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--- Begin Message ----Caveat Lector- Defense Firms Consolidate As War Goes High-TechBy Renae Merle Washington Post Staff Writer Tuesday, May 27, 2003; Page A01 The nation's leading defense contractors are gobbling up small technology firms in a consolidation binge driven by the Pentagon's demand that future military conflicts be dominated by high-tech warfare. The buying spree is contributing to a fundamental change in the structure of the defense industry as the top players move away from their roles as mere weapons makers and increasingly cast themselves as "systems integrators" that produce high-tech networks for the battlefield. In the past three years, contractors have swept up about 180 small tech firms, mostly in Northern Virginia, a 25 percent increase from the previous three-year span. In one recent high-profile case, General Dynamics Corp., which makes M1 tanks, bought Herndon-based Creative Technology Inc., which designs computer networks that transmit classified information. The Pentagon has pushed in recent years for a more intensive role for war technology, but the pace has accelerated with the proven high- tech successes in Afghanistan and Iraq and the demands of fighting terrorism. The rush to grab the premier small companies is sparking bidding wars and redesigning the landscape of the local tech industry -- a cornerstone of the region's business community that blossomed in the shadow of the dot-com revolution. Underlying the consolidation is the sharp competition among the big defense companies to secure a lucrative role in the transformation of the military envisioned by Defense Secretary Donald H. Rumsfeld and backed by a growing Pentagon budget. Some industry observers worry, however, that the absorption of the small tech firms into the giant contractors could crimp innovation in a field that thrives on swift advances. The companies attracting attention often work quietly behind the scenes, producing the technology essential to the new ways of war. Among the firms recently acquired are Alexandria-based Adroit Systems Inc., which writes software that instructs hovering drones to transmit surveillance photos to fighter jets, ships and ground stations; Chantilly-based Integrated Data Systems Corp., which develops software that allows the Pentagon to share classified information with other agencies on a secure network; Premier Technology Group Inc., a Fairfax firm that analyzes and disseminates intelligence for the Army; and Conquest Inc. of Annapolis Junction, Md., which specializes in managing information networks for the intelligence community. "Just 20 or 30 years ago, the airplane was the thing or the ship was the thing," said Stuart McCutchan, publisher of Defense Mergers & Acquisitions, an industry newsletter. "Now those things are just nodes in the network, and the network is the thing." The deals are more numerous but smaller in value than those of the last great merger wave, after the end of the Cold War. Contractors signed 65 deals last year valued at about $4 billion, according to the investment bank Houlihan Lokey Howard & Zukin. The industry is on track to beat that figure, with 31 deals signed in only the first four months of this year. Twenty-one were signed in the same period of 2002. In the early 1990s, defense contractors joined forces in several mega- deals that reduced the number of the industry's aircraft makers to three from eight; tactical-missile manufacturers declined to four from 13. In a typical year a decade ago, the total value of the deals was more than $10 billion. The most attractive companies today -- those in the secretive intelligence field or staffed by employees with top-secret security clearances -- are drawing bids far in excess of their earning power. But they might still sell for less than $100 million each. "Two years ago you could not get any of the big top 10 companies to look at anything under $1 billion. You couldn't get any of the big investment banks to look at anything under $1 billion. Now everybody is going after" these tech companies, no matter how small, said an executive at a leading defense firm. General Dynamics started its push into the information technology business in the late 1990s. At the urging of the Pentagon, the Falls Church-based company had begun outfitting its tanks, submarines and warships with the latest technology. The Army stopped ordering new tanks but spent millions upgrading its existing arsenal with digital capabilities, said Kenneth C. Dahlberg, executive vice president of the information systems and technology unit. "The new focus was on digitalizing the battle space," he said. As a result, General Dynamics decreased its reliance on technology subcontractors and started to buy small tech firms. In 1997 it paid $200 million for a unit of Lockheed Martin Corp. that specialized in defense technology. The same year it made two other deals. In 1998, General Dynamics set up an IT unit -- a novel concept in the industry at the time. The unit, established almost solely through acquisitions, is now a nearly $4 billion business and one of the company's fastest-growing sectors. Bethesda-based Lockheed Martin expanded its presence in the defense IT field in 2001 with the acquisition of OAO Corp., a Greenbelt-based firm. This month it acquired Orincon Corporation International. Lockheed, the maker of the F-16 fighter jet, also established an IT business council that includes