A contrarian view on two clear trends emerging in the defense industry that will create unexpected opportunities:
1) Top-tier prime contractors will spend on M&A that diversifies them (further) into UAV, cyber, and intelligence/data.
The most widely accepted trend, this one has the critical fault that the top tier primes do not necessarily have a place in those market verticals. Simply put, why does DoD need the very biggest primes to procure fast-moving technology like cyber and big data? What value do they add for the substantial cost premium? UAV alone is just not a huge market, and both cyber and intel could arguably be served more effectively and efficiently by smaller firms with more exposure to commercial markets. The difference between now and the last big consolidation in the 90's was the nature of the integrations. Back then Lockheed and its Big-5 peers were consolidating other industrial verticals -- other planes and tanks and major programs. From a business perspective that makes clear sense. But this time, the same big companies are attempting to acquire very different types of businesses, and in many cases not the type of companies & technologies that benefit from narrow, long-cycle defense-type development.
These same assets being acquired might be better leveraged in smaller firms with diversified technology business lines.
2) The same top-tier contractors are selling their non-core "mission support" divisions.
The logic seems clear. As the commitments wind down in Iraq and Afghansitan, logistics and engineering support business units -- already single digit operating margins -- become less attractive, especially while chasing new acquisitions in high-margin cyber. So Northrop sold TASC. ITT is currently selling Mission Systems. Also in May PE firm Leonard Green & Partners announced the planned sale of defense consulting services firm Scitor, which it purchased 5 years ago.
In this case I'm not sure it's the market size really shrinking, but the nature of the business risk to the current holders. Surely, these are growing, profitable divisions when the US is deployed somewhere, and that type of support will clearly decrease in coming years. But at the same time, the requirement around the world for vehicle & equipment maintenance and supply chain is set to explode, with no clear leader in a complex global logistics network.
Some argue that the drawdowns will actually increase the need for logistics & supply chain as the DoD organic capability redeploys. During the next 10 years of budget austerity, the fact is existing platforms will obviously need to last longer and will require robust programs for recap/reset, modifications, and upgrades. Especially for the Army's land systems.
Apart from the US based requirements, the need for general maintenance as well as MRO will intensify in emerging foreign markets, when one considers the substantial Leave-Behind-Equipment (LBE) sets and increased Asian, Indian, and Middle Eastern imports, which are frankly growing much faster than the logistics & supply chain infrastructure for those fleets.
So the issue is likely that large, public companies do not want to compete globally in that verticle due to perceived risk. They rightfully would rather concentrate resources in increasing exports to new foreign markets. However, the same "low-margin" support services business could be a strong match for a foreign company with a different risk profile, looking for a sustainable link to the US DoD & defense base. Likely the right type of strategic buyer could deliver those services a lot more efficiently (i.e. minus Big 5 overheads) and greatly enhance the margins.
Stumble It!
Tuesday, May 22, 2012 at 04:18 
