While the broad defense fever that followed September 11th has cooled, it remains a favored and more focused sector, with continued opportunities for consolidation. Defense companies have taken advantage of the window of opportunity presented by the focus on the military and the war on terrorism to raise billions of capital in the public markets. They moved to put this newfound money to work, engaging in highly competitive auction processes to acquire defense related businesses. As it became clear during the months following September 11th, however, that not “all things defense” would benefit equally from increased funding going forward, investors became more savvy, buyers became more discerning, and defense company valuations embarked on a downward trend after reaching their peak in mid-2002. Today, buyers’ acquisition requirements for one or more of a defensible market niche, a position on selected, coveted programs, and/or proprietary technologies, combined with their having satisfied their appetites for acquisition to some degree, has created a bifurcation in defense sector deal activity and valuation. While businesses that focus in the areas such as smart munitions, unmanned aerial vehicles, and command, control, communications and computers, intelligence, surveillance and reconnaissance (C4ISR) remain hot commodities for buyers, lower technology, build-to-print, and/or legacy program-based businesses now tend to generate yawns rather than aggressive buyer pursuit. While businesses focused in the aforementioned “hot” segments will continue to garner premium valuations, as sellers enter the market in increasing numbers, many will not be accorded the attention and valuation that they for which they may have hoped. While these less coveted businesses certainly still generate interest, in order to be saleable, sellers will have to bring their expectations in line with the realities of current defense industry valuation trends.
At the same time, it is important to note that, in general, defense company valuations have maintained a downward trend since mid-2002, even during and immediately after the war in Iraq. As time passes since September 11th, and as has happened historically in this cyclical sector, Wall Street’s and investors’ focuses will wane and turn elsewhere. Accordingly, while we expect continued M&A activity through 2003 and into 2004, we also forecast a continuing erosion of defense industry valuations. This, coupled with the fact that the defense industry continues to outperform the broader market, despite having passed its peak over a year ago, suggests that prospective sellers would be well advised to enter the market sooner rather than later.
After the war in Iraq and as a result of the ongoing threat of terrorism, the DoD and the federal government will focus in several areas: (i) continuing to modernize and transform the armed forces; (ii) internationalization, and (iii) developing advanced technologies for both military and for homeland security applications.
Lighter, Faster, Smarter and More Lethal
The swift military victory in Iraq, aided by the impressive array of new technologies and weapons, provided a measure of validation for the Pentagon’s view of how wars are best waged and won in the current geopolitical environment. As a result, DoD will redouble its focus on enhancing C4ISR capabilities to handle wide area and, therefore, theater air surveillance and asymmetric warfare challenges; integrating manned and unmanned platforms; refining sophisticated electronic warfare (EW) capabilities; developing collaborative, real-time capabilities with space-based assets to network centric warfare to sensor-to-shooter technologies; and deploying a national missile defense system. In other words, establishing full spectrum dominance, and lighter, faster, smarter and more lethal armed forces that can react more quickly and wage and win battles in multiple theatres around the globe.
Internationalization
Notwithstanding dissent within the United Nations regarding the war in Iraq, whether Bosnia, Afghanistan or Iraq, military operations are increasingly taking on an international element. International cooperation is key to improving competitiveness, as well as to sustaining and growing sales and profitability. Governments, particularly in Europe, are increasingly pooling resources with allies to pay for big-ticket, high-tech programs and improve interoperability between allied forces. This window for cooperation and collaboration between defense peers is likely to open even wider in the new few years, especially between the United States and the United Kingdom.
Additionally, if the United States is successful in transforming its export control system and overcoming technology constrains, while European governments continue to harmonize defense requirements and integrate regulatory infrastructure to improve trade, investors will continue to see trans-Atlantic and intra-European alliances and M&A activity as defense firms scramble to establish a bigger footprint in both United States and in European markets. While United States and European prime contractors have already embraced the concept of trans-Atlantic partnership and mergers, small- and mid-sized companies have yet to wholeheartedly dive into the globalization sea. As a result, many of these small- and mid-sized companies are searching aggressively for acquisition opportunities on the opposite side of the Atlantic Ocean, having realized that a physical presence “on the ground,” rather than merely hiring foreign sales representatives, is a requirement to do meaningful business with foreign prime contractor.
Investments in Technology for Military and Homeland Defense Applications
After September 11th, defense companies have been slow to embrace the latest technology play, one that may well yield more successful results than those that preceded it. While pools of traditional venture capital funding have dried up, there has been a tremendous amount of press regarding the need for innovative new technologies in support of homeland defense and asymmetrical warfare initiatives. Not unlike the defense companies of 1993 who sought Technology Reinvestment Project (TRP) funding during the Clinton Administration as a last resort to generate revenues during a Peace Dividend downturn, hundreds of small commercial companies have re-engineered their business plans because they see the Pentagon or Department of Homeland Defense as their financial saviors.
One of the core competencies of any large, successful defense company is an ability to follow and access federal funding. These small commercial companies do not have the expertise, capital or patience to do so. Defense companies are starting to recognize this unique position and are more actively pursuing transactions to leverage this competency to act effectively as intermediary between the government and the small technology companies. Industry insiders have already seen that the “will” is there. The hold-up, just like it was in 1993 before the current mechanisms of industry consolidation became commonplace, is fighting tradition. Defense companies have become quite comfortable valuing/acquiring other existing contractors. Valuing a small technology company, especially one that may be “pre-revenue,” is outside a defense company’s historical framework. This is a model, however, that has been successfully employed for years by industry-leading commercial technology companies such as Microsoft, Inte and others as they seek to plant inexpensive seeds today, to hopefully generate tomorrow’s growth. Defense companies will not achieve this benefit unless they once more step out of traditional models of valuation. It is therefore likely that this process will begin, as did the last one – industry consolidation – with the actions of a few prime contractors who have the size and vision to test new practices. While this may be slow to start, it is a journey that will eventually be made by all, in one form or another.