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US Defense Cuts Not Hurting Everyone
By James. H. Smith
October 3, 2005
Despite prognostications that proposed cuts in the US defense budget are bad
news for some companies, especially contractors manufacturing military
weapons hardware, it is business as usual for some defense companies
operating in information technology and other peripheral sectors.
The US Senate Appropriations Committee’s defense subcommittee recently
produced a US$440.2 billion defense spending bill for 2006. While the budget
is subject to change as it goes through the approval process and is rife
with the usual "pork", it still allows plenty of room for some defense
companies to proceed with ambitious expansion plans.
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Rating agency Standard and Poor's (S&P) on 24 September predicted that, “US
military procurement, research and development budgets will grow at modest
but sustainable rates.” S&P based its assumptions on the questionable need,
expressed by key Pentagon officials, for “huge arsenals of traditional
weapons systems” as the conflict in the Middle East basically involves small
terrorist cells. S&P predicts that long-term military procurement spending
will grow at average annual rates of 2 to 4 per cent annually.
What this means is that some companies, while continuing in an overall
expansion mode, may shift priorities beyond purely military products into
providing services to support military and homeland security programs.
That strategy is exemplified in the recently announced plans by New
Jersey-based DRS Technologies as they acquire Missouri-based Engineered
Support Systems Inc (ESSI) for about US$2 billion in a combination of cash
and DRS common stock.
Focused on defense technology, DRS, which had less than US$400 million in
revenues five years ago, develops and manufactures a broad range of mission
critical systems for the battlefield, radar, communications and surveillance
systems, and power supply units.
ESSI, on the other hand, supplies integrated military electronics, support
equipment and technical services focused on support for the US military,
prime defense contractors, certain international militaries, homeland
security forces and selected government and intelligence agencies, including
power generators, fuel-supply trucks, protective shelters, and water
filtration and perimeter security systems. The company's products can be
used after natural disasters, such as hurricanes to establish government
command posts and assistance centers. ESSI also produces specialized
equipment and systems for commercial and industrial applications.
While DRS is exposed to cutbacks in at-risk "legacy" programs, the acquired
company's revenue stream probably will not be affected by any paring down in
US defense spending.
California-based Science Applications International Corp (ESSI), which
provides scientific, engineering, systems integration and technical services
to government agencies, such as the US Department of Defense and Homeland
Security, as well as to commercial markets, is probably immune to defense
cuts.
SAIC expects to go public in early 2006 in an initial public offering (IPO)
that is expected to raise some US$1.7 billion. However, SAIC has yet to
indicate the number of shares to be offered or the price range but the IPO
will be underwritten by Morgan Stanley and Bear Stearns.
To say that the SAIC public offering is ambitious is an understatement. If
the IPO launches in early 2006 as expected, the exercise will have been
completed against a backdrop of several less ambitious offerings. To date in
2005, there has been only one IPO completed that was valued at over US$1
billion, that being orchestrated in February for Utah-based chemicals
manufacturer Huntsman Corporation - a company that has limited, if any,
exposure to the defense sector.
Also likely to go unscathed is Texas-based DynCorp International Inc, owned
by US private equity firm Veritas Capital. Veritas, which acquired DynCorp
in February from Computer Sciences Corporation for US$850 million, plans to
raise up to US$450 million from an IPO, according to documents filed on 29
September with the US Securities and Exchange Commission (SEC). That
offering includes an undetermined number of shares at an undisclosed price.
While the offering is non-specific, DynCorp will issue US$450 million of
Class A common stock, with proceeds earmarked to pay US$100 million to
holders of its Class B common stock, to repay certain debt, to pay certain
prepayment penalties and transaction expenses and for general working
capital purposes. CS First Boston Goldman Sachs, Bear Stearns, CIBC World
Markets, Jefferies Quarterdeck, UBS Investment Bank and Wachovia Securities
were listed as underwriters for the offering.
Computer Sciences didn't make a bad deal, having bought DynCorp in 2003 for
a US$570 million in cash and stock. DynCorp's immunity from the wrath of
Washington pencil-pushers stems as well from its non-involvement in military
hardware. While critics refer smugly to the US as the world's police force,
DynCorp fills that bill albeit under contract with the world's premier
super-power.
DynCorp operates a US$2 billion civilian police program in 12 countries -
including Iraq and Afghanistan - to train and offer logistics support to the
local police and assist with infrastructure and reconstruction.
In May 2005, the US Department of State awarded DynCorp a US$554 million
contract to aid in the eradication of illegal drug operations. DynCorp
intends to capitalize on the US government's increasing reliance on
outsourcing and increased spending in targeted end-markets, the company
said.
DynCorp posted a loss of US$2 million for the quarter ended 1 July, on
turnover of US$425 million, compared with net income of US$14 million and
turnover of US$407 million in the same period last year.
At 1 July, DynCorp was shouldering US$664.1 million of debt and had US$69.9
million of additional borrowing capacity under its senior secured credit
facility. While DynCorp has traditionally derived the bulk of its revenues
from the US government, the company is looking further afield. DynCorp has
been named as preferred bidder for programs in Australia and the UK.
DynCorp is optimistic about its future.
While it is good to be king, sometimes it is better to be the cop.
Disclaimer
James Smith is an independent columnist for this web site. James Smith may
hold long or short positions in any of the stocks mentioned in this article
and those positions can change at any moment.
InvestorIdeas.com Disclaimer:
www.InvestorIdeas.com/About/Disclaimer.asp, InvestorIdeas is not
affiliated or compensated by the companies mentioned in this article. James
Smith is a freelance writer. Nothing in the articles should be construed as
an offer or solicitation or recommendation to buy or sell any specific
products or securities. Past performance does not guarantee future results.
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