A marriage of convenience

Jon Kutler

Special to Washington Technology

The conventional wisdom is that the defense industry's future is as assured as the battlefield successes of the U.S. military in Iraq.

But much of the defense budget increases are for operations and maintenance, not procurement. Even within new spending, a rising tide of defense funds will not "float all boats" equally. Much of the sector's gains will be disproportionately focused on programs associated with the "poster children" of the war effort, such as unmanned vehicles, smart munitions, intelligence-based systems and sensors and the infusion of information technology onto the battlefield.

As contractors move to position themselves in these higher growth areas, many are turning to the traditional answer of mergers and acquisitions. Because of this, the industry has seen a dramatic increase in valuation spreads between "average" defense properties and those in key program areas.

But there is another?though less traditional?way for defense companies to pursue growth: Join the venture capital pool. By acquiring smaller firms with promising technologies, defense companies can help those firms tap into the Defense Department and other federal funding sources.

Defense companies, however, have not taken advantage of non-traditional methods for growth in the past. In 1993, for example, President Clinton touted the idea of defense spin-offs, believing the technology that won the Cold War could be adapted to solve other ills. But the funding for the Technology Reinvestment Project was small, and the projects generated relatively little revenue or growth.

Defense technology spin-offs surfaced again in the late 1990s during the commercial technology bubble as defense companies looked for ways to mimic the huge financial gains achieved by commercial technology start-ups. But for the most part, defense spin-offs were not successful, and so acquisitions remained a primary driver of growth for the defense companies.

Given this history, no one should be surprised that defense companies have been slow to embrace another non-traditional method for growing, such as buying young companies with promising technology but no track record.

But this is a potentially huge opportunity that should not be ignored. That's because the pools of traditional venture capital funding for these small companies have dried up at the precise time the government has declared a strong and growing need for innovative new technologies to support homeland defense and asymmetrical warfare initiatives.

Hundreds of small commercial companies have re-engineered their business plans because they see the Pentagon or Department of Homeland Defense as their financial saviors. Unfortunately, many companies entering this market have little understanding of how to compete or get access to federal funds, and they lack the financial resources to stay afloat during the long gestation period of government contracts.

One of the core competencies of any large, successful defense company is its ability to track and access federal funding?a skill many of these small commercial companies lack. Consequently, by acquiring these smaller firms, defense companies can help them bring their promising technologies to market.

The problem facing defense companies is this: While they have become quite comfortable valuing and acquiring other contractors, they have not learned to value small technology companies, especially ones that have not yet produced revenue.

This is a model, however, that has been successfully employed for years by leading commercial technology companies such as Microsoft Corp., Intel Corp. and others to plant inexpensive seeds today that generate tomorrow's growth.

It will take a while for defense companies to embrace this model. Just like commercial giants, it is important for large defense companies to carefully search for the few gems found in a large pile of opportunities. They should structure a transaction to mitigate risk.

They cannot, however, achieve this benefit unless they once more step out of traditional models of valuation. A decade ago the industry similarly balked at the value creation potential of embracing synergy-based valuation metrics and creative financial structures, yet it led to a profitable wave of industry consolidation.

If the lessons of a decade ago are to be our guide, it will not be easy. It is likely that this process will begin, as did the last one, with the actions of a few prime contractors who have the size and vision to test new practices.

Even with increasing defense budgets and an incrementally transformed procurement process, the defense community no longer has the monopoly on technology development it once enjoyed.

It will, over time, be forced to further marry commercial research and development into its unique knowledge of system integration, customer requirements and funding. The defense companies that survived the successful end of the Cold War did so through evolution.

In boardrooms across the defense industry, the recent U.S.-led victory must be viewed as a reward for prior preparation, not a mandate for the status quo. The leaders of tomorrow will be those that embrace change early.

Jon B. Kutler is founder and chief executive officer of Quarterdeck Investment Partners LLC, an investment banking firm serving the global aerospace, defense, and federal information technology industries. It is a wholly owned subsidiary of the investment firm Jefferies Group Inc.

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