Retrospective on M&A Performance in Defense

JAMES HASIKwww.jameshasik.com • 512-299-1269 • [email protected]

A retrospective on M&A performance in defense: some further (working) results

Briefing to the SRI Aerospace & Defense Investors Conference

The Hyatt Regency, Reston, Virginia • 19 March 2008

A long line of literature finds that mergers and corporate acquisitions are largely a waste of shareholder value for the acquiring firms, and frequently a net loss of value overall. More recent evidence, however, suggests that management is capable of serial learning in ongoing acquisition campaigns1, and that many companies may be improving their performance as acquirers, making smarter deals at better prices.2 Smaller firms (those in the bottom quartile of overall market value on the New York Stock Exchange) have also been found to be, across all sectors of the US economy, statistically better acquirers than large firms.3

In the arms industry, a further thesis holds that selected vertical integration can be important for taking advantage of the militarily and industrially transformational effects of advanced technologies for command, control, communications, comput-ing, intelligence, surveillance, and reconnaissance (C4ISR). Incorporating network-centric C4ISR technologies within the walls of a corporation, the argument holds, can efficiently exploit scope economies, internalize inefficiently leaky information,

1 Matthew L.A. Hayward, ‘When do firms learn from the acquisition experience? Evi-dence from 1990–1995,’ Strategic Management Journal, January 2002, pp. 21–39.

2 See Sam Rovit & Catherine Lemire, ‘Your Best M&A Strategy,’ Harvard Business Re-view, March 2003, pp. 16–17; and

3 Sara Moellner, Frederik Schlingemann, and Renee Stultz, ‘Do Shareholders of Acquir-ing Firms Gain from Acquisition?’ National Bureau of Economic Research Working Paper #9532, August 2003

[introduction]

http://www.jameshasik.com


mailto:[email protected]?subject=Vehicles%20comparison

mailto:[email protected]?subject=Vehicles%20comparison

and fully expropriate the quasi-rents of specific intellectual assets (or, forestall shakedowns by the firm with greater power in the market).4

As retired French admiral Jean Bétermier argued at the ‘Euro-Forum’ of the Cen-ter for Strategic and International Studies (CSIS) in June 1999, NATO’s air cam-paign over Kosovo made the United States “material and technological dominance within the NATO alliance overwhelmingly apparent,” presenting a challenge to in-dustry worldwide to restructure to match these advances. The impact was felt in the United States as well. The strategic efficacy of the precision bombing campaign (if not its tactical effects), and apparent “irrelevance” of heavily armored ground forces (using the word of then-US Army Chief of Staff General Eric Shinseki), com-bined to call into question existing priorities in military procurement. In a speech at the Citadel that September, US presidential candidate George W. Bush stated that his administration would

challenge the status quo and envision a new architecture of American defense for dec-ades to come. We will modernize some existing weapons and equipment, necessary for current tasks. But our relative peace allows us to do this selectively. The real goal is to move beyond marginal improvements – to replace existing programs with new technolo-gies and strategies, to use this window of opportunity to skip a generation of technology.5

The attacks of 11 September 2001 and the subsequent decision to depose Saddam Hussein rather interfered with this goal. A few years into the campaigns in Afghani-stan and Iraq, the demands of counterinsurgency had made clear that while ad-vanced C4ISR technologies would continue to be important, steel plating had en-during value.

All the while, a wide range of arms makers, and particularly US-based defense con-tractors, continued to acquire firms large and small as they restructured the indus-try. While the nature of what was needed militarily changed, the pace of the indus-trial change did not abate. But did these efforts prove useful, and under which political-military conditions: the state of the world after the bombing of Kosovo, or that after in invasion of Iraq? Thus, I decided to ask whether systematic acquisition campaigns, particularly of firms with C4ISR technologies, can produce superior shareholder returns for defense contractors, or whether other approaches may be more financially rewarding.

Testing requires methodology. Somewhat arbitrarily, I set a start date of 10 June 1999, the end of the Kosovo campaign, as the start of the real change in military force structure. Both the Task Force Hawk debacle and the 5th Allied Tactical Air Force’s relative inability to inflict significant damage on Yugoslav forces on the bat-

A retrospective on M&A performance in defense: some further results

JAMES HASIK • [email protected] • www.jameshasik.com page 2 of 18

4 For more on when these conditions apply for smaller defense contractors, see James Hasik, Arms & Innovation: Entrepreneurship and Alliances in the Twenty-first Cen-tury Defense Industry, University of Chicago Press, forthcoming, August 2008

5 See http://www.citadel.edu/pao/addresses/pres_bush.html for the transcript.



http://www.citadel.edu/pao/addresses/pres_bush.html

http://www.citadel.edu/pao/addresses/pres_bush.html

tlefield indicated that something had to change across military forces, and both military officers and industrialists began thinking more seriously about how to do that. Next, I set an end date of 9 June 2006—seven years later, if only to ensure a good run of data. I further restricted the sample to quoted, US-based, defense hardware and software producers. I specifically excluded recently formed enter-prises, such as Rockwell Collins, for whom financial data do not reach back to 1999; companies focused on commercial markets, such as Boeing and Honeywell, whose value depends too greatly on matters outside the military realm; services specialists, which would not be subject to quite the same industrial network dy-namic; and largely European and Asian firms, which did not benefit as greatly from the huge run-up in US arms spending that US firms did.

