Globalization arrives at a crossroads

Market Watch | Financial views of a competitive environment

A number of recent significant cross-border transactions, regulatory actions, and domestic and international political developments have put globalization of government and defense into the cross hairs of the 2008 presidential election.

Of the $1.5 trillion in U.S. mergers and acquisitions activity in 2007, $444 million, or 29 percent, involved non-U.S. acquirers. That was up 90 percent from 2006. This activity is being driven by a weak dollar and reduced competition from private equity acquirers who rely on debt financing.

With the strong buying power of the euro, European firms are making a concerted push to purchase U.S. government and defense contractors.

Finmeccanica S.P.A.'s offer to acquire DRS Technologies Inc. for $5.2 billion is the largest acquisition of a U.S. defense contractor by a European firm — actually the largest defense M&A deal since Northrop Grumman's acquisition of TRW in 2002. The Italian government owns 34 percent of Finmeccanica.

DRS Technologies provides systems and services in areas of high national security. It appears Finmeccanica will obtain regulatory approval. The purchase is a substantial premium at 1.5 times revenue and 11.4 times earnings before interest, taxes, depreciation and amortization.

Two other significant M&A transactions involving United Kingdom buyers have now closed: Cobham plc's acquisition of Sparta and BAE Systems Inc.'s acquisition of MTC Technologies Inc. Again, a premium valuation at 1.2 times revenue and 11.4 times EBITDA.

In addition to the spate of cross-border deals in the government and defense industry segments, two other recent developments will also test U.S. policy-makers. President Nicolas Sarkozy of France recently announced the first major change in French defense policy in 14 years: to integrate France into the NATO command structure for the first time in 40 years and emulate the shifts in defense policy and strategy in the United States and the United Kingdom. The focus will be on a leaner French military with budget increases for intelligence technologies, homeland security and cybercrime.

If the French parliament approves these changes this fall, it will spur M&A activity on both sides of the Atlantic to integrate U.S. with French technologies and capabilities.

EADS N.V. and Thales Group could become serial acquirers such as BAE and Qinetiq Group plc.

Two major imperatives are feeding the globalization of government and defense activities. First, defense and security have merged as a result of the war on terrorism, and technology is the enabling factor fostering convergence. Cyberwarfare is an example of the convergence and the increased need for a global capability.

The other imperative is the need for multilateralism and sharing of post-conflict stabilization and nation-building activities.

European governments and the United States will increase the outsourcing of crisis management and peacekeeping operations to private firms that can operate globally.

The recent Government Accountability Office decision that the Defense Department erred in its biggest ever trans-Atlantic defense contract — the $40 billion tanker jet contract awarded to Northrop Grumman and EADS of France — exposed the tension between those who want to protect U.S. jobs and favor insulation from foreign influences and the proponents of globalization.

Thus, we are at a crossroads in the globalization of the government and defense contracting industry. The ultimate resolution of the tanker jet award, the regulatory handling of Finmeccanica's acquisition of DRS, the fate of Sarkozy's defense initiative and the political rhetoric in the U.S. presidential election could set the stage for the United States to integrate more closely its defense, security and stabilization efforts with its European allies and lead to more cross-border transactions. The result would be greater burden sharing, lower costs and heightened security for the world.

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