L-3 Will Spin Off Government Services Unit

L-3 Communications  announced today that it will spin-off its Government services unit into a separate entity called "Engility." It will also reflag its cybersecurity and defense intelligence business as National Security Solutions.

Details on L-3 Activist

There's a good article from Reuters on the activist investor targeting L-3 Communications. Relational Investors has accumulated a nearly 6% stake, making it the largest L-3 shareholder. They are seeking a break-up that includes shedding not just the Government services division, but also its aircraft modernization and maintenance (AM&M) business. As the article points out, these divisions account for significant revenues but are substantially lower margin.

The services and aircraft divisions both had operating margins of just above 8 percent in 2010. In comparison, the electronics division's margins exceeded 14 percent, while the intelligence unit saw 11.6 percent in margins.

This case is different than ITT, which was about separating the defense business from unrelated businesses in water technology and industrial components. But with L-3, Relational is going after a company that has tried to diversify across product lines that are all still (tightly) defense related. 

There could be some gain if L-3 were split into multiple divisions and those units would then get acquired at a premium by rivals in a two-step process, some sources said. But what are seen as most attractive takeover targets -- electronics and intelligence divisions -- are where the company wants to focus its growth.

Instead, L-3 would like to do a small divestiture within the services division at this point, separating the labor-intensive military support business while keeping the high-end intelligence and cyber-focused part, people familiar with the matter said.

Relational might have a harder time with L-3, particularly considering that the shares still trade at a better-than-industry-average premium. So inevitably they will have to come forward and offer more details about their strategy.

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?