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As illustrated in the chart above, these restrictions reduced the sample set to just thirteen firms, for which the table on the following page provides some detail. While a disappointingly small sample, they remain, nonetheless, a diverse group of firms that undertook some 197 significant transactions over the course of the seven years in question. The data came from a wide range of sources, including news reports, press releases, and annual reports; though foremost from CRA In-ternational’s database of aerospace and defense industry transactions, which has been published for the past several years as a well-packaged chart.6



6 An electronic copy is available at http://www.crai.com

Largest military suppliers worldwideby 2006 military contracting revenues (US$ MM)

less state- and privately-owned enterprisesless foreign companiesless services specialists

less companies focused on commercial marketsless recently formed companies

[methodology]



http://www.crai.com

http://www.crai.com

Defense News

rank for 2007 Company Symbol

approximate 2006 defense

revenues (US$ MM)

reported 2006 total revenues

(US$ MM)

approx. market capitalization on

10 June 2006 (US$ MM)

# of significant transactions, June 1999 to

June 2006

1 Lockheed Martin LMT 36,090 39,620 29,786 16

4 Northrop Grumman NOC 23,649 30,148 22,094 20

5 Raytheon RTN 19,500 20,291 19,124 8

6 General Dynamics GD 18,769 24,063 25,710 27

8 L-3 Communications LLL 9,989 12,476 9,676 51

17 ITT ITT 3,659 7,808 9,009 12

20 Alliant Techsystems ATK 3,066 3,565 2,821 10

21 DRS Technologies DRS 2,736 2,821 2,074 17

31 Armor Holdings AH 1,898 2,361 2,100 5

60 EDO EDO 686 715 534 8

71 Cubic CUB 564 821 489 7

75 Curtiss Wright CW 549 1,282 1,391 16

95 Orbital Sciences ORB 321 803 895 0

197

Next, I calcu-lated returns to shareholders: not just share price apprecia-tion, but total returns, includ-ing reinvested dividends. As shown in the chart on the

next page, those returns over the seven-year time interval can be broken into two categories, conveniently breaking into two equal groups at the level of 200 percent return on investment (which is shown in the chart as an indexed return of 300). Indeed, the best performers, DRS and Armor Holdings (recently acquired by BAE Systems), provided their shareholders more than a four-fold return over those seven years. The remainder in the top half includes Alliant Techsystems (ATK), Cur-tiss Wright (CW), EDO Corporation (EDO), and L-3 Communications (LLL). The bottom half, which still includes some firms with impressive financial performance, is comprised of Cubic (CUB), Orbital Sciences (ORB), Raytheon (RTN), Lockheed

Snecma

Gespac Integration

Boeing Corinth facility

Snecma SabenaEngine Service stake

Teuchos

Sopartech

Sagem

e-Software

Leica Vectronix

Morpho Systemes

ARNAV Systems

Sagem

Aerospace and Defense Industry Restructuring(January 1992–December 2006)

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Aerospace Co. to Veritas Capital

Montek Division to Moog

E-Systems

BAe Corporate Jets

GeneralDynamics Applied Remote Technology

Chrysler ESI &CTAS

JPS Communications

Honeywell ADS Australia

Photon Research Associates

UTD

Virtual Technology

Solipsys

AlliedSignalCommunications

Hughes Aircraft

Amber Engineering

TRW LSI Products

Optical Systems to Goodrich

Sonobuoys to Ultra Electronics

MMIC Operationsto TriQuint

Microwave & PowerTube Division to Litton

Aircraft Services FBOsto Mercury Air

Flight Training to L3

AIS to L-3

Texas Instrument DSEG

RF Components toFairchild Semiconductor

Aerial Targets to Composite Engineering

Systems CompositeProducts toSpecialty Materials

Fastening Systemsto Platinum Equity

Fuel Systems toWoodward Governor

Turbine EngineComponents to Utica

Avco toAssociates First Capital

Textron Aerostructuresto Carlyle Group

Commercial Infrared to L-3

Ground EO/FPA to DRS

Raytheon

Racal Instruments toThomas Weisel/JF Lehman

AeronauticalServices to SAS

Antennas to Cobham

Avimo Group

Experlan Global Control

Arisem

ADI stake

Racal Electronics

Sextant Avionique

Raytheon Rediffusion Simulation

ADI

Acoustics toJF Lehman

High Tech Optics to Candover Investments

Thales Navigation toShah Capital Partners

Shorts Missile Systems

Alcatel MilitaryCommunications

Magellan

Altech African Defense Systems

Wormald Technology

Deutsche System

Thorn-EMI

Texen to Barco N.V.

