Few companies more than New York-based aerospace and defence giant L-3 Communications owe their existence to the consolidation frenzy of the last cyclical downturn in US defence spending. As part of the 1997 merger of Lockheed and Martin Marrietta, 10 unwanted business units were sold to the "three Ls" - Frank Lanza, Robert LaPenta and Lehman Brothers - to establish a budding conglomerate.
As a new cycle of flattening or declining defence budgets looms, L-3 chief executive Michael Strianese offered a peek inside the company's strategic play-book in a May interview.
"I would expect or anticipate some more rationalisation among companies where operations are less core," Strianese said. "I see more streamlining going on."
Strianese's words have since proved more prophetic than probably even he imagined.
On 22 June, activist hedge fund San Diego-based Relational Investors revealed it had acquired a 5.8% stake in L-3 and is now the largest shareholder. The fund's mandatory filing with the US Securities and Exchange (SEC) made its intentions plain. Relational Investors wants to break L-3 into smaller pieces - reversing a decade of rapid growth fuelled by acquisition.
L-3's management and board of directors does not appear to be fighting the kind of corporate restructuring favoured by Relational Investors. According to the hedge fund's SEC filing, recent discussions with corporate leaders suggest L-3's board and management want the same thing.
It may be part of a different approach that is evolving as the US aerospace industry responds to a new downturn in defence spending.
The previous cycle of steadily declining defence budgets drove a wave of consolidation at the prime contractor level.
"I'm not sensing there's that appetite," Strianese said. "There was a very different structure in the industry 20 years ago than there is today, as there were many, many, many more companies to consolidate. What you are left with are a handful of large primes, very few companies in the mezzanine space - only about three or four that I can think of - and a large supplier base - third-tier I would call it - which we have been consolidating but cautiously because of valuations."
Since 1998, US and global defence spending has galloped to historic highs. At the moment, the fiscal year 2012 budget request by the Department of Defense seeks a slight increase over this year.
Real declines in top-level defence spending are likely to begin in FY2013 and continue for several years. The DoD has announced plans to slash $400 billion from long-term spending plans.
How that changes the landscape of the US defence industrial base is still unknown, but some signs are clear. Strianese discussed one key difference several weeks before he became the target of an activist hedge fund.
"It's a different environment now than in the mid-1990s," Strianese said. "First of all the DoD has come out and said that they are really not in favour of consolidation at the prime level. So what do I see? We've seen some divestments actually."
Lockheed Martin spun off the PAE group and Northrop Grumman divested its shipbuilding business. Strianese also noted that ITT was splitting up into three companies. ITT's break-up happened only after Relational Investors acquired a major ownership stake, with the same intentions as with L-3.
According to Relational Investors, macro-economic issues, such as investors' fears about long-term earnings entering a cyclical downturn, are not primarily responsible keeping L-3's stock price below market averages.
Instead, the reason is that companies such as ITT and L-3 Communications should divest low-margin segments of their business. A smaller L-3 is more valuable to investors than its current form, according to Relational Investors' stock filing.
In L-3's case, two of its divisions have been struggling to maintain previous rates of growth. At the end of the first quarter, L-3 was forced to lower guidance on annual sales and operating margins for aircraft, modernisation and maintenance and government services.
Meanwhile, two other segments - command, control and communications and intelligence, surveillance and reconnaissance and special programmes - are growing more slowly, but still making progress.
Whether L-3 follows the course advocated by its largest shareholder is still unknown, as is the shape of the aerospace industry if a deconsolidation trend gathers momentum.
Strianese added: "One interesting point I'll highlight for you is if you look at the divestitures none of these companies have been acquired by defence companies. That should be indicative to you of a different mentality among defence contractors."
Source: Flight International
