Potential Areas For Defense M&A

Includes: GD, LMT, RTN
by: Matthew Potter

In the 1990's, the last time there was a significant reduction in U.S. defense spending, there occurred a large amount of Merger & Acquisition (M&A) activity. As the budget and work declined, companies looked to keep work or expand their markets through the addition of other companies. In the case of the merging of large defense firms such as Boeing (NYSE:BA) and McDonnell Douglas or Northrop (NYSE:NOC) and Grumman it was done with the encouragement of the Department of Defense and the Clinton Administration.

The idea behind these mergers was that due to the rapid decline in the investment into new, large programs and production of systems after the rapid buildup of the 1980's keeping fewer large systems contractors meant the industrial base was more secure as there was little chance of one of the producers of a key system or component going bankrupt or leaving the market.

There was also much activity with the acquisition of smaller, more focused companies by the bigger ones that allowed them to expand into markets they did not typically use. This included Northrop Grumman's acquisition of Logicon who provided intelligence and engineering services to the U.S. military. That became part of their TASC division which up until 2009 provided services to the U.S. Air Force and Navy primarily in the realm of system design and acquisition.

The five large defense contractors, Lockheed Martin (NYSE:LMT), Raytheon (NYSE:RTN) and General Dynamics (NYSE:GD) along with Boeing and Northrop have already begun to make targeted acquisitions to expand their market share of what are expected to be key investment areas by the U.S. even with the proposed declining budgets. These primarily are Unmanned Aerial Vehicle (UAV) development, production and operations and healthcare IT.

These companies already have a large amount of cash on hand which they have been using to pay down pension costs as well as buyback shares. This money could easily be used to do strategic acquisitions.

General Dynamics acquired Vangent a healthcare IT and management company in a billion dollar deal that significantly expanded their role in that market. It is expected that with the large number of veterans plus DoD's goal of increasing efficiencies in healthcare delivery and management this area will see significant investment.

Smaller companies like ECare, Inc. or AuthentiDate (NASDAQ:ADAT) whose joint venture last year won a contract from the VA for telehealth support are the kind of companies that eventually could be candidates. The VA in 2011 grew its budget for telehealth about six times. Overall the VA spending has increased 23 percent since 2009 and the 2012 budget request is for $132 billion.

UAVs are also a key part of the current military spending plan. UAV provide key reconnaissance, surveillance and strike capability in the current Administration's fight against terror. They allow attacks in areas where manned aircraft or ground troops would not be viable. Unmanned systems provide long range and loiter time beyond what manned systems are able to do and the U.S. Air Force and Army have invested billions in them since 2001. There is also investigation of using them to provide logistics and Medical Evacuation mission support replacing crewed helicopters and these missions should expand.

Defense is not the only part of the U.S. government looking at using these systems. They have significant capability in border control and surveillance as well as missions to perform missions like collection of agriculture and environmental data, pipeline inspection, natural disaster monitoring and reaction and so on. The current market will see significant growth as UAVs move into areas currently done by manned aircraft. Defense contractors will lead the way into these kinds of missions.

What this means is that smaller or even mid-size companies that make UAV or software related to their control systems may become targets. One of the largest companies in this business area is General Atomics which is privately held and shows no sign of ending this status but with their business base and products could see suitors. A company like Advanced Defense Technologies (OTCPK:ADCF) which is designing and manufacturing sensors and support equipment or other small businesses entering the market could also be a possibility. There are many small, new businesses like them. This is only heightened as it can be expected that even if procurement of items is cut there will still be development of capability.

As the defense budget declines and there are less contracts to bid on or new work to get M&A should begin picking up. There will probably not be the kind of deals like in the 1990's that saw companies with tens of billions in revenue merging but certainly there is the potential for several in the one to five billion range as well as innumerable smaller ones as emerging companies are targeted.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.