AlliedSignal Aerospatiale Canada

Thomson-CSF

Finmeccanica

Textron

Fort Worthto LockheedElectronics mfg

to Elbit/Crossroads

Electronics to Carlyle GroupMissile operations

to Hughes Cessna Aircraftto Textron

Lucent ATS

Bath Iron Works

Teledyne Vehicle Systems

Lockheed Martin Defense/Armaments

NASSCO Holdings

Computing Devices International

Galaxy Aerospace

Primex Technology

Santa Barbara

Saco Defense

GTE Government Systems

Gulfstream Aerospace

Space Systems to Martin Marietta

Space Propulsion to Aerojet

Applied RemoteTechnology to Raytheon

Motorola IISG

EisenwerkeKaiserlautern Command

System

Advanced Technical Products

Datron IMCO

Steyr Spezialfahrzeug stake

MAYA Viz

Itronix

Chamberlain MfgScranton facility

Anteon

FC Business SystemsDatamat

BAE Systems militaryand secure comms

AMS AirTraffic Mgmt

Tadpole Computer

Engineering Technology

Veridian

GM DefenseCreative Technology

Digital System Resources

TriPoint Global

Spectrum Astro

Aeronautics Services to Wyle Labs

Airborne Electronic Systems to Astronics

C4 Systems Interactive to KoolConnect Technologies

General

Dynamics

Aeronautics & Transportation Testing to Calspan

Propulsion Systems to L-3

Jeppesen Sanderson

SBS International

Conquest

Frontier Systems

Carmen Systems

Aviall

Hughes Space &Communications

Preston Group

McDonnell Douglas

Alliant MarineSystems

Magnavox Electronic Systems

Litton Itek

CAE Link

GD Missile Ops

Hughes

St. Louis fabrication operations to GKN

Sensors & Electronic Systems to DRS

Rockwell Aerospace & Defense

Litton Precision Gear

Precision Gear to Derlan

ACESII Ejection Seat to Goodrich

de Havillandto Bombardier

Information Services to SAIC

ARGO Systems to Condor

Civil helicopters to RDM

Autometric

Hawker de Havilland

Flight Training to GECAS

Avicom to Rockwell

Hughes Aircraft to Raytheon

Inertial Systemsto Litton

Rediffusion Simulationto Thomson-CSF

Ordnance to ATK

Spokane facility to Triumph

Electron Dynamic Devices to L-3Wichita/Tulsa facilities to OnexRocketdyne to United Technologies

