Last month, ACG National Capital presented a “State of the Defense Industry” with Wall Street sell-side analysts for a discerning panel discussion.
Moderated by Randy Lynch of Bank of America Merrill Lynch, the panel included Edward Caso of Wells Fargo Securities, LLC, Brian Gesuale of Raymond James, and Stifel Financial Corporation’s Bill Loomis. Topics of discussion included government spending habits, the constant threat of sequestration, and current drivers of M&A activity.
Is the defense contracting industry experiencing any growth at all? According to Bill Loomis, it is.: “What you heard from other companies saying it’s a better environment is true; it’s better as in RFP’s are starting to come out,” Bill stated. “Proposals that were held up are starting to see movement again. We’re starting to see life in some past orders that were made a year or two ago, so I’m hopeful we’ll see more of those as we move to the year’s end.”
While Edward Caso also believes the environment is improving, he’d like to see new contracts awarded rather than just extensions and bridges to old ones. “If you want any hope of having organic growth you have to take away somebody else’s business. You can’t take someone else’s business unless there are new awards.”
Ultimately, some opportunities are disappearing as defense spending decreases, while new areas are seeing increased activity and presenting new opportunities for businesses.
When asked where defense spending was decreasing, Brian Gesuale pointed to the OCO (Overseas Contingency Operations) area. On the other hand, he believes that the cyber security space will continue to grow and evolve, “not only to combat enemies and adversaries over the next few years, but to also change the means from what’s been leaked to the press.” Diversification was also highlighted, with health care in particular experiencing a growth spike.
Although the current environment has offered its share of challenges, margins have been sloping upwards and – in some cases – reaching an all-time high. According to Brian Gesuale, this has a lot to do with new spending habits. “It’s not a steep trajectory, but we do look at maintaining a slight uptick. One driver is our new spending discipline, which has been far more disciplined than it has in the past. CFOs have done a great job at being nimble and cutting costs.”
Based on the discussion, the one certainty in today’s government contracting industry is uncertainty. Government uncertainty has changed the way most defense companies operate, especially when looking back at sequestration. When asked how to plan around it, Mr. Caso had some sound advice: be ready for anything. “We don’t get comfortable. You need to have an array of budgets: a base case, a not-so-good case, and a really bad case budget and work from there.”
When it comes to driving M&A activity in the defense space, it appears as though deals will be falling into a couple of broad buckets: strategic deals, where it almost doesn’t matter what you pay because you need the asset strategically, and very cheap deals, where you pay a low initial price and do a lot of fixing. Everything else falls in between. According to Mr. Gesuale, “there’s no singular catalyst; it’s more about ongoing visibility.”
Ed Caso believes that M&A activity will be slow among small business, which are really challenged at the moment. “Anything in health care, energy, cyber, and intelligence is going to remain on track.”
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