The path that led to L3-Harris combo might explain some next steps

Since Chris Kubasik became L3 Technologies’ CEO in January, he has driven the company to recast itself as the U.S. defense industry’s “nontraditional sixth prime” through one key divestiture, a subsequent series of acquisitions and organizational realignments to push in that new direction.

Fast forward to Sunday: Kubasik and Harris Corp. CEO Bill Brown have done exactly that through a merger to create what will become “L3 Harris Technologies” if the deal clears the scrutiny of both antitrust regulators and the Pentagon.

L3 Harris is indeed set to be that sixth-largest prime at $16 billion in pro forma revenue behind the $25 billion General Dynamics bolstered by CSRA in April and in front of BAE Systems’ roughly $11 billion North American arm.

Both CEOs of L3 and Harris are touting in media interviews the same thesis many government IT and services companies have used in their own deals to bulk up quickly and re-position to gain a piece of the growing defense spending pie.

"There's definitely a need for greater investment, which requires scale,” Harris CEO Bill Brown told the Wall Street Journal Sunday. “We are in an environment where the economy is pretty strong, we know defense spending is coming up, the 2019 (federal) budget is up 3 percent over 2018, 2018 was up 9 to 10 percent over the prior year,” Brown separately told Reuters.

So how did L3 and Harris get to this merger of equals and where do they go from here?

Long and winding road

Both L3 and Harris have been equally aggressive as buyers and sellers of businesses to shape the companies they are today. And L3 itself is the product of a divestiture in 1997 of nearly 20 business units from Lockheed Martin.

When it comes to defense primes, L3 has been one of the most aggressive in exits from most government services work to focus on products and platforms. That includes the spinout of Engility Corp. in 2012, the sale of the former National Security Solutions business to CACI International in 2016 and this year’s sale of three aerospace services divisions to private equity firm American Industrial Partners.

After that aerospace sale, L3 went on a string of acquisitions this year to add new technologies and platforms that align with the U.S. national security strategy. The deals include a space company and another unmanned sea vehicle tuck-in to follow last year’s spree in that domain.

Harris Corp.’s recent M&A and divestiture history is just as windy and complex. In 2015, they acquired former rival Exelis that was also the product of a spinout from former parent ITT Corp. four years earlier. Exelis spun out its services business to form Vectrus in 2014. And Harris sold its IT services business last year to private equity firm Veritas Capital, which rebranded that business to Peraton.

Given that history, Technology Business Research’s lead public sector IT analyst Joey Cresta told me Monday to expect “leadership to look closely at the combined portfolio and look to shed pieces that may not match with the direction of the company.”

Brown himself said as such to Defense News, “given the diversity of the business mix we’ll have together. It does create the optionality for additional portfolio shaping.”

That in turn also creates opportunities for buyers to find assets. For example, General Dynamics is selling a citizen contact and call center business to Maximus amid the ongoing integration of the more mission and modernization-focused CSRA.

“Like what we saw recently with GD/CSRA, sometimes with consolidation of two large entities there may be redundancies, conflicts or units that aren’t core to the go-forward operation that could be divested,” said Bob Kipps, co-founder and managing director of investment bank KippsDeSanto & Co.

Given what L3 and Harris have already done, Kipps believes any “future divestitures likely won’t be very large.”

Scaling and shoring up

Perhaps what Kubasik told Defense News expresses the key rationale that drove the deal. L3 Harris will have scale and reach in over 100 countries worldwide with more ability to create integrated offerings, he said.

“So if we go domain by domain, you see the ability to better connect the different platforms to focus on the secured communication. I think we're well positioned for the multi-domain, command and control and communication systems,” Kubasik said.

Many government IT and services companies that have undertaken large M&A transactions see scale as helping spread their costs around a wider base of business, which brings costs to the government down and puts them on better footing to win larger, complex contracts. Product and platform companies are no different, according to Korn Ferry Principal Jon Barney.

“You can bring in more solutions to the government customer,” said Barney, who advises aerospace and defense companies. “It’s both a growth element in finding new opportunities by having a broader (and) more balanced portfolio, but it can also help you on the rate side too because you’ve got some scale.

“And when you see the competitors doing it too and moving in that direction as well, it becomes a key way to just be able to compete.”

Brown's comments in a Monday morning call with Wall Street analysts help illustrate that point of adding versus duplicating.

"There's negligible overlap of the businesses. We don't really often compete head-to-head going to the market and (at) a combined $16 billion, it's very, very small. There's less than $100 million of sales between us," Brown said.