the presidents of four of its business units to help it pursue contracts in the growing market. "This is an evolving market because the technology is very dynamic," said Jeffrey Maclauchlan, Lockheed Martin's vice president of financial strategies. "It is definitely a focus area for us as we execute our growth strategy." Raytheon Co., maker of the Patriot missile, is working on ways to further expand its IT business, a spokesman said. Last Monday, a spokesman said, the company grouped all of its information technology businesses into a single unit with more than $650 million in annual revenue. The competition for the small tech firms is so ferocious that the average price paid for a defense industry IT company in 2000 was six to seven times its earnings before interest, taxes, depreciation and amortization, or EBITDA, according to Houlihan Lokey. In recent deals, companies have demanded nine times EBITDA or more. It is not just the top-tier defense firms that are pursuing consolidation. The trend is playing out among the mid-level players that have less than $1 billion in revenue. ManTech International Corp., a Fairfax company with annual revenue of $500 million, bought Integrated Data Systems in February. Integrated, a high-end IT company that works almost exclusively on classified programs, sold for about $67 million, 13 times its EBITDA, according to the investment bank Aronson Capital Partners LLC. "Current valuations are generally up" 10 percent to 30 percent from levels in the late 1990s, said Robert Kipps, director of Houlihan Lokey's McLean-based aerospace and defense group. They are up "nearly 100 percent" from the post-Cold War period of the early 1990s, he said. "Military successes in Afghanistan and Iraq . . . have validated the criticality of technology to our military strategy and has buoyed the attractiveness of high-end defense IT providers." Some industry experts have begun to worry that if lumbering giants absorb too many small niche players, innovation could suffer. They are concerned that consolidation will wring out competition -- and without competition the fire for technological advance may be doused. "Will IT, like the rest of the defense industry, become solely the domain of the [giant firms] because all of the small contractors have been absorbed?" said Christopher Hellman, a senior research analyst with the Center for Defense Information. But many within the industry discount such concerns. Despite the accelerated rate of consolidation, there is little danger that all of the thousands of firms that make up the defense-related IT sector will be consumed, industry officials said. Many companies still refuse to sell, hoping that their future growth will bring a higher price later, they said. Others are headed by young entrepreneurs who are not ready to give up the helm. "There are frankly too many $50 million companies still out there," said Jon B. Kutler, chairman and chief executive of the investment bank Quarterdeck Investment Partners LLC. "They are large enough for their heads to pop up, but not large enough to have the efficiencies, balance sheets to be successful in capturing larger and more complex contracts." Consolidation could spur innovation if the deals create a capital- infusion used to fund new ventures, said Suzanne D. Patrick, deputy undersecretary of defense for industrial policy. "I am hopeful that the companies that can sell their ideas to the larger companies at a considerable premium will use that capital as start-up for the next company that they will found or the next idea that they will develop," she said. The Pentagon has another reason to support consolidation: It saves the government money. A recent Defense Department report found that 10 acquisitions completed since 1994 saved the agency $4.7 billion. Every contract includes the cost of a company's overhead, which can be squeezed if providers join forces, agency officials said. Still, the Pentagon recognizes the dangers of too much consolidation, Patrick said. "We also as a government have become very conscious of the fact that some of the most valuable pieces of innovation we have in the industrial base are embedded in these emerging defense suppliers," she said. When Raytheon bought Solipsys Corp. for $170 million this year, the Pentagon stepped in. Solipsys had developed technology coveted by the Navy that linked ship radar systems. In an effort to breed innovation, the Defense Department urged Raytheon to share the technology with its competitors for three years, and Raytheon agreed. Government intervention on mergers is typical in multibillion-dollar combinations but not for small deals, industry officials said. "It's unusual, but I think agreements like that might be more commonplace going forward as these companies attract the interest of large companies," Patrick said. "We know innovation typically comes not from the primes but from the second- and third-tier suppliers." © 2003 The Washington Post Company http://www.washingtonpost.com/wp-dyn/articles/A42090-2003May26.html ------------------------ Yahoo! Groups Sponsor ---------------------~--> <FONT COLOR="#000099">Get A Free Psychic Reading! Your Online Answer To Life's Important Questions. </FONT><A HREF="http://us.click.yahoo.com/Lj3uPC/Me7FAA/CNxFAA/vseplB/TM";><B>Click Here!</B></A> ---------------------------------------------------------------------~-> Please let us stay on topic and be civil. 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