Digital Cinemato AccessIT

Flight Safety Boeing Training stake

Continental Graphics

On Demand Mfg to RMB

Products

Arnprior facility to Consolidated Industries

Boeing Commercial Electronics to BAE

Corinth facility to Snecma

HughesBoeing

Aeroframe Services to Linden Street Capital

EADS Sogerma Servicesmaintenance to TAT Group

Sextant ATE

SODERN

Cogent Defense Systems

Australian Aerospace

Nortel Cogent

Astrium stake

Racal Instruments

Dutch Space

Talon Instruments

IFR

Sofrelog

Nokia professional mobile radio

Paradigm Comms stake

Aerospatiale Matra

DaimlerChrysler Aerospace

Siemens Defense Electronics

Matra Hautes Technologies

Construccionnes Aeronauticas

CAC Systemes

Sycomore

Giravions Dorand

Aeroformation

Elekluft Elektronik to Serco

MTU to DiamlerChrysler

CMS Group to Primex

Dornier Luftfahrt to Fairchild

TelefunkenSendertechnik

to Tech-Sym

Airport Systems to Honeywell

Daimler-BenzAerospace Aerospatiale

Shur-Lok Group

Special Metals

Air Industries

SPS Technologies

Western Australia Specialty Alloys

AE Turbine Components

Precision Gear to Boeing

Intevac E-OSystems

Vought Aircraft

Imo Electro Optics

PRC

PRC AEGIS Servicesto Tracor

Teldix

Racal Marine

Avondale

TASC

Denro

Weather Services to Landmark Communications

Scaled Compositesto Burt Rutan

EADS Les Ulis naval and ground Overwatch SystemsInnovative

SurvivabilityTechnologies

US Helicopter M&O

Petroleum Helicopters Acadian Composites

Carbide Technology helicopter skid shoe

Interstar Technologies

Hexcel EMTMaterial

Logicon

Westinghouse ESD

Inter-National Research

Sperry Marine

SAI Technology

Sterling Software Federal SystemsNavia Aviation

Comptek Research

CaliforniaMicrowave ISD

DPC Technologies

Ryan Aeronautical

Commercial Aerostructuresto Carlyle Group

Electron Devices & Displays to L-3

Newport News Shipbuilding

Litton Industries

Mannesmann Dematic Postal

NetworkSix

Aerojet EIS

TRW

XonTech

Fibersense Technology

Federal Data Corp

Ferretec

Teledyne Electronic Systems

Fibercom

Raytheon Microwave& PowerTube

Precision Productsto AlliedSignal ITEK to Hughes

Hughes Inertial Systems

SPS Magneticsto Audax Group

Wyman-GordonTitanium Castings

to Ladish

VEAM/TEC to ITT

SciTec to mgmt

Poly-Scientific to Moog

Kester toAmerican Capital

Automotive to Blackstone Group

Life Support to Cobham

Cutting Edge Optronics

LSI Products to Raytheon

Electronic Productsto ETA Technologies

Aeronautical Systems to

Goodrich

Lucas Fabricated Systems toMB Aerospace

Lucas Varity

BDM International

Astro Aerospace

Pierburg Luftfahrtgerate

Illgen Simula

Confluent RF Systems

Navigation & Space Sensors Canada to L-3

Winchester Electronics to Audax Group

Teldix to Rockwell Collins

Airtron Microwave Products to Cobham

SiC Group to II-VI

Motion Controls & Sonar Canada to Wescan

NorthropLitton

IndustriesTRW

Integic

Ten businesses

Defense/Armamentsto General Dynamics

OAO

Orincon

Comsat Mobileto Telenor

Electro Mechanical Systems to DRS

LM Aerospace ElectronicSystems to BAE Systems

LM Control Systemsto BAE Systems

World Systems CDTI to Intelsat

Comsat Generalto Intelsat

Comsat General to Intelsat

Comsat to World Data

Unisys Defense Systems

IBM Federal Systems

LTV Missiles

General Dynamics Space Systems

Martin MariettaLockheed

Loral DefenseElectronics

Loral Space &Communications

GE EngineFabrica Militar de Aviones

ACS FederalCommercial

Solutions to ACS

SYTEX Group

Coherent Technologies

INSYS Group

STASYSSippicanAstrolink

LoralMartin

Marietta Lockheed

GE Aerospace

General DynamicsFort Worth

COMSAT

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

Celerity Systems to Aeroflex

Spar Aerospace

Coleman Research

Raytheon Flight Training

EnvisoNet

AlliedSignal Space & Navigation

Interstate ElectronicsAydin

Microdyne

ILEX Systems

Satellite Transmissions System

L-3 Communications

SPD Technologies

EER SystemsKDI Precision Products

Raytheon AircraftIntegration

Aeromet

PerkinElmer DetectionSY Technology

Emergent Government ServicesBulova Defense

MPRI

Honeywell TCAS

TrexCom LNR/EMP

ElectrodynamicsStorm Control Center

ESSCO

Network Security to Symantec

Hycor to Sippican

Com-Cept TMAWestwood

International Microwave

WescamShip Analytics

Northrop Grummanelectron devices & displays

AlliedSignal Ocean Systems

Goodrich Avionics Systems

Vertex Aerospace

Nova Engineering

TRL ElectronicsNautronix Defence

Crestview AerospaceSSG Precision Optronics

CyTerraAdvanced System Architectures

SAM Electronics

Sonoma Design Group Mobile-VisionInfraredVision Technology

Ipicom IpitekOYO Klein Associates

EOTechTitan

Joseph SheairsAssociates

Applied Signal and Image Technology

BAI AerosystemsGeneral Dynamics Propulsion SystemsBoeing Electron Dynamic Devices

