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Defense Sector to See Mergers, Acquisitions

With the U.S. government tightening its grip on its purse strings and defense spending in decline, there are likely to be mergers and acquisitions ahead for military contractors.

Eric DeMarco, CEO of San Diego-based Kratos Defense & Security Solutions Inc., sees it in the next few years.

“2014-2016 will be extremely heavy M&A years in the DoD market,” the executive said.

Spending is dropping with a decade of war in Iraq and Afghanistan winding down. Disagreements in Washington gave the Pentagon a 2013 budget … late. That sour mood may linger past Oct. 1, the start of the new fiscal year, giving military leaders little more than a continuing resolution, which locks spending at 2013 levels.

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Then there is sequestration, a congressional attempt to control federal spending that turned into cuts to most every line item of the Pentagon budget.

Major Consolidations

Jim McAleese, a Washington, D.C., attorney, says Pentagon leaders predict “significant program terminations” if sequestration lasts into 2014. And, McAleese said, they see major consolidation among midtier defense contractors.

Once the 2014 budget is resolved, Defense Department observers will have a better idea of what programs will — or will not — be funded, said DeMarco of Kratos. Those observers might also get a better idea of how long sequestration will last.

“Once the 2014 budget is resolved, hopefully this calendar year, I believe significant M&A activity will commence, with the Strategics (such as Lockheed Martin, Northrop Grumman and General Dynamics) sitting on piles of cash to spend,” DeMarco said.

Private equity firms have cash too, he said, adding there are also “great” leveraged finance or bond markets in place right now.

Buyers will target small or midtier companies, DeMarco said. Midtier firms may see an advantage in merging, he added.

Brad Antle, CEO of Salient Federal Solutions Inc., sees a lull before a storm. Defense industry mergers and acquisitions have taken “a bit of a hiatus,” said the CEO of the Virginia-based company, which has has 34 employees in San Diego.

Defense contractors are still waiting to see which programs will be eliminated, Antle said.

Picking Winners

“Buyers are trying to figure out who the winners and losers will be,” the executive said. “How well protected will a company’s programs be? The last thing an acquirer wants to do is buy something and find you have a hole in the bag of the acquired assets, draining away money.”

Antle appeared on the San Diego scene in 2010, when Salient acquired SGIS, a locally based information technology and engineering company, for undisclosed terms. The acquisitions continue. Late last year, Salient bought LIST Innovative Solutions Inc., a federal contractor in northern Virginia.

There is a disconnect between buyers and sellers regarding the value of defense companies, noted Ken Herbert, senior vice president with Imperial Capital LLC in San Francisco.

Sellers are pricing their assets based on their value between 2009 and 2011, Herbert said. On the other hand, buyers are looking at expected value in 2014 and 2015.

The gap will close, but the process may be slow, he said.

Herbert agrees there will be mergers and acquisitions at all levels except among the biggest diversified contractors. Specialists in aircraft structures, aircraft systems, or components might feel the need to merge, he said.

Antle, the CEO of Salient, dismissed a prediction that midsized companies will be forced to merge. “If you’re midsized or above, you can pretty well weather the storm,” he said.

However, he predicted spinoffs in the future, with large companies “jettisoning nonstrategic assets.” The same thing happened during the 1980s and 1990s, he said.

Though sequestration is starting to take effect, Antle also observed that the federal government spent “a slug of money” in the first quarter of the calendar year.

Herbert sees sequestration affecting companies unevenly. Firms that provide hardware might not be seeing it yet. But firms that provide training, services and technical support certainly feel it, he said.

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