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The upcoming presidential election is more likely to have an impact on the defense industry than the current credit crunch, as budgetary changes have historically been drivers of industry consolidation.
Should spending for defense decrease, large players may use their significant cash reserves to consolidate the industry further, two experts told mergermarket.
”The credit crunch is likely to have a trickle-down effect on the defense industry,” said Dr Nayantara Hensel, a Pentagon scholar-in-residence who has conducted an extensive study of defense M&A. Hensel pointed out that reductions in defense spending have historically triggered consolidation. She referred to the 1993 ”Last Supper” in which Undersecretary of Defense for Acquisition Bill Perry laid out the Pentagon’s plans for dealing with reduced defense spending. The event was widely seen as beginning the wave of industry consolidation that lasted throughout the rest of the 1990s.
”When defense spending declines, you tend to see deal flow increase,” according to Steven Grundman, a vice president and the leader of the Defense, Aerospace, and Transportation practice at CRA International (formerly Charles River Associates). Grundman further speculated that the US defense budget could be near peak spending. ”The financial crisis has taken some of the [peak defense spending year] outliers off the table, so we could be looking at peak spending for 2009. Possibly budget outlays grow into 2010, but authorities might have peaked in 2008.” Grundman also said that the credit situation would drive out private equity players, and help moderate valuation multiples. ”I think we’re nearing an inflection point, where sellers realize that they can’t get yesterday’s prices,” said Grundman.
The industry is generally under-leveraged, with healthy amounts of cash on companies’ balance sheets to make buys. Big companies like Lockheed Martin, Raytheon, and Northrop Grumman are likely to continue to be bidders, experts predicted.
”Right now, everyone’s got enough dry powder to keep them going for a while,” said one industry banker. ”It’s exactly the opposite of being over-leveraged. They’re trying to figure out how to put their cash to good use.” Another banker described sector M&A as ”healthy,” pointing to Serco’s recent acquisition of SI International for USD 32 per share in cash, for a total price of USD 423m and a premium of 40%. ”The defense industry is a net producer of cash, not a net consumer.” Further, the current conflicts in Iraq and Afghanistan have allowed defense contractors to pay down the debts incurred during post-Cold War consolidation.
Low debt obligations combine with healthy cash flows to make a ”healthy” M&A environment. An industry analyst pointed out that foreign weapons sales are booming, due to problems abroad in Iran, Pakistan, and North Korea.
Paul Nesbitt, a defense equity analyst at JSA Research, identified several significant bidders in the space. He called Lockheed Martin ”one of the most aggressive buyers”, and said that Northrop Grumman had slowed its pace. Raytheon could also do a big deal, he said, though it has had ”indigestion” from some previous acquisitions. BAE Systems, Finmeccanica, and General Dynamics have also been active in the space.
”When it comes to targets,” said an industry banker, ”it will be driven by DoD priorities. If a company is overexposed to the wartime supplementals, they’ll look to reduce that exposure.”
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