Pyramid Vision Video Security

D.P. AssociatesAvisys

BrashearBeamhit

Northrop Grumman Navigation and Space Sensors Canada

Cincinnati Electronics

Raytheon Commercial Infrared

Bombardier MilitaryAviation Services

CAE Marine Controls

Metrum Information Storage to Group

Technologies

Marine Systemsto Hughes

Kilgore Flaresto Chemring

Astra UPC

Ferrulmatic

Hercules Aerospace

Motorola Fuzing

Alcoa Thiokol

Blount SEG

Boeing OrdnanceScience & Applied Technology

Composite Optics

Simmons Outdoor to Meade Instruments

Allied Aerospace GASL/Micro Craft

PSI Group

MissionResearch

Alliant Techsystems

Solid rocketsto Aerojet

WFEL to DunedinCapital Partners

Photonics to Uniphase

Altair AvionicsOrbital Sensor Systems

Magnaghi Hydraulics

Cade Industries

Dallas Aerospace

Braathens Engine Maintenance

Caribe Aviation

Space Power

Turbotech RepairsClaverham Group

Derco

Rzeszow

Great Lakes Turbine

IMI Marston Aerospace

Helicopter Support

Ratier-Figeac

Howmet Airfoil Refurbishment

Sundstrand

Interturbine Flight RepairP&W Klimov

H&S Aviation Overhaul

NordamPropulsion Systems

Dynamic Controls

Koor Carmel Forge

United

Technologies

Helitech aerospace services

Schweizer Aircraft

Keystone Ranger Holdings

Page Group

CTA

BAE Systemsfin actuation

BoeingRocketdyne

Lenel Systems JcAIR Test Systems

to Aeroflex

Avionics Systems to L-3

Engine ElectricalSystems to Unison

Hughey & PhillipsAirport Lighting

Marine Bearingsto Duramax

TRW Aeronautical Systems

Sensors Unlimited

Hella Aerospace

Dana Glacier Bearings

Air Science Engineering

Humphrey REMECAutoliv OEA Aerospace

Raytheon Optical SystemsCorning EO Sensors

Advanced Creations

IBP Aerospace

EDO BarnesBoeing ACES II Ejection Seats

ITHACO Space SystemsColtec

AMMI

Rohr

Gulton Mark IV

Lucas De-Icing

Sheldahl Hoskins Aviation Lighting

Technology Integration

Weed Aerospace

EmersonRosemount

Aerospace GE SpecialtyHeating &Avionics Power

Abex ClevelandPneumatic

Atlantic Instruments

ATIS Carbine

Universal Propulsion

Goodrich

Corrosion Engineering Services

EPD Container Solutions

Honolulu ShipyardSchunk Cercom

United StatesMarine Repair

Cell ITS

Bofors WeaponSystems

Kaiser Compositek

Barnes & Reinecke

Synectics

GEC

Tracor

Alphatech

Practical ImagineeringMaridan

DigitalNet

Piper Group

MEVATECAPTI

Heckler & Koch to mgmt

Advanced Systems Gaithersburg to IDT

Flight Training & Simulation to CAE

BAE Systems Canada to ONCAP/Onex

Siemens Plessey Electronics

Shorts Military Vehicles

GEC Marconi Electronic Systems

LM Aerospace Electronic Systems

Corbett Technologies

AWA Defense Industries

Imaging Sensors to Carlyle Group

Radomes to Cobham

BAe Australia military vehicles to Tenix

RO liquid engines to Atlantic Research

Space Systemsto Matra Marconi Space

Femtometrics

Watkins Johnson

CorporateJets toRaytheon

LM Control Systems

Camouflage, Concealmentand Deception to Saab Barracuda

Avionics to Meggitt

Condor PacificLand comms to Cobham

Ocean Systems toUltra Electronics

Atlas Elektronik to EADS/ThyssenKrupp Technologies

STN Atlas navalsystems stake

Alvis

STI Government Systems

EW Passive Expendables to Esterline

United Defense

GEC-MarconiBritish

Aerospace

Fin actuation to United Technologies

Aerostructures to Spirit AeroSystems

UnitedDefense

National Sensor Systems

Grimes Aerospace

Banner Aerospace Operations

Normalair/Garrett

Tristar Aerospace

Communications to Raytheon

Ocean Systems to L-3

Trimble Air Transport Systems

Mora Aerospace

Chadwick-Helmuth

Baker Electronics

Silent Witness

Quantum Laser

AlliedSignal Honeywell

Hermetic Aircraft to AAR

TCAS to L-3

DASA AirportSystems

Hughey & Phillips

Smiths FOG

Space & Navigation to L-3

Aerospatiale Canada to Thales

DuPont Lanxide Composites

GKN Hermetic Aircraft

LORI Heat Exchange

Northrop GrummanPrecision Products

ELAC-Nautik to AlliedSignal

Advanced Circuits to TTM

Advanced Composites to GE

ADS Australia to Raytheon

First Technology Safety &Analysis to HG Capital

Indalex Aluminum Solutionsto Sun Capital Partners

Hymatic Group

HoneywellAllied-Signal

Aerospace & Defenseto Boeing

Rockwell

Collins

Teldix

IP Unwired

Anzus

Evans & Sutherland simulation

NLX

Airshow

CommunicationSolutions

Kaiser Fluid Technologies to Tactair Fluid Controls

Rockwell Scientificto Teledyne

Kaiser Aerospace & Electronics

Sony Trans Com

Intertrade

Flight Dynamics

Hughes-Avicom

RockwellAutomation

Rockwell

International

United Technologies Microelectronics Center

Snecma

Grumman

SMA stake

Gear Systemsto Triumph

Vickers DefenceSystems to Alvis

Vickers TurbineComponentsto RBS Group

Bristol Aerospace toMegellan Aerospace

Rolls-Royce

SAIC Data Systems& Solutions stake

VT Controls

INTERING

BMW Rolls-Royce stake

Vickers

LucasVarity Geared Systems

Allison Engine

FAvS National Airmotive

Opto-Electronics

ALSTOM Gears

David Brown Group

Cessna Aircraft

Edwards & Associates

Drop Dies and Forgings

UEF Aerospace

Schlosser Casting

Pittler

Wyman-Gordon

Marconi OTE

Marconi Strategic Communications

Telespazio

AMS Italian facilities

GKN AgustaWestland stake

Forezio Aermacchi stake

Houston Associates

SVS

TDA Armament stake

Airbusstake

DynamicProcessSolutions

Get Electronique

Les Ulis naval andground to Safran Pacific Architects and Engineers

Savi Technology

ISXMagnet-Motor SafeViewTCS Design and Management Services

Defense Investment

Growth Indices

-20 0 20 40 60

Market Value of Equity Commercial Aircraft Sales

-20 0 20 40

Raytheon ThalesGeneral DynamicsBoeing EADS Northrop GrummanLockheed Martin Precision Castparts Safran TextronFinmeccanica L-3 CommunicationsATK United TechnologiesGoodrichBAE Systems Honeywell Rockwell Collins Rolls-Royce

Precision Castparts

-20 0Percent (%)

20 40

YoY percent change in Aerospace/Defense Major

Diversified Index

YoY real percent change in U.S. RDT&E and

Procurement outlays (Source: U.S. DoD)

YoY real percent change in sales of civil transport,

regional, and business aircraft (Source: Teal Group)

Military and secure comms to Finmeccanica



The 13 firms in the sample, and a detail

from CRA’s A&D restructuring chart.



Martin (LMT), Northrop Grumman (NOC), General Dynamics (GD). The median performer over the long haul was ITT (ITT), as it was, curiously, in each of the three shorter time spans over which I tested.

As is visually evident in the chart above, shareholder returns moved in three phases:

(I) From the end of the Kosovo campaign until 11 September 2001, during which all issues but ORB and RTN provided positive returns. Amongst the former, EDO and DRS provided returns of roughly 200 percent. I will relate the reasons for these two cases later.

(II) From 11 September 2001 until the invasion of Iraq, during which most is-sues provides large returns quickly, but then provided negative returns in the throughout most of 2002. Initial presumptions about a huge surge in US defense spending were deflated by the routing of the Taliban from the popu-lated areas of Afghanistan. The easy victory, many assumed, would preclude a large military build-up.

(III) From the invasion of Iraq until the end of the analysis period. Every single issue in the sample of thirteen provided positive returns in this period, though Cubic’s were lackluster (11 percent in total over 3.22 years), and Armor Holdings’s were particularly impressive (422 percent in the same time period).

Next, I quantified the degree of serial acquisitiveness. I did this rather bluntly, by





measuring the value of the acquisitions, less the top three acquisitions, to the overall ending value of the enterprise. I screened out the top three to remove the big-bang effect of deals like Northrop Grumman’s acquisition of TRW: while these are important transactions, I intended to test whether acquiring a large number of smaller firms would provide better returns than a relatively unacquisitive program. I further classified the firms by their ending market capitalization in order to judge their performance by size. Using the ending value for market capitalization could be criticized, but the results indicate that the approach only biased the effect to-wards larger firms, and against the thesis articulated above.

