M&A Storm Before the Calm in the Defense Industry

As I sat in the dark and listened to Hurricane Charley wreak havoc on my home and yard, I reflected on what I heard only days before at the Defense & Aerospace Investor & Corporate Development Conference. Pentagon, industry, and Wall Street experts met in San Diego, California to discuss issues ranging from defense and aerospace market drivers to who the winners and losers are in this rapidly changing sector. The “big” take-away was not about market drivers. Instead, it was this sector’s advancement or prompt movement from the calm “eye” into the “back-side of this mighty storm.”

Consolidation Trends: Let me explain. The wave of consolidation in the defense industry that began a decade ago, when several mega-deals reduced the number of prime defense contractors from 100 to only five, is seeing a rebirth in merger, acquisition, and divesture activity among the second and third tier defense contracting companies. Having lived through three hurricanes in three months, I know the “backside” of any storm is many times stronger and fiercer than the first bands.

 

Reports published by the Center for Strategic and International Studies (CSIS) show that in 1991 the 107 top-tier defense contractors were awarded 31,885 DOD contracts with a value of $55 billion. In 2003, the five top-tier defense contractors were awarded 35,882 contracts, with a value of $67 billion. CSIS reported that the number of DOD defense contractors has grown from 29,781, in 1991, to 54,819, in 2003. That is 184% increase in a little over 11 years! The graph below illustrates the “barbell-shape” of this sector, indicating a rich environment for consolidation for defense contractors in all three tiers.

High Tech Warfare Changing Industry: The prompt movement toward consolidation is being driven by industry fragmentation and low barriers to entry, but more importantly, the Pentagon’s demand that future military conflicts be dominated by high-tech warfare. The Pentagon supports consolidation because it saves the government money by squeezing overhead costs if contractors join forces. Industry experts at the conference contended the consolidation trend is playing out between second and third tier providers, vertically integrating critical specialties – Operation & Maintenance, Knowledge Management, or Defense IT – with the goal of being an acquisition target by a first tier contractor.

Florida Contractors Can Benefit: What experts talked about nationally is playing out on a local level. Florida is readily positioned to benefit from the sector’s consolidation trend, given the large presence of defense and aerospace contractors located in the state. This year alone, our firm has been involved with multiple mergers, acquisition and divestiture deals between local second and third tier industry players. Because of our work and experience in this sector, PCE has identified more than 10 value drivers to maximize shareholder value for those defense related companies, positioning themselves for sale or consolidation. Two such strategy examples are:

    • Allowing only a small percentage of revenue being awarded under the Federal Small Business Set Aside program,
    • Allocating less than 25% of revenue generated from any one contract.

With uncertainty being the constant in political conditions worldwide, the aerospace and defense industries will continue to advance into the uncharted “backside of the storm” with buyouts, consolidation, and structural changes driven by the increased attention and higher investment levels. Hang on and hunker down, it should be an incredible ride.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
David Jasmund

Investment Banking
djasmund@pcecompanies.com
Orlando Office

407-621-2100 (main)
407-621-2111 (direct)
407-621-2199 (fax)