peter Manos, a managing partner at private equity firm Arlington Capital Partners, who noted that these investors have in some instances outbid strategic acquirers.

In the end, analysts said, the universe of defense contractors will look different -- but not necessarily smaller.

"It's not as if there appears to be a shrinking pool of defense equities," said Byron Callan, a director at Washington-based investment research firm Capital Alpha Partners. "But maybe the nature and color of those change."

In fact, Thompson noted, he doesn't anticipate a reduction in the number of companies as long as the budget stays steady.

"Most of the big defense companies have been anticipating a downturn in military demand since at least the last decade," he said. "They're surprised that the downturn did not materialize when President Obama took office, and now they're beginning to suspect there won't be a downturn at all."

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