The result over the entire seven-year interval, as shown in the chart above, sug-gests that superior returns amongst US-based defense contractors, at least in the longer run, are connected with serial acquisitiveness and and small-to-mid-sized market capitalizations, which I have somewhat arbitrarily set here to mean any-thing less than $15 billion in June 2006. To test for a statistical difference between the performance of the firms that were serial acquirers, and the rest of the sam-ple, I used the Mann-Whitney-Wilcoxon test, a non-parametric evaluation as to whether two samples came from two different distributions. In this case, the test



[results]



result exceeds the 98 percent confidence level for differentiation. The result may not be authoritative, but it is certainly very suggestive.

I then tested the re-turns performance of the firms in the sam-ple over two shorter runs, intervals (1) + (II) and (III). Testing over intervals (I) and (II) separately seemed unreason-able, as the time in-volved would not necessarily be enough in which to capture the benefits

of an acquisition, much less a series of them. As shown in the chart above, over these first two intervals, the period between the end of the campaign in Kosovo and the invasion of Iraq, shareholder value did go on some wild rides.

That value, however, was not so strongly connected to the acquisitiveness, whether by smaller or larger firms in this case. In this case, I need not dis-tinguish between the acquisitive mid-cap and acquisitive large-cap firms sim-ply because there were none of the latter over this time span. There were more than few

strong financial performers, but several of them made rather few acquisitions, and for rather little value as a percentage of the firm’s total value. At the same time, at least one highly acquisitive firm, General Dynamics, dropped 16 percent of its





shareholders’ value. The company was then (as it is to a degree now) heavily in-volved in shipbuilding and armored vehicle manufacturing, but these were at the time supposedly the weapons of the Cold War. Overall, the Mann-Whitney Wil-coxon result at the 86 percent confidence level is not enough to lead us to a con-clusion about a short-run connection between acquisitiveness and shareholder value.

The third interval similarly shows dis-tinct share perform-ance behavior, as noted in the chart at left. However, as shown in the lower chart, performance had even less to do with acquisitiveness in this interval: the test provides just 64 percent confidence of a connection.

The same sample can also be tested, over these two time frames, for a link between shareholder value and simple ac-quisitiveness, whether by firms large of small. Over-all, as indicated in the table on the next page, the data in our admittedly limited sample suggest that superior shareholder returns correlate well to serial acquisi-

tiveness over the longer term (the generally accepted 95 percent confidence limit is almost met), but particularly well to serial acquisitiveness over the long run by smaller firms.





Time frame for the thirteen-firm sample

Test for superior re-turns and serial ac-

quisitiveness

Test for superior re-turns and serial ac-

quisitiveness plus mid-sized market capitali-

zation

Kosovo to Iraq (June 1999 to March 2003)

86%reject

86%reject

Iraq to Iraq +3 (March 2003 to June 2006)

47%reject

64%reject

Kosovo to Iraq +3 (June 1999 to March 2006)

94.95%almost accept

98%accept

With such a limited sample set, I next looked case-by-case at the five serial acquir-ers that performed best over the long run: ATK, CW, DRS, EDO, and LLL. As shown in the chart below, their shareholders experienced gains in seven years of at least 217 percent (representing a compound annual growth rate of 11.7 per-cent), and as much as 514 percent (representing a CAGR of over 26 percent).

These are thus five outstanding cases of arms makers which created shareholder value, but whether this value has been increased substantially by their acquisitions, and just how those acquisitions have contributed to this growth, are yet other questions. Is the network-centric thesis viable here, in an amalgam of scope effi-



Results of the Mann-Whitney-Wilcoxon

tests over varying time frames and firm sizes

Financial performance of the five most suc-cessful serial acquirers in the sample over the long run



ciencies and informational synergies, or has something more pedestrian, if just as economically valuable, been at work?

To get at this, we should peer under the hood, as closely as we can at least, at the specific acquisition campaigns. In the first example, ATK bought a few select firms to reinforce growing businesses with precision, composite, and hypersonic tech-nologies. The chart below illustrates at what point the companies were purchased as ATK’s returns to its owners rose.

ATK’s acquisitions were not completely homogeneous. Thiokol Propulsion diversi-fied the company’s activities into building launchers for space satellites, but Sport-ing Equipment merely brought new, civil ammunition customers to a company that already produced large quantities of similar products for military ones. Later on, the purchases of GASL, Microcraft, Mission Research, and PSI Group were in-tended to reinforce ATK’s hypersonics and space satellites businesses, but their long-term value to the company may be yet to be seen. For while it is difficult to correlate ATK’s shareholder returns to specific lines of expected customer spend-ing, the chart does indicate how ATK’s returns broadly match the rise in spending on munitions by the Pentagon in those categories in which ATK is competitive.

Curtiss Wright, as the next chart illustrates, engaged in a four-year, ongoing acquisi-tion campaign to reinforce its flow control and motion control businesses. Serious serial activity started just after the September 2001 attacks, and continued until the spring of 2005. The deal team was thus busy, and particularly busy with US companies, but hardly at all in what CRA’s database classified as the computing and electronics (C&E) sector. Rather, Curtiss Wright was busy buying up companies



[cases]



that make systems for aircraft and ships, which one might not expect to be the dominant growth sectors in the midst of a land war in Asia.

Similarly, DRS seems to have pursued acquisitions as an ongoing, periodic, corpo-rate development activity. The company purchased a wide set of companies, and considerably focused on US firms in the C&E sector. Acquisitions began earlier and ended later for DRS than for either ATK or CW. Acquisitions were also pursued not just when shareholders were doing well, but as the value of their investment was falling significantly in 2002. If nothing else, the pace indicates particular confi-dence within DRS’s senior management and deal team as to the soundness of their strategy and their judgement.





