Of course defense companies start consolidating after World War II, and then again in the 1970s after the Vietnam War. Many observers see industrial consolidation as a response to cyclical downturns in budgets corresponding with wars. In reality, defense firms have been consolidating all along, accelerated by downturns but not reversed in the boom years. Here’s a slice from Barry Watts’ excellent 2008 report, US Defense Industrial Base, Past Present and Future.
Companies increasingly recognized that non-defense markets—which were growing, exploited technologies to develop new products, produced better financial rewards and served customers with less monopsonistic power—provided more attractive alternatives to their defense businesses. One result of these perceptions was industry consolidation. During 1985–1988 ten of DoD’s top sixty prime defense contractors either acquired, or were acquired by, others in the industry.
It is notable that these major changes in the defense industry predated the collapse of the Soviet Union. In spite of the continued importance of the USSR as the major military competitor, by the mid-1980s many corporations appear to have concluded that selling to the government was so much in conflict with their responsibilities to their shareholders that their defense businesses should be divested or isolated within their portfolio. Moreover, managers appear to have begun adopting the modern management practices, which had the effect of focusing them more on the merits of their defense businesses as businesses and less on the value of building unique products or supporting national defense. The US government had made dealing with its departments and agencies so uncertain as to sales and revenue, so cumbersome in day-to-day operation, and so risky in terms of sharing responsibilities that the collapse of the Soviet Union only served to accelerate restructuring and consolidation processes that had already begun.
This is nice quote from the 1980s on how Wall Street views defense companies, a view that is all too painfully obvious today.
“If the defense industry is substantially more profitable than comparable industries with equivalent risks, why do defense stocks sell at a significant price/earnings discount to the SP 400? If the industry earns excessive returns, why do Wall Street analysts believe that any significant defense industry stock issue would have a large negative impact on the issuer’s stock price? With such profitable business to pursue, why have several companies used their cash to repurchase stock?” (MAC Group, Impact on Defense Industrial Capability of Changes in Procurement and Tax Policy 1984–1987, p. D-9).
Consider the valuation difference between Lockheed and the “sexy” new entrant Palantir. Lockheed had $59B in 2019 revenue with $8.5B of income. Palantir had just $743M in 2019 revenue and took a $576M loss. That’s like night and day from a financial perspective. Yet Lockheed’s market cap is just a little more than double that of Palantir ($95B vs. $43B). That’s why company valuation has little to do with income statements and balance sheets.
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