A few weeks ago, business editor Jon Sindreu from The Wall Street Journal was wondering whether, after thirty years of pretty solid Mergers and Acquisition activity, consolidation among defense players was not finally coming to an end, at least in the US… “Defense stocks, known for being boringly reliable dividend payers, may have just gotten more boring,” he wrote. That was just a few weeks after the iconic conglomerate General Electric – born in 1982 - split in three separate entities, and also after it became known that the latest defense mega-merger between Lockheed Martin and Aerojet Rocketdyne would probably not go through due to anti-trust concerns.…
The last supper
Back in 1993, at a dinner held in the Pentagon – known as “the last supper” - then Defense Secretary William Perry warned top US defense executives that the post-Cold War “peace dividend” meant that the Pentagon would not be able to sustain enough demand to keep all major players in business. Following this, a wave of consolidation completely reshaped the American defense industrial base. Many historical names - such as Hughes Aircraft, McDonnell Douglas, Rockwell, North American and others - simply disappeared or were absorbed by bigger players. As a result, three types of aerospace & defense company profiles emerged: a very select group of top-tier pure defense players with portfolios spanning a wide range of military hardware markets; a bunch of others (like Boeing, Textron or General Dynamics) able to compensate the defense budget downturn with their commercial aviation businesses; and a last group of pure players including Lockheed Martin and Northrop Grumman trying (unsuccessfully) at the time to diversify in other areas such as energy, infrastructure, IT and telecommunications.
Even if their strategies differed, all players were fighting for their survival and trying to secure long-term value for shareholders at a time of shrinking military budgets. The idea was to find leverage strong enough to acquire other companies and create leading industrial conglomerates able to navigate the crisis.
The global defense budget crunch also fostered consolidation in Europe with the rise of major players such as EADS-Airbus, Bae Systems, Finmeccanica/Leonardo or Thales. And everyone seemed to be satisfied with the situation until recently.
In 2015, William Perry himself acknowledged that consolidation had effectively reduced competition and driven up prices, and then-Defense Secretary Ash Carter would not welcome further consolidation among large U.S. weapons makers. And no later than a month ago, an official report from the Pentagon reiterated his point, with updated data.
Indeed, since the 90s, the number of aerospace & defense prime contractors narrowed from 51 to just 5: Lockheed Martin, Raytheon Technologies, General Dynamics, Northrop Grumman, and Boeing. When it comes to the number of tactical missile suppliers, they declined from 13 to 3, fixed-wing aircraft suppliers from 8 to 3, and satellite suppliers from 8 to 4. The report said 90 per cent of missiles now come from three suppliers only.
As for the defense industrial base itself, the report estimates that it has contracted by 40% over the last three decades, while 15,000 suppliers are now at risk.
To a lesser extent, the situation is also preoccupying in the UK. A recent study found that “In 2020/2021, the ten main suppliers to the British Ministry of Defense accounted for 43.1% of total procurement expenditure. BAE Systems position as the number one supplier of the MoD has even been further strengthened in 2020/2021, during which the company received 183 million Euros more compared to last year,” the largest increase among the ten largest MoD supplier groups.
DoD experts are now calling for a complete change of policy on mergers and consolidation among contractors to avoid major risks to the U.S. economy and national security. According to them, consolidation in the defence sector has led to higher prices, supply chain gaps and threats to readiness. It has “left the US military less well-equipped and needlessly overburdened taxpayers”.
It identifies five sectors that needs to secure their supply chains. Shortages are indeed a major concern at the DoD since the industrial base review in 2018 identified 300 vulnerabilities and single points of failure in the defense supply chains. More recently, the coronavirus pandemic disrupted global supply chains for semiconductors and other goods creating shortages and inflation. The five priority sectors are: casting and forgings, missiles and munitions, energy storage and batteries, strategic and critical materials as well as microelectronics.
So, what is new today as compared to Ashton Carter’s position of more than ten years ago? Actually, it’s three main things.
First, this alarming DOD report is only the latest sign of worry of excessive consolidation leading to excessive bargaining power, but it is published amidst a global protectionist wave following the pandemic, in a tense international situation (China, Russia).
Recently, the US but also European governments, have severely strengthened their investment legislation to enable them to veto any merger they deem detrimental to national security. While President Biden recently reinforced the Buy American Act, the European Union is still considering an equivalent “Buy European” measure. For its part, the European Defence Fund (EDF) is - on paper - calling for “consolidation where appropriate”.
However, a joint letter from the defence ministers of France, Spain, Italy and Germany stated that they prefer cooperation programmes to consolidation. In a still politically divided EU, and given supply chain concerns caused by the pandemic, the trend is more towards a greater autonomy of member-states.
They could very well decide to prioritize their national industries rather than promoting cross-border operations. In the UK, a “national security and investment Act” came into force in January 2022. Cobham Group, (owned by an American equity firm Advent International) offer to acquire Ultra Electronics might be the first “victim”, as business secretary Kwasi Kwarteng asked the UK’s Competition and Market Authority (CMA) to review the deal invoking “national security concerns”.
In parallel, US engineering group Parker-Hannifin has offered a number undisclosed mitigation measures in order to convince local and European authorities to approve its £6.3 billion takeover of British defence supplier Meggitt. To date, those two major cases remain pending.
Second: If Democrats are historically more wary of M&A than Republicans, the Biden administration pushes to overhaul competition policy and break up concentrations of corporate power across the economy is unprecedented. To meet his goal, President Biden surrounded himself with a solid “anti-trust team”. It is composed of Jonathan Kanter, who leads the Justice Department’s antitrust division after spending years as a lawyer fighting giants like Facebook and Google on behalf of smaller and often rival companies. Lina Khan, who helped reframe the academic debate over antitrust now leads the Federal Trade Commission, and Tim Wu, an historic opponent of Facebook and other large companies is now the special assistant to the President for technology and competition policy. According to this team, consolidation not only raises prices but is detrimental to innovation.