EDO was the most open about its objectives, noting in its 2003 annual report that its acquisition campaign was aiming at “diversifying the base of major platforms and customers”. Overall, the company was far less acquisitive in terms of the number of individual firms it bought, but it did buy rather larger entities — before it was acquired itself by ITT, another company in the sample. On its own, it is unclear what this indicates, but EDO’s example does not lend support to the network-centric hypothesis. Much of the company’s positive returns to shareholders were achieved in 2000, well before the large increases in military spending, when it won several important contracts for the supply of systems for military aircraft such as the F-35 Lightning II and the Eurofighter. The company subsequently purchased a range of firms with skills that were not obviously complementary to its own—save for Emblem Group, a British supplier of weapons release systems for military air-craft. While teasing out the effect of this purchase on the value of the company would be very difficult, the timing is graphically intriguing.

Finally, LLL has been the poster child for serial acquisition campaigns, treating ac-quisition as a defining corporate competency since its formation in early 1997. In the seven years in consideration, LLL undertook 57 acquisitions for roughly $2.86 billion dollars. Of those transactions, 88% were of primarily US-domiciled firms, and 57% of them have been in the C&E sector. LLL’s approach may be the most significant anecdotal impeachment of the network-centric thesis. This is not be-cause of what companies LLL bought, but what it did with them afterwards. LLL was designed and run largely as a holding company, a financial acquirer that sought out undervalued assets in defense contracting, making its money on a better un-derstanding of the domain knowledge of armaments than was possessed in the market as a whole. For years, this seems to have worked very well, though notably, since the death of co-founder and CEO Frank Lanza, the company has completely shifted gears, acquiring very little, and making some effort to integrate its holdings into more somewhat more closely organized business units.





Reviewing the patterns of acquisition in aggregate, it is clear that these five firms had quite different approaches strategically. Only EDO concentrated on acquiring firms in the C&E sector, but several of these acquisitions were of firms with sig-nificant positions as subcontractors in the Navy-Marine Corps Intranet program, an interesting place to want to be, and not one deeply embedded in tactical C4ISR systems. With some of its acquisitions, ATK was buying capabilities for precision weapons that it wished to develop, but even this is a bit afield from the network-centric thesis, as it was articulated above. Regarding the common success of these varying approaches, we cannot rule out the financial explanation: the possibility that the management of firms like L-3 are simply better are recognizing underval-ued assets than the average actor in the market.

CompanyIndex of returns

# of deals, less top 3

# in the C&E sector

% in the C&E sector

Cost in US$ B

ATK 317 10 2 20% 0.39

CW 331 21 6 29% 0.37

DRS 614 17 10 59% 0.36

EDO 376 6 5 83% 0.08

LLL 331 57 32 57% 2.86

Finally, we should consider the two relatively unacquisitive mid-cap firms with dia-metrically opposed results for shareholders, Armor Holdings (AH) and Orbital





Sciences (ORB). The gap in performance, illustrated below, is visually striking, and neither firm was remarkably acquisitive over the period of the study.

First, looking back even further in time, we may note that ORB performed poorly over the fourteen years preceding the endpoint of the study. The chart below shows ORB’s share price in US dollars, which is slightly more informative, but only because the company has never split its shares or paid a dividend.

From 1992 to 1997, ORB was a dedicated acquirer, pulling in some well known names in the space industry, particularly Fairchild, Magellan, and MacDonald Dettwiler. In 1998 and 1999, the value of the company’s shares twice spiked and





fell precipitously. In 2000, the share price relatively collapsed, and ORB’s manage-ment resolved to overhaul its strategy, refocusing the company on its original mis-sion of building satellites and light launch rockets. Almost immediately after the announcement of the intent to divest MacDonald-Dettwiler, the largest acquisi-tion, the company’s shares began recovering. Indeed, between that point and the end of the period of the study, ORB’s shareholders experienced a ten-fold return on their investment.

AH’s performance was spectacular, but only started after the campaign in Iraq got underway, and was substantially attributable to a single acquisition and burgeoning requirements for counterinsurgency kit. In particular, Armor Holdings purchased O’Gara-Hess & Eisenhardt in the middle of 2000, at a time when almost no one expected that ‘up-armored’ Humvees would be in such high demand. As shown in the chart below, Armor Holdings’ returns to its shareholders compare rather well visually with an index of the quarterly fatalities amongst US troops who were rid-ing in unarmored vehicles in Iraq.7 Only after its stock became so much more valuable did Armor Holdings begin acquiring companies and consolidating the mili-tary vehicles and armoring industries (before itself being acquired by BAE Systems in 2007). Thus, whether by particular prescience or just plain luck, AH’s returns depended not on an overall acquisition campaign, but with a single successful move.

While the sample set is small and the evidence still circumstantial, these seven case studies do suggest that systematic acquisition activity can pay off in defense con-tracting, with some conditions and caveats:



7 For more detail, see James Hasik, Professional Grade: A working paper on recent fatalities in military vehicles in Iraq and Afghanistan, 31 October 2006 (revision 3.1), available at http://www.jameshasik.com





✦ The long run matters. Financial returns to acquisition that outdo those of other defense contractors only appear convincingly in the seven-year view, and not in either of the two roughly three-and-a-half year views. This suggests that for all the repetition, in lists of best practices in acquisition, that integration begin immediately, time is required for the benefits to appear. It also suggests that either the financial markets as a whole were not valuing these acquisition campaigns correctly, or that the actual value of the acquisitions simply did not appear for several years after the firms were acquired. If the latter is true, the time horizons of the financial models that strategic planners use for evaluating acquisitions may need some elongation.

