Defense & Government Services 2012 Year in Review

The McLean Group has published an overview of M&A trends in 2012 for Defense & Government Services, including representative transactions, index performance, and some general industry news.

McLean's Mitchel Martin was also quoted in a Nov-2012 article in the Washington Post talking about the pressure on the Governemnt Services sector and the need to be "very selective" on what to bid in an environment of low-price-technically-acceptable.

 “...more companies going after smaller opportunities and lower-level work. You’re competing with Lockheed Martin now where you didn’t have to before.”

Of course, this highlights a central issue discussed here on Defense Ventures, of how defense contractors will remain competitive under price pressure and in (mostly) unfamiliar commercial markets. ManTech CFO Kevin Phillips says, "...we've done this before" and that they know "when and where to diversify," implying this is a regular cycle in the defense industry.

That may be true. Low-price acquisition in DoD seem to come and go, usually ushered out by the creep of poor quality and inevitable, expensive contract failures that LPTA tends to engender. Eventually the Lockheeds flush out the little guys through a combination of cash, patience, and aggressive lobbying.

However, a most dangerous trend for the biggest industry players would be a convergence of low price with increased commercialization. That is, what if the wars of the future don't need the defense industry (as much)?

What if, more likely, adjacent commercial markets in security, networked communications, public services, healthcare, big data.... don't turn out to be fertile growth grounds for top-heavy, monolithic corporations better suited to big weapons programs and 10-year backlogs?

What if the Government figures this out?

10 "Future" Defense Technologies

Back in Nov 2011 National Defense Magazine listed 10 Technologies the US Military Will Need for the Next War. 

1. Faster, Quieter, Safer Helicopters
2. Weapons That Don't Kill
3. Inventions that Lighten the Soldier's Load
4. Ultra-Light, Super-Survivable Dune Buggies
5. Unmanned Mini-Submarines
6. High-Speed, Bulletproof Power Boats
7. Anytime, Anywhere Communications
8. Robots That Think For Themselves
9. Cheap Liquid Fuel
10. Persistent Wide Area Surveillance

An interesting, creative list and one that in some areas is coming into being faster than might have been expected just a year ago.

How Global is Defense?

Looking for comments and feedback:

How global is the defense industry?

We know it's big and pervasive, but how interconnected is the industry worldwide? 

Clearly US defense spending dominates the global total. Does that hamper or facilitate innovation?

What are example of truly international defense companies, outside of the biggest, top-10 firms?

Are foreign firms (unnecessarily) excluded from doing business with US DoD?

Very intersted in feedback, links, references. Comments here are open and/or email me direct: patrick@defense-ventures.com

I plan to publish some consolidated views on this subject and will post here soon. THANKS.

DynCorp vs KBR on Strategy

Here is a rather sober analysis on DynCorp's latest quarterly results. Reasons for concern and "negative" outlook:

• 75% of revenues derive from US operations in Iraq and Afghanistan
• Delays in approving the FY13 defense budget which could hold up orders on current and new contracts
• Further potential cuts to DoD budgets under sequestration 

Although contract win rates have increase over the past couple years, operating margins sit at around 5%, suggesting that DynCorp may be cutting costs on its bids to maintain a healthy backlog during tighter times.

This raises a fundamental question about diversification for defense contractors, particularly for those in the Defense & Government Services and Logistics sector. Is it better to be a USG or DoD specialist or to diversify those programs with commercial work? The market has a habit of punishing diversification -- ITT and L3 both spun off businesses that had successfully grown into emerging industrial sectors. The former Chairman of Lockheed Martin once commented that "the record of diversification in the defense industry is unblemished by success." So why is DynCorp getting a negative outlook for specializing?

In a vote for diversification, consider DynCorp's close competitor, KBR. In Q3 KBR had revenue on the LOGCAP contract of just $156M, compared to DynCorp's $438M. Clearly, KBR has been on the losing side of many recent DynCorp advances on market share, and they are fighting to stay relevant in a shrinking, crowded environment for USG logistics & infrastructure services.

However, looking at the bottom lines of both companies, we find operating profits (for 9 months through Sep 2012) of $126M derived from KBR's two Government units (North American Government & Logistics, and International Defense & Support Services), compared to $114M for all of DynCorp for the same period. At KBR the defense business is probably less than 20% of the total, most of which comes from a Hydrocarbons business that produced over half KBR's turnover for Q3. 

I think KBR benefits in their Government work by having a diversified portfolio of related commercial work. They’ve protected margins better by making resources compete for returns across many different markets. DynCorp, on the other hand, with its concentration in DoD and State, has to cut its margins and low-bid everything in order to drive revenues/backlog. 

More on the Internet of Drones

Yesterday I mentioned a blog post by John Robb at Global Guerillas describing the “Internet of Drones” as the next very BIG thing. While Robb’s example looks at the fascinating implications of commercial uses for drones – namely, “short haul logistics” – I think it’s worth considering the potential ramifications a step back into the defense & security sector.

As pure thought exercise, imagine the following:

• A massive, globally distributed network of commercial drones at a scale of the internet, in fact, connected directly into the internet
• A powerful and/or autocratic Government or regime that has access to this network, in addition to or integrated with its own militarized network of drones – for the collective purposes of surveillance, reconnaissance, tracking, and weapons system delivery
• A rogue or otherwise aggressive regime or terrorist force conducting a strike on US territory – similar to the cross-border strikes by the US against terrorists
• Ground forces that can be covertly inserted somewhere and then entirely supported logistically by invisible, disposable drones for very extended periods

This is part sensationalism and free association, but still a lot of this scenario is entirely possible within a relatively short period of time and with (mostly) current technology. Start to combine this internet of drones with other emerging trends like 3D printing and robotics, and it’s easy to imagine a global security environment that very soon looks much different than today.

