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Defense companies are expected to undergo consolidation once the market finds a new price equilibrium, where sellers and buyers agree on new valuation levels, industry bankers and consultants told mergermarket. The looming prospect of a democratic president and questions surrounding US Department of Defense supplemental budget requests are making investors pause as defense company valuations could slip to lower levels in coming years. At the same time defense contractors are looking at exit strategies to preserve current valuations in the face of a presidential election and a potential down-sizing of defense procurement budgets in 2010 and beyond, industry sources said.
One industry consultant said he was aware of three sets of ongoing “discussions” regarding the sales of defense companies. In each case, however, sellers were hoping for a bid based on historical value rather than future earnings. Buyers in those situations are understood to be more interested in acquisitions to bolster weakening research and development pipelines.
Several market sources agreed larger defense companies are in the market to buy defense technology services contractors and operational support contractors this year. By making buys in those markets, larger contractors will increase their exposure to sectors that receive government funding.
Sellers concerns over their slipping valuations come at an interesting time when larger defense contractors have been perusing a shell game like strategy of plowing money into funding pensions, buying back stock and other methods to avoid making acquisitions, a ex-DoD official said. Many of the larger defense contractors who are the typical buyers now have large amounts of cash on their books and are running out of alternative strategies to deploy this cash, he said. Eventually they will have to start buying companies to fill in their pipelines, he noted.
Some of the defense contractors with cash currently have better exposure to attractive sectors such as technology while others are more exposed to ground forces support and force protection, the ex-DoD official said. Lockheed Martin and Northrop Grumman currently have better exposure to technology while General Dynamics, BAE Systems and Raytheon have good exposure to so-called “standoff” technology rather than ground forces, he said.
Technology companies like SAIC, SRA International, CACI Stanley and ManTech International topped the list of attractive takeout targets that have done well in this defense spending cycle, the industry consultant said. Services companies such as Dyncorp have also had an impressive run thanks to the war in Iraq, an ex-DoD official said. The industry banker said companies with exposure to communications intelligence and troop protection items in the base budget would also be attractive targets.
Additionally, M&A activity could pick up in the Homeland Security sector in the case of a democratic presidency, the industry consultant and a source at defense IT services company Stanley agreed. The ex-DoD official said in general and especially in the case of a democratic president, larger defense companies could make divestitures to finance acquisitions and reposition themselves in a period of diminished defense spending. He said while 2007 saw several significant mergers he expected this trend to either increase or stay at the same level in 2008. However, a source at listed military vehicle manufacturer, Force Protection, and the source at listed defense IT services company, Stanley, said they do not expect a sizable change in M&A activity in 2008 over 2007.
The source at Stanley said his company could capitalize on an up tick in Homeland Security spending and be attractive from an M&A standpoint as well. The Stanley source said if a republican won the election it may mean more of a focus on rebuilding the military with the beating it has taken in the war in the Middle East. He added this would mean more money spent on reset programs and IT systems, along with the modernization of the military.
Several sources agreed three key points this year will help predict the level of M&A activity: the Presidential election in November, the supplemental budget request expected by the summer and the Department of Defense’s base budget for 2009 which was released Monday. The 2009 defense budget increased spending levels to about 7.5% which was in line with industry expectations. Supplemental budgets, which are expected to emerge in the spring or summer, have served as a powerful relief valve for DoD contractors and their intense competition to fund various programs. However, the size supplemental requests is still not known, therefore when those requests emerge they could have drastic effects on defense contractor valuations.
An ex-DoD official and a banker currently working on several deals in the aerospace and defense industry said defense spending levels on the whole would remain relatively stable for the next two years. Yet, uncertainty beyond that time horizon has led to slumping valuations and multiples for many defense contractors, especially those of defense IT contractors, an industry investor said. On the whole there is a perception democrats would be bad for defense companies, the investor said. The industry consultant, however, said he believed a democratic president would maintain current spending priorities for a period of time and then eventually divert funding from international programs, such as the Iraq war to fund Homeland Security programs instead.
The ex-DoD official said if a democrat were elected their effect on the overall budget would be much less significant than that of a John McCain presidency. McCain, a republican with a military background, would be seen as a president who could introduce a ”high beta” to the defense budget, the ex-DoD official said. McCain, who is on the Senate Committee on Armed Services, could bring substantial changes to the way the US military spends its budget the ex-DoD official said.
In addition to potential consolidation activity in the sector, one value investor said he would buy into this group of stocks because of their recession-proof quality. He said during a recession defense companies generally remained relatively strong because government procurement budgets were fixed and in the case of a terrorist attack defense stocks would have a huge upside.
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