Third: At stake is also the need to rejuvenate genuine production capacities, should a major, hi-intensity conflict arise. Early last year, a CSIS study also showed that even in the United States, the defense industry is not capable, in the short term, of increasing production rates. With unchanged industrial capacities, the US industry would take 8 years on average to replace lost platforms, and replenish missile and ammunition stocks... And a recent French Parliamentary report is showing that for certain ammunition, production times – excluding activities already scheduled – are 24 to 36 months. And, for certain platforms, they can reach up to six years...
The Way forward: a few takes
In spite of the notorious GE split case (as well as occasional rumours of a Boeing’s break-up due its Commercial aircraft division liabilities…), it is difficult to believe that the US would be advocating a path towards deconsolidation. Last year, M&A in the aerospace and defense sector were still largely dominated by American companies: 65% of all bids, 11 out of 16 transformational one, according to Janes figures… After all, the world’s top ten defense companies (Airbus, BAE Systems, Boeing, General Dynamics, L3 Harris Technologies, Leonardo, Lockheed Martin, Northrop Grumman, Raytheon Technologies and Thales) were responsible for only 4,2% of transactions as buyers last year…
Nontraditional providers promoted
As noticed by consultancy Avascent, the DOD has quickly embraced contracts with nontraditional providers, as a way to diversify the supply base. For instance, “SpaceX share the National security space launch role with United Launch Alliance, Microsoft supplies the Army’s integrated visual augmentation system and General Motors won the US Army’s infantry squad vehicle contract in 2020”, the consultancy recalls.
Less interesting deals and change in priority, but still room for M&A in specific activities and to secure supply chains, in a post Covid era As financial analyst Byron Callan from Capital Alpha Partners underlines “there aren’t that many good acquisitions targets left beyond some specific segments”. Yet, M&A movements can still be expected in cyber, artificial intelligence, hypersonics, hybrid warfare, quantum computing, anti-satellite weapons and so forth.
Defense is technology-driven, and larger contractors will always acquire specific high-tech companies to gain access to their technologies. In fact, this is exactly the reason that Lockheed Martin CEO gave in 2020 when he acquired a company called i3 in the field of hypersonic glide bodies “we wanted to bring in-house and accelerate our own potential for developing that piece of the technology that’s so absolutely critical”. That is also why he wanted to acquire rocket engine maker Aerojet Rocketdyne, a 4.4bn dollars bid probably too big to go through these days….
In France, Thales, who bought cyber security firm Gemalto in 2019 for €4.8 billion, announced in November 2021 its interest to acquire RUAG International’s training unit. In the UK, Cobham has set its sight on Ultra Electronics, in a €2.6 billion deal that still has to be approved by Her Majesty’s Government, due to the sensitivity of certain Ultra’s core capabilities.
The European naval sector still seems to offer room for consolidation. Thyssenkrup for example was recently looking to merge its shipyard subsidiary with a competitor. According to the German financial newspaper, Handelsblatt, it had been approached the Italian group Fincantieri, the French Naval Group and the Swedish Saab. Howerever, the German conglomerate reconsidered the sale since the Ukrainians events.
Additionally, especially after the pandemic and in a context of high demand, companies might be willing to acquire firms that can secure their supply chain. It was already the case in 2021, when we observed a high consolidation for companies focused on subsystems or engineering. We might continue to see consolidation by family parts: forging, components, aerostructures, electronics and interiors as firms focus on gaining economies of scale.
This trend is also accompanied by Private equity and strategic funds. In France, for example, Airbus, Safran and Tikehau Ace Capital signed an agreement in February 2022 with Eramet for the acquisition of Aubert & Duval, a strategic supplier of critical materials and parts for the aeronautic, defense and nuclear sector. With this acquisition, Airbus and Safran, as well as other Aubert & Duval customers are securing their strategic supply and the development of new materials for current and future programs. This operation is part of the initiatives to support the entire French aerospace sector taken in recent years, in particular the creation of the Ace Aéro Partenaires fund, managed by Tikehau Ace Capital, with the support of the French State.
The role of private equity in the defense industry remains key. Again: half of the six “transformational bids” in 2021 valued at more than $3 billion, three were backed by private equity (Peraton's bid for Perspecta, Cobham/Advent’s bid for Ultra Electronics, and Veritas Capital and Evergreen Coast Capital's bid for Cubic Corporation). As noticed by Janes, on the other three, two were conducted by companies with fairly limited exposure to defence markets (Parker Hannifin Corp. and Viasat), and the last one was Teledyne Technologies' acquisition of FLIR Systems (The same Teledyne that was barred from buying French night-vision specialist Photonis in 2020 on National Security grounds…)
All these speculations must be re-evaluated in light of the groundbreaking budgetary and strategic repercussions of the Russian invasion of Ukraine.
Even the most reluctant defense spenders, including Germany, have realized that – alas – military weakness is no longer an option. In other words, the peace dividend era, highlighted by Secretary Perry to his guests is over. And as valuation of publicly traded defense group is booming, so are the prospects of new M&A deals and further consolidation, although not among the Big Five.
With military budgets skyrocketing almost everywhere, Defense stocks are definitely not boring anymore, especially if they can manage to avoid ESG pressure. Just like the globe-trotters in the iconic surf movie from the 60s, “Endless Summer”, it seems that defense industry players will still have plenty of organic growth and portfolio adjustment waves to ride, in what increasingly looks like an… “endless Supper”