Emerging (Defense) Technology Changing Everything

I believe one day we'll look back at the next 2-3 years as the beginning of a major, dramatic shift in the global defense & security sector. This will be the result of a number of converging forces of economics, globalization, demographics, technology, and security policy -- among other factors.

This year I hope to look at some of these important trends, with an emphasis on the way technology is shaping modern warfare and security. To get started here are some links for just a few interesting areas of emerging technology. 

Internet of Drones. Watch this space. BIG, indeed.

Mutant Tech. For real.

Terminator.

More to follow on each area, plus other future trends.

Defense & Government Firms Build Cash

How will the defense firms at the mid & large level compete with private equity backed executive teams? CASH.

Aronson Capital Partners reports in its November Market Update:

"Average cash holdings for Mid-Tier Federal Service Providers... have increased by 168% since September 30, 2011 and 25% since September 30, 2010. In comparison, companies in the Standard & Poor’s 500 Index have increased cash balances by only 17% since 2010. Tier 1 Prime Contractors... are also increasing cash holdings with a 20% increase over 2011 levels and a 36% increase over 2010. These large primes have increased cash balances by $5.7B with Boeing and Lockheed leading the group with $11.1B and $4.7B in cash and short-term investments, respectively."

Strong balance sheets put pressure on private equity firms with higher costs of capital and could shut them out of certain deals. Of course it remains to be seen whether defense firms can effectively deploy all that cash, and there are still disruptive and/or niche areas for investors to focus on. But firms like Galeos Group (mentioned here on a previous post) may have difficulty competing for targets with a cash-rich Tier-1 contractor -- maybe that's the reason Galeos is steering clear of cyber.

Executive Teams Lead Dealmaking

What will defense deal-making look like in an increasingly uncertain budget environment? Two trends working together:

1. Look for firms with most of their concentration in commercial sectors to carve out defense & security divisions in order to gain better returns in other verticals.
2. Expect to see smart insider executive teams with equity sponsors snatching up those divisions and rolling them into new mid-market firms.

Former Stanley CEO Philip Nolan (who led the sale of Stanley to CGI for >$1B) has recently formed the Galeos Group with $300M in private equity capital to search for a mid-market Government services acquisition. He's added to the team his former COO, James Brabston, as well as former Sotera CFO Joseph M. Cormier. 

Nolan says they'll steer clear of crowded sectors like cyber and cloud computing, but a corporate carve out like a recently announced sale of Morgan Franklin to SRA International might be the kind of space where Nolan's team can exploit their knowledge of pricing and focus on low cost solutions.

I believe larger mid-sized defense firms, and in some sectors the Big 5 themselves, should be concerned if more teams like Galeos come into the market with strong equity sponsors. These are true insider teams who know how the bigger firms price and how to go after cost efficiencies in their proposal and task order work. In fact, Nolan has that right out in front of his team's strategy:

Nolan said the group plans to put together a cost-conscious company sized to handle the government’s focus on lower prices.

“We need to build out a company that is focused on that right from the very start,” Nolan said. “That is a potential advantage that we have.”

Watch out.

AUSA Conference Meet-Ups

I'm going to be at the AUSA Conference next week, attending Mon and hanging out in DC until Wed evening. Already scheduled a few meet-ups and looking forward to seeing others at the show and around town. 

To get a lead on the show, here is an AUSA 2012 Preview that just went online from Defense-Update.

Allied Minds Launches (another) VC Partnership with Government

A VC firm specializing in commercializing university R&D and other early stage technology, Applied Minds has now established a bold new initiative to partner with the Government on cutting edge defense technology. The new division, called Applied Minds Federal Innovations, sets out the following thesis:

 

“Allied Minds’ investment in AMFI is predicated upon the strong belief that the intellectual output of over 100 U.S. Department of Defense research labs represents an under-utilized national asset. Unlocking the commercial value of this intellectual property creates exponential benefits for competitive advantage, employment opportunities and the U.S. economy.”

 

They’ll partner with DoD and the Aerospace Corporation (and other agencies) to idenitfy emerging new technology from the $100B in federally funded R&D and then finds ways to commercialize for wider industry applications. So far named areas of focus are:

• Cyber security (enterprise, infrastructure & mobile)
• Wireless communications
• Data analytics
• Robotics and autonomous systems
• Energy & Power Storage
• Advanced Materials 

While I applaud any efforts to promote wider development of defense technology and to turn taxpayer-backed R&D into more sustainable innovations, I wonder still how this will ultimately succeed. My (uninformed) intuition is that this thesis suffers from the false premise that defense R&D still happens in relative isolation from industry. This may have been the case when Government invented the Internet or many other advances historically tied to Government research, but in the last 20 years alone it seems that industry is so deeply woven into the most important phases of technological development that you hardly need a separate public-private partnership to get at it.

 

Why do we need AMFI when we have a well incentivized, concentrated defense industry? Why should we look for commercialization when Government increasingly calls on industry to bring in and adopt their commercial technologies for military applications? Do we really thing we’ll find true innovation in cyber or energy or any other of these areas by looking inside today’s Government?

 

Again, I think this is an exciting, intriguing, and noble initiative, but one has to wonder how this will succeed when similar initiatives (i.e. DeVenCI, CIC-Tech) and a general commitment to industry openness have fallen short  (while DoD gets the tech they want anyway).