By Loren Thompson
Published: 11 July 2011
Already saddled with the prospect of softening demand from its government customer, the nation’s defense industry now faces a new threat. Activist investors are stepping up the pressure on military contractors to bolster shareholder returns, even if that means abandoning strategies aimed at making companies more resilient for the long term. The spate of shareholder challenges to management teams and strategies has dispelled any notion that the coming consolidation of the sector will be a collegial affair in which like-minded enterprises reshape their portfolios. Instead, outsiders will continuously question company plans and performance, threatening to displace executives who don’t keep their share prices up.
The latest episode in this unfolding story came just before the July 4th weekend, when longtime corporate raider Carl Icahn disclosed that he had amassed a 9.5 percent stake in Oshkosh Corporation, the big military truck maker. Oshkosh faltered badly during the subprime crisis when demand for its construction equipment dried up right after the company had taken on massive debt to buy Wall Street darling JLG, a maker of lift equipment. The real-estate collapse then led to falling demand for the company’s fire trucks and emergency vehicles as municipal tax receipts plummeted. What saved the company from possible insolvency was the award of two big Army truck contracts in 2009, which boosted Oshkosh’s defense sales from less than $2 billion in 2009 to $7.2 billion in 2010.
That sounds like a positive for investors, but the first contract was a short-lived production run for the war in Afghanistan that is already winding down, and Oshkosh bid so aggressively for the more substantial second contract that now it looks unlikely the company will break even on the 23,000 trucks and trailers it must deliver. The stock had fallen 18 percent since the year began when investor Icahn burst onto the scene with his surprise announcement that he owned 9.5 percent of shares and would seek a meeting with management to discuss ways of boosting shareholder value. Other investors predictably piled into the stock, raising the share price markedly but burdening Oshkosh executives with a sizable faction of shareholders bent on realizing substantial near-term gains. That can’t be good news for a company still carrying a heavy debt burden from recent acquisitions and facing soft demand in all its major markets.
It isn’t so clear what Icahn’s game is with Oshkosh, since the company isn’t likely to fetch a big premium from suitors in its current state and any effort to break it up would impair economies of scale dependent upon integrated manufacture of diverse product lines. But what’s significant for the purposes of this commentary is that Icahn’s move on Oshkosh is just the latest in a series of hostile shareholder actions against military contractors that could significantly reshape the defense sector at a time when companies were already facing major challenges. Only days before Icahn’s disclosure, San Diego-based Relational Investors launched its own assault on L-3 Communications after amassing enough shares to become the biggest holder of the sprawling military contractor’s stock. L-3 has been steadily rolling up defense properties since it was first spun off from Lockheed Martin in 1997, growing to over $15 billion in sales last year.
However, L3 wasn’t the first big defense contractor that Relational CEO Ralph Whitworth had gone after. Last November, he proposed an outside slate of directors to pressure management at ITT Corporation, the White Plains, New York-based conglomerate that includes a sizable military electronics component among its various business lines. Whitworth argued that a weak outlook for military sales was undercutting the value of ITT’s commercial businesses, and that management should therefore sell the defense unit to enhance shareholder value. The company’s management responded to the pressure by announcing in January it would split into three companies, spinning off defense and fluid management businesses to shareholders in tax-free transactions. Company claims that a breakup had been contemplated for months and was not the result of investor pressure was greeted with skepticism, since senior executives had previously been discussing further diversification moves.
Relational Investors’ first foray into the defense sector — ITT has about $6 billion in annual military sales — was initially viewed as being about deconglomeration rather than the defense industry, and commentary about the move therefore focused on what it meant for other diversified industrial companies like Tyco and Illinois Tool Works. But now that Relational has gone after L-3 and Icahn has targeted Oshkosh, the story is taking on a different meaning. It appears that activist investors are focusing on the defense sector as an area of opportunity as companies adjust to the reality of declining defense budgets. Many of the biggest defense companies are generating strong profits and carrying billions of dollars in uncommitted cash, but the market is undervaluing shares because of what it fears lies ahead for military contractors. That sounds like a situation where sharp financiers might be able to make a killing.
