September 8, 2011 / 5:20 PM / 9 years ago

Arms firms in strategic bind over cuts

WASHINGTON (Reuters) - Defense companies set to feel the spending ax under a recent U.S. debt deal are making urgent reviews of their strategic options — under pressure to find ways to secure growth in an overall declining industry.

Boards faced with the new budget reality are weighing the benefits of boosting growth through acquisitions and investments against returning more to shareholders, companies and dealmakers said at the Reuters Aerospace and Defense Summit in Washington.

The Defense Department is cutting at least $350 billion from previously projected spending. Additional cuts of as much as $600 billion could kick in if a congressional committee fails to find at least $1.2 trillion more in deficit reductions by year end.

But while there is little doubt the core cuts will lead to more restructurings, sell-offs and consolidation, uncertainty over the magnitude of any additional restraint means many companies may seek to avoid lurching too abruptly into further shake-ups.

“A lot of board meetings this fall and winter will really be strategic reviews of operations ... and what is the tradeoff between returning cash to shareholders today and investing for earnings in the future,” said Adam Palmer, who heads aerospace and defense investments for the Carlyle Group.

“We are looking to put our capital to work to make acquisitions, but are we making any large bets between now and November or December? That’s highly unlikely,” he said.

“I don’t believe there’s good visibility into what the budget is going to look like until the (congressional) committee finishes its process.”

Michael Urfirer, co-founder and CEO of investment bank Stone Key Partners, said companies are evaluating which segments of their portfolio have better prospects than others.

That could spur more spinoffs or sales of noncore assets.

“If I can’t be 1, 2, 3 in the market, why should I be in it? Some people are taking that basic philosophy very seriously,” Urfirer said.

“It wasn’t a rosy environment before then but a lot of changes have happened in the last 30 days,” Deutsche Bank (DBKGn.DE) Managing Director Greg Starkins said.

“Because this is going to drag out over the next couple of months to over one year ... everyone is going back to their board and rethinking their capital deployment plans,” he said.

Linda Hudson, BAE Systems’ (BAES.L) U.S. chief executive, said the company had been doing a “great deal of scenario planning” to be prepared for whatever may come out of the debt reduction review by U.S. Congress.

“I think it is important that we don’t just wait,” she said.

“We’re trying to read the tea leaves about the right place to put money, but I view right now as not the time to do something kind of bold and outrageous.

SHARE BUYBACKS: COUNTERINTUITIVE?

As defense industry stocks languish amid worries about severe budget pressure, prime defense contractors including Northrop Grumman Corp (NOC.N) and Lockheed Martin Corp (LMT.N) have been focused on returning cash to shareholders.

But analysts including Rob Stallard of RBC Capital Markets have questioned whether share buybacks are viable, given a 21 percent average drop in defense stocks in the past five years.

“In tough times what you really want to have is the strongest balance sheet you can find,” Stone Key’s Urfirer said.

“There is a lot of pressure from investors to return capital but at some point it puts pressure on your credit rating, it reduces your financial flexibility and it may put you in a position when strategically when you need the capital to do something you can’t.”

Carlyle’s Palmer said publicly listed companies need to respond to shareholders looking for returns, but it needs to be balanced with the industry’s multi-decade investment cycle.

“If you’re not making those decisions to invest, it might not be under the same executives’ watch but some point down the road you are going to have a large hole in your portfolio.”

“These proceeds that you’ve given back to shareholders are not on your balance sheet, so you are not either able to defend yourself in the storm or you’re not able to take advantage of when other companies run into issues,” Palmer said.

“So you watch companies increase share buybacks and dividends as the defense budget starts to decrease — that’s somewhat counterintuitive from a five-year investor perspective.”

Lockheed Martin Corp (LMT.N), which has returned more than half of its free cash flow to shareholders in recent years, is trying to strike the right balance between returning cash and doing acquisitions, Chief Executive Robert Stevens said.

“Our board meeting is coming up later this month and at that board meeting, I will review the capital structure with the board and we’ll talk about the varying merits of the repurchase program and the dividend program,” Stevens said.

COMMERCIAL AEROSPACE: BRIGHT SPOT

While defense giants are staring at spending cuts, commercial aerospace is enjoying a relentless boom driven by the replacement of old fleets and wealth in emerging markets.

“If you look at the backlogs combined with a lot of the new aircraft that are entering production, it’s tough to see anything short of a horrible external event that’s going to change a lot of the growth rates over the next two, three, four years,” Palmer said.

While that strengthens the balance sheets of the top players like cash-rich EADS EAD.PA, parent of the world’s largest jetliner maker Airbus, it could result in a shakeout among smaller suppliers as they try to keep up with rising rates.

Airbus and Boeing (BA.N) are talking to suppliers about extending their plans to raise output of workhorse narrowbody planes from already-record projected rates of 42 a month.

While the underlying reasons for growth are unlikely to go away, any economic surprises cold result in the pace of production increases slowing down, Starkins said.

France’s Latecoere (LAEP.PA), which supplies doors to both major airframe manufacturers, has already put itself up for sale and more are seen scouting around for buyers.

“There are smaller companies that realize the coming wave of production and they don’t have the capital to support that,” said Palmer.

Reporting by Soyoung Kim and Tim Hepher, editing by Matthew Lewis

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