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Tuesday, Dec 6, 2022
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Mergers Best Offense Against Defense Cuts

Band together. It’s what some animals do when times get tough. And that is probably what defense companies are going to do as Pentagon spending comes under pressure, said retired Rear Adm. Ken Slaght.

“It wouldn’t surprise me at all” to see companies merge as the United States defense budget gets squeezed, Slaght said. “Companies large and small are looking at ways to consolidate.”

Slaght is one of several local executives who shared their views with the San Diego Business Journal after Lockheed Martin’s future CEO, Christopher Kubasik, told the Wall Street Journal in early May that he saw mergers on the horizon for the defense industry.

A move to balance the federal budget, called “sequestration,” calls for automatic cuts of $500 billion from the Pentagon budget over 10 years, beginning in 2013.

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That follows an earlier round of budget cuts.

New Cuts?

Slaght, who is past president of San Diego’s National Defense Industrial Association chapter, said the likelihood of new cuts looks greater than it did a few months ago.

No one was on the record saying that during a recent conference on military electronics in San Diego, Slaght said. However, he said that he “heard from more than one person concerned that sequestration was going to become a reality.” That is a departure from the previous sentiment in the defense community, which was that Congress would come up with “an 11th hour solution” to avoid the automatic cuts.

Slaght, who was formerly commander of the Space and Naval Warfare Systems Command, or Spawar, noted that defense budgets typically wax and wane.

“It’s a cycle. It’s a natural occurrence,” he said.

In the 1990s, the collapse of the Soviet Union spurred defense cuts in the United States, he said. Spending rose following the Sept. 11, 2001 terrorist attacks and as the U.S. entered wars in Afghanistan and Iraq. Indeed, the Pentagon worked from supplemental budgets to fund the wars.

The 1990s were tough on defense contractors. “Given the new challenges facing the world, defense enterprises knew they either had to grow or be acquired,” defense giant Northrop Grumman says in a recap of its corporate history on its website. Northrop Corp. opted to acquire Grumman Corp. in 1994, Logicon Corp. in 1997 and Teledyne Ryan Aeronautical in 1999.

Lockheed Corp. and Martin Marietta Corp. combined in 1995 to form another huge contractor, Lockheed Martin.

Eric DeMarco, president and CEO of Kratos Defense & Security Solutions Inc., said there are “absolutely” going to be mergers in the defense sector. “It’s going to accelerate,” he said.

Large companies such as Lockheed Martin, Northorp Grumman, General Dynamics and BAE Systems will likely remain, DeMarco said, adding that “Raytheon will probably stay independent.” The executive noted that it is the “next tier” of companies that will likely buy or be bought. Typically with revenue less than $20 billion to $25 billion, the group includes ATK, Harris Corp. and L-3 Communications Holdings Inc.

“The electronics field will rapidly consolidate,” DeMarco said.

Kratos, incidentally, is no stranger to acquisition. A few days ago it announced that it signed a deal to acquire Composite Engineering Inc., a Sacramento company with revenue of $94 million. CEI makes jet-powered target drones as well as composite structures.

Kratos said it will pay $155 million for the company. Some $135 million of the amount will be in cash and $20 million will be in stock. Separately, Kratos said that it intends to sell $55 million in stock to Oak Investment Partners, an existing Kratos shareholder, partially for the CEI acquisition.

Large Acquisition

An unrelated and larger acquisition is in the wings. Aircraft parts maker Goodrich Corp., with $8.1 billion in revenue and a big presence in Chula Vista, is being picked up by United Technologies in a deal announced in September.

Eric Basu, CEO of San Diego-based Sentek Global, a privately held defense contractor with $17 million in revenue in 2011, says big defense houses may prefer to grow by acquisition.

“When there is no potential for the big contractors to increase their revenues through growth, and they are trying to offset declining contract revenues, they have to keep the shareholders happy (or at least, at bay) by showing growth through acquisitions,” Basu said by email.

“In addition, because valuation multiples are low compared to recent years, there are a number of opportunities to increase market share cost effectively for the big contractors.”

Slaght says he sees General Atomics, Northrop Grumman and General Dynamics Nassco standing firm under Defense Department budget cuts.

“The good news for San Diego is I think we’re going to be fairly resilient,” he said.

As for Kratos, which reported revenue of $723 million during 2011?

“If along the way an offer comes in, we’ll take it to the shareholders,” DeMarco said.

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