ITT Exelis Heralding Defense M&A Activity?

| About: Exelis Inc. (XLS)

One of the fallouts from the major declines in defense spending in the Nineties after the Eighties boom was a sharp increase in Merger & Acquisitions (M&A) among the defense industry. Companies large, like McDonnell Douglas, medium, like Logicon, and small, like TASC, combined with each other due mainly to the lack of contracts and new weapon programs. In some cases it was encouraged by the U.S. government despite industrial base worries.

Since 2001 with the large expansion of defense spending the market has diversified. This has primarily been with European defense contractors such as EADS and BAE Systems (OTCPK:BAESY) entering the market to compete with the five large U.S. companies. Now with budget plans showing a cut of $100-200 billion a year in total defense spending such activity could be expected again. Recently the new CEO of Lockheed Martin (NYSE:LMT) told The Wall Street Journal that consolidation should be expected.

While Northrop Grumman (NYSE:NOC) over the last four years has made two significant moves by divesting its shipbuilding group into Huntington Ingalls Industries (NYSE:HII) and selling its support contractor, TASC, to a private equity firm most of its competitors have focused on acquiring smaller contractors providing intelligence, cyber security and Unmanned Aerial Vehicle (UAV) capabilities. Now that the amount of cuts expected has been made clear it would not surprise if they either jettisoned parts of their companies with low revenue or looked at consolidating product lines across contractors.

ITT Exelis (NYSE:XLS) is one third of the former ITT Corporation (NYSE:ITT) that last year split itself into three parts. Defense, which focused on electronic systems and scientific and engineering support, became Exelis. The fluid and water group became Xylem and the rest remained ITT. ITT Exelis just reported their second quarterly results and actually showed some improvement. Its first quarter 2012 came in at 5 cents above expectations at 47 and revenue was up 6 percent to $1.4 billion. The company is holding firm on its 2012 projections of $5.4 to 5.5 billion or $1.80 to $1.86 a share.

A few weeks after these results were announced came word that Exelis was seeking to sell its Mission Systems group. This unit primarily provides logistics and other services to the U.S. military and other government agencies. In 2010 this group alone had $1.52 billion in revenue and contributed last quarter to good performance for their Information and Technical Service segment. Even so it is considered a low margin business for the company and would represent further focus by ITT Exelis on its electronic systems products.

With the upcoming removal of troops from Afghanistan following the Iraqi pullout last year this type of work should decline even further. If the projected budget cuts hold then U.S. will have to limit the size of its military and their deployments overseas. This too will then negatively affect the type of work the Mission Systems group does. A company could buy the unit to roll it into similar efforts that it does to try and increase margins and lower costs beyond what Exelis is able to accomplish. That would be a sensible M&A effort.

The largest transaction from last year is yet to close. This is United Technologies Corp.'s (NYSE:UTX) buying of Goodrich Corp. (NYSE:GR). The two companies have similar product lines in aircraft parts and components, and there would be some unity there. The move was approved two months ago by Goodrich's shareholders and the $16.4 billion move should go through. Goodrich will remain a subsidiary of United Technologies joining engine manufacturer Pratt & Whitney and helicopter company Sikorsky as one of the largest components of the diverse industrial company.

A similar sized deal has yet to materialize so far in 2012 but it is expected there will be some moves. Once the 2013 budget shapes up which won't be until late Fall there may be more impetus for such moves as product lines are defined depending what is cut and what is funded. Already Congress has done some push back on the proposed cuts moving money around in the overall budget to cushion some of the planned reductions. If this kind of effort continues then there may be less motivation for consolidation in the industry for another few years. Eventually the defense budget, as all of U.S. spending, must see some decline as the country cannot afford $1 trillion or more deficits every year.

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

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