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General Investing

Analyst Q&A: M&A Predictions In the Defense Space

January 14, 2010

The following is an excerpt from TWST‘s interview with Michael French, senior vice president of equity research at Morgan Joseph & Co., and Tom Gallagher, managing director of the same. Both specialize in the fields of aerospace and defense, and lend TWST their thoughts on M&A activity within the sector.

TWST: Are we going to see much M&A activity?
Mr. Gallagher: We are not seeing a lot of M&A. I’m disappointed to say that within the past year, at least in the defense industry, M&A transactions are off 90%. I think the relevant numbers are 154 transactions in 2007 compared with 14 transactions in 2009. I think the modest M&A activity that we are observing is very revealing, however. I would just point to a couple of areas which I think are significant: The divestiture of Northrop’s (NOC) technical services division, what they call TASC, and its purchase by a knowledgeable private equity firm tells you how important serving the intelligence community has become because that business covers everything from signals intelligence to training analysts. It’s a very, very deep column in the intelligence community and an asset that was highly sought-after. The valuation was very attractive. Most significantly, the transaction was easily financed at a time when it’s been very hard to finance transactions at all.
The second example: The appeal of government markets must have influenced Mrs. Burns at Xerox (XRX) when she decided to buy Affiliated Computer Services (ACS). This is a story that’s not received much attention – the amount of work ACS performs for government customers, and how large a share of its profits depends upon the government service space, an amount disproportionately greater than its revenue. I really admire what she is doing, and I wish her well because with Minolta on one side and and Cannon on the other, a large share of government contracts can help manage the competitive onslaught.

TWST: Mr. French, what are your thoughts on the M&A situation?
Mr. French: Tom is right. It hasn’t been as robust as is typical. And one of the reasons that he mentioned is that financing has been an issue. Another issue is that sellers’ expectations have been really high. They were based on previous years’ multiples, and they’re thinking they’re going to get 10 to 15 times EBITDA when buyers are thinking more like seven to 10 times EBITDA. But lately I think what we have seen is the sellers’ expectations have come into line with reality. At L-3′s (LLL) recent analyst day, they were anticipating very significant turnaround in the M&A picture in the near term, and there are a couple of reasons for that. One is what I mentioned about the sellers’ expectations coming down, and the other is they’re thinking that in the first quarter some of the larger companies will start disposing off some units that don’t really fit in with what they’re doing. For example, FLIR (FLIR) recently sold their data systems division. I think a combination of those factors is going to start to propel more M&A activity. That said, it’s always a part of the industry. Cadence (CDNS) is one good example, where they have a bunch of really smart engineers, they decide that they could do a better job on their own, and maybe they start up in a small office park or in a garage or something, but they come up with some mousetraps that’s better than any other mousetrap out there. And they start building and building and building, and then they get to a point where they sell to one of the larger companies. And that’s something that I’ve seen in this space throughout my career. It’s part and parcel of the way this community works. So I think there are going to be fast cycles and slow cycles, but there will always be an element of this space.

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