When New York-based ITT announced on January 12 that it would split into three publicly traded companies, reporters rushed to hail the trend toward “de-conglomeration.” Despite the impressive success of multi-industry behemoths like General Electric and United Technologies, the prevailing view in the financial community is that investors would prefer to deploy their funds in pure plays — meaning single-industry enterprises. If that’s true, then other mid-sized conglomerates with stakes in defense like Textron might also be headed for breakups (ITT Chairman Steven Loranger was once heir apparent to the top job at Textron). That makes ITT an early test case of how the defense sector could rearrange itself in the current period of softening demand.
It may take the better part of a year before ITT Defense is renamed and begins to operate independently. But once it does, the $5.8 billion company isn’t likely to stay independent for long. It probably is being eyed by strategic planners at every big system integrator in the defense sector, because of its impressive array of forward-looking franchises in electronic warfare, tactical communications, sensors and technology services. Some of these business lines are hard to characterize, such as the NASA support contract that apparently also has a classified intelligence component. But there isn’t much doubt that in any other country, ITT Defense would stand out as a national treasure of security-related technologies. Only in America, with its gargantuan defense budget, does ITT look like a “mid-sized” military contractor.
The big question when bidders come calling will be valuation. ITT Defense has strong prospects even in a period of softening demand. However, electronics is the most competitive sector of the military hardware market, with half a dozen other players matching or surpassing ITT’s revenues. For example, it leads one of four teams competing for the Navy’s Next Generation Jammer program, and all of its rivals — BAE Systems, Northrop Grumman, Raytheon — are world-class companies. Similar cut-throat competition prevails in tactical communications, where there are too many solutions chasing too few requirements. As a result, ITT’s military sales have been relatively static in recent years despite the company’s capabilities, and bidders trying to knock down the price will point out it has been heavily dependent on war-related supplemental funding.
The good news for ITT is that defense secretary Robert Gates did not cut any of the company’s key franchises in his recent round of recommended budget reductions, and he increased funding for several near-term opportunities such as the jammer and Army battlefield communications. ITT Defense could actually grow revenues even as it is being spun off, and the floor Gates seems to have put under demand for military hardware will bolster the case for a premium from any bidder. With most of the big defense players cash-rich from a decade of strong demand and Wall Street counseling against diversification, ITT will look like an attractive acquisition candidate. The bad news, though, is that the government is borrowing $4 billion per day, the House of Representatives has been taken over by deficit hawks, and even Secretary Gates now concedes defense spending isn’t likely to grow in future years. So valuations won’t stay high forever.
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