✦ It’s not how many, but how much may matter. Over the seven years of the study, L-3 made 51 significant acquisitions, Curtiss Wright 21, DRS 17, Alliant Techsystems 10, and EDO just 6. All performed well financially, but the com-mon thread was the value of the transactions (less their three largest) to the ending market value of the companies. This suggests that the lumpiness of the intake was not so important as the overall substance of what was being ac-quired. Whether the skills, technologies, or access to customers being acquired arrived in one company or ten, a certain volume was beneficial.

✦ There is no single path. The difference in the approaches to acquisition of L-3 Communications and Armor Holdings is wide, and in between lie Curtiss Wright, DRS, and EDO. All were successful companies and particularly, suc-cessful acquirers. More so, and somewhat in opposition to the preceding point, Orbital Sciences’ divestitures indicates that the right scope of activities is not necessarily ever-wider. It is notable that Orbital’s success only came after con-siderable disappointment to its shareholders, and in the end, produced less than a five percent return in fourteen years. All the same, its strategy was just as much a conscious effort at portfolio shaping as that of Alliant Techsystems or EDO.

✦ Management is a heterodox and limited resource. That is, several of the com-panies in the study concentrated their acquisition activities in a few industrial sectors that were particularly complementary to their own existing skills. L-3 Communications stands out as the singular firm that performed well while diversifying into a wide range of business segments, but its management team was specifically assembled for the purpose. As noted above, while Frank Lanza was in charge, the company relatively limited the integration of its acquisitions to horizontal efforts at shared services and common technological develop-ment. As he said at the 2001 Paris Air Show, “we don't want to be a systems integrator; there are enough of those in the world... we’re the Sears catalog.”8 While L-3 performed very well extending itself into a wide range of compo-



8 John Morris, ‘On the Record with Frank Lanza, Chairman and CEO, L3 Com-munications: Contrarian L3 Specializes in Specialization,’ Aviation Now, 20 June 2001.

[observations]



nent businesses, Orbital only thrived by returning to the knitting with its highly integrated products: satellites and their launchers. Moreover, it is notable that the larger companies in the original sample of thirteen — General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon — all underperformed the smaller firms. Whether the problem is one of scale or scope, it does pose an uncomfortable question about the limits of managerial attention in such large defense contractors.

So much for the observations. As did the earlier iteration of this study (as pre-sented in September 2007), this work does present some questions for further study:

✦ Can the benefits of systematic acquisition activity be sustained over the even longer run? This study favorably compares performance over seven years to that over three, and through several dissimilar secular political-military cycles. That said, it is unclear how long any particular strategy should be sustained, and I have not tested the ability of individual management teams to sustain the success of even adaptive strategies over time. This would be a methodologi-cally challenging question to pursue.

✦ Is acquisition necessarily a better strategy? While the emphasis of this briefing is on acquisition, the example of Orbital Sciences shows its limits. Portfolio shaping, after all, runs in both directions. Indeed, the most successful effort at portfolio management in defense contracting was probably that of General Dynamics’ great sell-off in 1993. Shares of GD returned 53 percent (including dividends) between 1 January and 31 December of that year, all while the company was divesting six significant divisions, including its missiles, electron-ics, and fighter aircraft operations.This is significant because at some point, large firms can become overburdened by the breadth of their activities.

✦ How do margins change as smaller firms are consolidated? Indeed, briefings at this and other conferences have observed that smaller defense contractors tend to achieve higher margins on sales than larger contractors. Since the ef-fect seems widespread, one may wonder whether this is attributable to some scale or scope diseconomy in defense contracting. Ceteris paribus, higher mar-gins lead to higher valuations, so we should be asking whether the margins of smaller acquired entities survive the acquisition process. Since the public re-porting of their financial data is lost in the acquisition, this would also be a methodologically challenging question.

✦ Is M&A really the new IR&D? Spending by defense contractors listed in the US on independent research & redevelopment (IR&D) remains historically low. Still, innovation continues, funded partly by customers and partly by entrepre-neurs. Acquiring innovative, entrepreneurial firms, then, can be both an ex ante and an ex post form of technological investment. The acquired organizations may obtain easier access to financing internally than in the capital markets, and future waves of entrepreneurs see acquisition as the liquidity events that spur



[questions]



their efforts. We might examine, then, which large contractors are doing this most effectively, and with which strategies.

✦ What are the organizational strategies that maximize the financial perform-ance of acquisitions in defense contracting? This view of the industry tests firms’ financial performance, but it does little to examine the reasons that one company’s acquisition strategy outperforms another’s over the long haul. As the preceding question regarding IR&D asks, acquisition may be spurring finan-cial success by providing access to important new technologies, but it may not always be the best approach for gaining this access.

This last question, of course, is the subject of a much longer study that I have al-ready completed, and that will be published this August.

James Hasik is a consulting business economist. He is Senior Defense Consultant to CRA International, and a member of the Council on Emerging National Security Affairs (CENSA). He holds an MBA (1997) in finance and applied economics from the University of Chicago, and is the author of the forthcoming Arms & Innovation: Entrepreneurship & Alliances in the 21st Century Defense Industry (University of Chicago Press, August 2008)





Retrospective on M&A Performance in Defense

Business

ma performance

existing programs

existing weapons

acquiring rms

smaller rms

better acquirers

strategic efcacy

strategic management