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?

Lockheed filing offers no further details on PAE sale

Lockheed Martin's 10Q filed yesterday failed to inform us any further about the terms of the PAE sale. They reported a loss of $18M from discontinued operations, but this is lumped with the EIG sale as well, and not much else but the following note in terms of details:

Earnings (Loss) from Discontinued Operations

Discontinued operations included the operating results for Pacific Architects and Engineers, Inc. (PAE) for all periods presented and those of Enterprise Integration Group (EIG) for the first quarter of 2010. The Corporation closed on its sale of PAE in the second quarter on April 4, 2011 and that of EIG on November 22, 2010. Earnings from discontinued operations resulted in a loss of $18 million ($.05 per share) for the first quarter of 2011 compared to income of $14 million ($.03 per share) reported in the first quarter of 2010.

Has anyone dug deeper into this? 

In general, here is a more detailed overview of the LMT results from Zack's.

Lockheed completes sale of PAE

Lockheed Martin announced this week that it has completed the sale of Pacific Architects & Engineers (PAE) to private equity firm Lindsay Goldberg LLC. Unfortunately for this and other interested observers, no details of the transaction have been disclosed. Still no obvious sign or even the remotest scuttlebutt about how LG will run this investment. No star chamber additions to the LG team... no sign of defense expertise in the list of affiliated partners.

Mr. Lindsay, Mr. Goldberg: what will you do with PAE?

Lockheed Sells PAE to Lindsay Goldberg

Lockheed Martin announced last week that it would sell it's Pacific Architects and Engineers (PAE), business unit toprivate equity firm Lindsay Goldberg. Lockheed's press release says PAE was "inconsistent with the corporation’s long-term strategy" and that "Their mission... never aligned with our core competencies.” For those who know both firms, it was always difficult to imagine how Lockheed might have ever integrated a construction and infrastructure support company with such a clearly different culture, not to mention the divergent risk tolerance that enabled PAE to build a billion dollar business in Africa.

No matter, now it's with the team at LindsayGoldberg to invest and expand PAE's strong position in contingency construction, logistics, and other services. So far there isn't much info out there (comments, anyone?) to say how they plan to do that, but of course it's very early. On the LG website they have listed the same press release from Lockheed rather than expanding on it themselves, so there's no info about who is leading the deal and post-deal for them, or what their strategy may be. I also don't see any defense related deals in their published transaction history, and no sign of any specific defense experience on their management team or with advisors & affiliates. Of course, in contrast Lockheed obviously had that in spades so perhaps LG should take a fresh approach. We'll see.