December 17, 2013
This past week Exelis, the former ITT Defense, announced that it would be spinning off its services unit, currently called Exelis Mission Systems, into a new, publicly traded, “global facilities, logistics and network services provider”. The soon-to-be-renamed Missions Systems will be a significant entity all its own, with 7,000 staff in 18 countries and about $1.5 billion in annual revenue. What remains of Exelis will then be focused as a "highly engineered C4ISR solutions and services company,” with about $3.4 billion in revenue.

We believe that the pending split of Exelis confirms a pattern we now regard as the initial wave of post-Iraq-war industrial restructuring: the separation of services companies from hardware and software companies. Several similar transactions establish the trend: Northrop Grumman’s sale of TASC to private-equity firms General Atlantic and Kohlberg Kravis Roberts (November 2009); Lockheed Martin’s sale of its enterprise integration group to Veritas Capital (October 2010), and of its engineering and support services business Pacific Architects and Engineers (PAE) to Lindsay Goldberg (April 2011); and, earlier this year, SAIC’s spinoff of Leidos. 

It’s no coincidence; there’s a multifold logic to these moves:

  • The business models of defense-services and defense-hardware are increasingly disparate, and the needs of strategic repositioning in both segments overextend management and resources.
  • The intensity of competition for IT services is ratcheting up from the progressive entry of still more commercially-based companies.
  • Customers have largely abandoned acquisition practices that envisioned the outsourcing of broad-scoped modernization ambitions to “large system integrators” who could weave services and hardware through a contract calling for “total system performance responsibility” 
  • Customers are more vigorously enforcing rules regulating organizational conflicts of interest (including its formulation of new rules in December 2009).

In an earlier era, these were just the kinds of businesses that provided the feedstock for consolidation. Speaking here at the Atlantic Council in October, Exelis CEO David Melcher said nothing, of course, about this then-pending announcement. But he did comment upon the recent popularity of share buybacks and dividend yields in lieu of systematic restructuring. The lack of certainty over future military spending in the US, said Melcher, has undermined confidence in valuations. “There’s really not much M&A going on,” he observed, "so this is the best use of cash in the eyes of the shareholders and the management right now.” That explains one reason why Exelis and its predecessors in this trend are separating rather than selling: there are no buyers at the price at which management would be willing to sell these businesses.

The impetus for the trend may be as simple as that. Or, it is just possible that the trend is more profound. What we are seeing may be the leading edge of the emergence of a more dominant form of large-cap defense contractor. Rather than a defense-conglomerate that stands ready to undertake every project that every defense ministry makes available, the new model may feature focus on specific competencies, customers, and core products. Seriously—how many companies with commercial customers build buildings, provide security guards, assemble aircraft parts, design communications systems, and repair trucks? That’s Exelis’ business today: slices of Bechtel, Allied Barton, Vought, Motorola, and Midas, all under one roof.

The only justification for that degree of diversification in a company focused on defense is a presumed set of synergies in serving a common customer, a rationale we find suspect. If focusing the portfolio is in fact the underlying strategic rationale for the announcement, Melcher and his team look to us like they're getting ahead of the next curve in industrial restructuring.

James Hasik is a senior fellow in the Brent Scowcroft Center on International Security. Steven Grundman is the M.A. and George Lund Fellow in the Brent Scowcroft Center.

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