L3-Harris Merger May Signal Pentagon Demand is Approaching A Peak
(Source: Forbes; issued Oct 15, 2018)
This weekend's announcement that second-tier military contractors L3 Technologies and Harris are merging is the latest indication that sector executives are expecting domestic demand for military hardware to peak in the near future.

Defense companies tend to consolidate when the outlook for organic growth softens, and while that hasn't happened yet, there are multiple reasons why it could occur after 2020. L3 and Harris may be trying to get ahead of that curve.

One reason, ironically, is the surge in Pentagon funding that has occurred under President Trump. The Trump plan originally was to raise military outlays 5% after inflation every year through 2023. But because of alarming threat indications, the White House decided to take the whole increase in 2018. That meant raising the Pentagon's annual outlays by an amount greater than Germany's entire defense budget. But it also meant there would be no further increases beyond inflation in subsequent years.

Defense contractors have benefited handsomely from the surge in military spending after years of depressed equipment purchases, but they now confront the prospect that (to quote the deputy secretary of defense) military budgets will flatline for the remainder of Trump's tenure. So once they adjust to the higher level of spending made possible by Trump's presidency, the prospects for further growth in domestic demand during the early years of the next decade will not be favorable.

A second reason to fear softening domestic demand going forward is that interest rates are rising at time when America has accumulated the biggest federal debt in postwar history. Every time interest rates increase 1%, the annual cost of servicing the debt balloons by over $200 billion. If interest rates were to revert to historic norms -- an outcome the Federal Reserve seems to be encouraging -- it might require a quarter of the entire federal budget just to keep up with debt obligations. The added money would have to come from elsewhere in the budget.

L3 Technologies was recently awarded an Air Force contract to shift sensors and other equipment from aging "Compass Call" electronic warfare planes to a militarized version of the General Dynamics Gulfstream 550 business jet.

Which leads to the third factor shaping future Pentagon demand, the spending priorities of a hyper-partisan political system. Defense is not the top priority, entitlements and debt service are. Once those items are covered, the partisans turn to defense and domestic discretionary programs like criminal justice and education. Republicans typically favor robust military spending, but within defense accounts readiness and personnel get funded before military hardware. "Modernization," as it is called, often becomes a bill-payer.

So, it's easy to see why defense executives might be looking ahead and trying to prepare for a flat-demand environment. The best-positioned companies in the sector, like Boeing, General Dynamics, Lockheed Martin and Raytheon, have good prospects for increasing overseas sales, growing commercial revenues and mining their backlogs for better margins. But even they have been reshaping their portfolios and making acquisitions of late, suggesting that nobody expects the good times in defense to continue indefinitely.

Against that backdrop, the L3-Harris merger looks like a classic move to gain market share through combination rather than competitive outcomes. With some companies already bidding very aggressively for new military business, the chances of taking market share from rivals do not look promising. To obtain the necessary mass to remain players as the sector consolidates and integrates vertically in the years ahead, second-tier players will need to combine.

In the case of L3 Harris Technologies -- the proposed name of the new entity -- L3 will bring bigger revenues to the table ($10 billion annually versus $6 billion), but Harris will bring stronger margins. The companies say their "merger of equals" will create the sixth largest U.S. defense contractor and one of the ten biggest military suppliers globally, which certainly sounds like sufficient mass to remain competitive. Their business lines are complementary, mostly in military electronics, but without raising major antitrust concerns.

The underlying synergy is reflected in the fact that Harris is best known for its radios, and L3 began life as a spin-off from Lockheed Martin with the name "L3 Communications." Electronic content tends to dominate the design of modern combat systems, and few companies will have greater expertise in that highly fungible skill area than L3 Harris. On the other hand, competition in military electronics is fierce, with players such as BAE Systems and Raytheon having at least as much depth and breadth in the marketplace as the new entity.

For L3 Chairman Chris Kubasik, the transaction is a second chance to reshape the defense sector. Kubasik was pushed out of industry leader Lockheed Martin on the eve of assuming the CEO's mantle, and he has spent much of the time since that happened finding his way back into the industry. Unlike others in a similar predicament he has succeeded, thanks to a quick mind and the high marks he received for steering Lockheed through some tough times on Wall Street.

Time will tell whether he can bring that same magic to L3 Harris, but under the terms of the merger he will ascend to the role of CEO in two years -- succeeding Harris Chairman William Brown -- and then he will become Chairman of the combination a year later. That should be just about the time that market conditions reward the kind of dynamic outreach Kubasik once exemplified at Lockheed Martin.

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