Sequester Fears Paralyze Would-Be Wave Of Defense Acquisitions

On the eve of the international Farnborough Airshow, a prominent aerospace and defense analyst says there is a wave of investment ready to pour into the defense sector – but investors are “paralyzed” by the unresolved threat of sequestration.

“A lot of people in the industry and a lot of investment capital outside the industry are circling opportunities right now,” said David Fitzpatrick, managing director at consulting firm AlixPartners, where he heads the North American aerospace and defense practice. “In the fall or maybe next year you’ll see a lot of activity” – once Congress finally resolves, one way or another, the automatic cuts to both defense and domestic spending that are due to take effect on January 2nd. Until that’s settled, “they are all sitting on their hands and their wallets,” he said in an interview with Breaking Defense. “The whole system’s pretty much paralyzed.”

Why would anyone want to invest in defense companies, whose government customers in both the US and Europe are cutting back sharply even if sequestration doesn’t occur? AlixPartners’ own annual industry outlook report – timed for the build-up to Farnborough – clearly states that commercial aerospace is coming back strong from the recession while the defense sector lags. But the report and Fitzpatrick draw a further distinction within defense.

Traditional programs to build “platforms” – ships, tanks, planes – will suffer “slowdowns and lower unit quantities for many years to come,” Fitzpatrick said, although he expects most governments to avoid outright cancelling major programs. But Fitzpatrick predicts growth in the electronic systems that go on those platforms, and “double digit growth” in cyber-security in particular. Those are the subsectors of defense that can attract investment, Fitzpatrick said. Those are also the subsectors with a lot of smaller, innovative firms: small enough to be affordable for investors to buy, innovative enough to be worth buying.

In particular, Fitzpatrick highlighted three areas:

First, he said, “anything that’s going to help defend and extend the capability of the aircraft carrier battle group” is worth a serious look, he said, given the Navy’s concern about “anti-access / area denial” threats to its crown jewels and its commitment to the “AirSea Battle” concept.

Second, Fitzpatrick went on, “if the US does liberalize its satellite technology export rules – which is kind of a long-overdue thing – there could be some interesting growth there.”

Third, “we’re in the Model A days of secure electronic communications,” he said: No one’s yet invented the cybersecurity equivalent of Ford’s Model T, a successful standard approach that the whole industry can follow.

“You don’t have to be a gigantic defense bureaucracy to be relevant in that space,” Fitzpatrick said. Though the traditional prime contractors – big companies like Raytheon, General Dynamics, and the giant of giants, Lockheed Martin – all have electronics and cyber divisions, they don’t dominate the electronic systems subsector the way they do the manufacturing of ships, tanks, and planes. Cybersecurity in particular is “fragmented,” with countless smaller firms.

“They’re smaller, they’re more nimble, they might have a technology that they can develop much more rapidly” without the institutional inertia and overhead of the larger companies, Fitzpatrick said. On the downside, “the small guys though oftentimes don’t have the business and program management functions that allow them actually to connect quickly and effectively with the defense procurement community.” That makes them ripe for partnerships with more established firms – or outright acquisition.

Zachary Lemnios, the deputy assistant secretary of defense for research and engineering, has publicly worried that such mergers might kill the goose that lays the golden egg by stifling small-company innovation in big corporate bureaucracies. That’s a concern, Fitzpatrick admitted, but only to a point. “Companies are born and die every day, that’s the normal process,” he said. “What you do worry about is companies that survive but lose their innovative capabilities because they’ve been absorbed by a company that doesn’t understand them….Wise buyers will try not to over-manage these new assets.”

Like many other analysts, Fitzpatrick didn’t foresee any comparable consolidation among the first-tier prime contractors, which were already winnowed down in the 1990s. Those big firms will soldier on, he said, despite the downsizing – and despite pressure to reform defense contracting. “You can get 14 percent profit on a good day on a cost-plus contract,” he said, better than almost anything in commercial aerospace, and he doesn’t expect cost-plus to go away. “I’m a cynical old guy,” he said. “I’ve seen, I guess, three cycles now of handwringing and ‘we’ve got to go to fixed price contracts.’ [But] the government never follows through effectively.”