Activist Investors Target Defense Firms

Former Lockheed Martin Chairman and CEO Norm Augustine once said, "When it comes to diversification, the defense industry's record is unblemished by success." Apparently this idea has enlivened activist investors to push for changes at some leading defense firms, namely the carving out of specific defense businesses from others and from commercial operations.

Forbes has a great article discussing the emerging trend, with details of famed corporate raider Carl Icahn's pursuit of OshKosh and Relational Investors' new assault on L-3 Communications after its succesful campaign to break up ITT. 

So what's happening? Forbes contributor Loren Thompson says outside investors (and increasingly private equity firms) are seizing on financial opportunity in an environment of uncertainty for defense contractors.

It isn’t surprising that outsiders would be taking a closer look at the defense sector these days, because after ten years of steadily increasing military outlays, demand is softening and terms are tightening in a manner likely to generate investor frustration. In such periods of discontinuity, it is easier to convince shareholders that current management teams aren’t doing their jobs well, that strategies need to change, and that major strategic moves should be contemplated. The problem, though, is that the sector’s fortunes are being driven mainly by factors beyond its control, like receding military threats and a ballooning federal debt. So while activist investors may succeed in improving near-term returns to shareholders, that windfall could be bought by undermining the long-term success of the enterprises they target. However fashionable it may be to break up a conglomerate into “pure-play” businesses, something is lost in terms of financial resilience and flexibility.

 While naturally there is some financial opportunism motivating these "outsiders," I'm not sure I agree with Thompson's overall view of the situation that these firms will end up less financially resilient. No, I think something much bigger is happening. The fact is, the biggest defense firms are uniquely great at manufacturing weapons systems -- in highly specialized, heavily designed, monolithic Government acquisitions. This alone is a steadily growing, sustainable, cash-flow positive business with high barriers to entry, even higher since the late 90's industry consolidation. They really should concentrate on that.

However, these same companies are NOT good at delivering services. A principle strategic assumption of the defense industry -- sell big ticket items followed by lifecycle support services -- is absolutely breaking down. The Government doesn't want to buy lifecycle support (or other Government services) from the OEM's. They know this is where the margin (fat) is, and they have responded by restricting this business through tighter conflict-of-interest regulations and a broad demand for more "scalable" platforms and more commercial off-the-shelf technology. These are the divisions that Lockheed and Northrop have been forced to sell, and the same type -- in addition to unrelated commercial business lines -- that activist investors want to see other defense manufacturers shed as well. Then they can focus on their real core business of manufacturing and hopefully do so in a more financially viable way then selling heavy tactical trucks at a loss to get the follow on services business.

This is indeed a MAJOR shift for the defense industry, and one that some firms (Lockheed, Northrop) are already better positioned to face than the competition (Boeing, L-3, Oshkosh). On the back end of this shift, however, is a substantial sea of market opportunity for smaller, more agile and flexible firms to specialize in delivering integrated logistics and other program management services. It makes me think of SAIC's announcement earlier this year that they too would divest some commercial businesses to pursue a "bolder" M&A strategy for defense related services. So far it's not really clear who the leading buyers are -- other than PE Firms -- for these businesses being spun away from the major manufacturers. Will a market leader emerge? Any guess who it will be?

Will they protest?

Some observers think EADS may consider a protest of the $30B aerial fuel tanker contract recently awarded to Boeing.

EADS may protest Boeing tanker contract

Most however, disagree:

Analysis: EADS unlikely to protest tanker defeat

It seems like they would have a hard time doing so, actually. Having (painfully) gotten bidders on the same specs since the Boeing protest, surely the Air Force made the decision based on price -- if for no other reason than that it would be easy to defend.

Boeing Criticism Now Mainstream

A potential BUY signal for the nation's largest exporter: the USA Today piles on Boeing in an article examining its string of bad fortune and mishaps over the past year. Nothing new here, of course, and all very first derivative thinking about the state Boeing is in.

Having said that, Boeing is indeed having problems. The 787 is late...again, this time due to engineering issues in production testing. The CEO admits their sales may have stretched out ahead of their ability to execute, and this sits on top of an overall weakening economy worldwide, affecting its entire customer base. For insult upon injury, Boeing's normally airtight defense business has been dented (nice timing!) by pending cancellation of Future Combat Systems and still unresolved situation on the KC-10 tanker award. As USA Today writes, the summer that was supposed to be their proverbial time in the sun has turned stormy for Boeing:

"Every aircraft, and every defense program Boeing is involved in is having problems," says Scott Hamilton, an independent aircraft manufacturing and sales analyst and consultant. "Boeing is, quite simply, a mess right now. And I say that as an unhappy shareholder."

Ouch. But looking again at this as superficial thinking, one could argue that the current hardships, although significant, will hardly slow down Boeing in the long run. The 787 will eventually get into a reliable production schedule and will be a great, even revolutionary plane. The backlog will still be huge. Boeing will still dominate in defense & space -- if nothing else they are one of the big 5 defense firms with existing major programs that are not going away. Enough to make Boeing a buy?