Viewed through the lens of recent developments, it appears that the interest of non-traditional investors in the defense sector began in 2009 — not coincidentally, the year after military spending peaked in the final days of the Bush administration. That was the year that investor dissatisfaction with uneven results led to the ouster of Northrop Grumman CEO Ron Sugar and his replacement with a new leader committed to major change. In short order, the company sold a sizable chunk of its technical services portfolio, withdrew from a risky joint venture on aerial refueling tankers with the parent of Airbus, exited the naval shipbuilding business, and adjusted performance metrics to emphasize the efficiency with which capital was deployed over mere growth. All of these moves were aimed at enhancing shareholder value, a goal that has become the centerpiece of current CEO Wes Bush’s strategy for the future.
The Northrop Grumman changes don’t look like more recent moves because company management acted preemptively to address shareholder dissatisfaction before it could translate into outside pressure, but it is noteworthy that managers were willing to fundamentally alter the character of the enterprise in order to be more responsive to shareholders. In that regard, Northrop Grumman’s transformation resembles the bigger changes announced at ITT despite obvious dissimilarities. The subsequent moves on L-3 and Oshkosh confirm that shareholder activism will be a persistent undercurrent influencing defense managers as they seek to adapt to changing market conditions.
A related trend is the role that private equity is playing as big defense contractors reshape their business portfolios and sell under-performing or ill-fitting assets. For instance, when Northrop Grumman and Lockheed Martin sold off units engaged in providing highly classified services for spy satellites due to new conflict-of-interest rules, the buyers were private-equity firms. The significance of these buyers stepping up is that, like activist investors, players at private-equity firms typically hail from outside the defense sector and are looking for relatively fast returns compared with executives who have made their careers in military contracting.
It isn’t surprising that outsiders would be taking a closer look at the defense sector these days, because after ten years of steadily increasing military outlays, demand is softening and terms are tightening in a manner likely to generate investor frustration. In such periods of discontinuity, it is easier to convince shareholders that current management teams aren’t doing their jobs well, that strategies need to change, and that major strategic moves should be contemplated. The problem, though, is that the sector’s fortunes are being driven mainly by factors beyond its control, like receding military threats and a ballooning federal debt. So while activist investors may succeed in improving near-term returns to shareholders, that windfall could be bought by undermining the long-term success of the enterprises they target. However fashionable it may be to break up a conglomerate into “pure-play” businesses, something is lost in terms of financial resilience and flexibility.
For example, one company widely mentioned as a potential target of activists is Textron, the Providence, Rhode Island-based industrial conglomerate that builds everything from the V-22 Osprey tilt-rotor to smart cluster bombs. However, an examination of how Textron has fared over the last several years reveals different units performed strongly from year to year depending on market conditions, so that what constitutes an “under-performing” business depends on which year the question is asked. The fact Textron is a conglomerate has a lot to do with why it has been around so long, because resources can be shifted among business lines as circumstances require. That same logic helps explain the long-term staying power of companies like General Electric and United Technologies, both of which are major military contractors despite being focused mainly in commercial businesses.
Taken too far, the logic of the activists could largely dismember the defense sector during a prolonged downturn. Wouldn’t Boeing perform better if its surging commercial-transport business was separated from its under-performing defense business? Would Gulfstream serve investors better if it were a pure-play builder of high-end business jets rather than being wrapped in a defense contractor? And what exactly is the synergy between Northrop Grumman’s information and aerospace sectors? Once you start posing such questions, there’s no end to the mischief that activist investors might cause under the banner of shareholder value. At some point the government would probably step in to protect what’s left of the defense industrial base, but until that day arrives, the defense sector could be headed for a prolonged period of what economist Joseph Schumpeter called “creative destruction.”