U.K.: Cutting a Larger Slice of the Sticky U.S. Defense Pie

Smiths Group PLC. of London doesn't build bombs; its machines detect them. Smiths doesn't manufacture expensive engines for jumbo jets; it sells the less visible (and generally more profitable) landing gear systems. Its largest business unit's U.S. headquarters isn't among the defense firms that encircle Arlington National Cemetery near the Pentagon, but rather is 650 miles away in Grand Rapids, Michigan, where it bought Lear Siegler in 1987.

In all, Smiths is low profile in a business--defense and aerospace contracting--that tends to attract the big and brassy. Some might say the company's last brush with prominence was a century ago, when it fitted the first British speedometer to the Mercedes of King Edward VII. As managing director John Ferrie, a Scottish engineer, understates it:"We're not the most recognized."

That's beginning to change. In the past 18 months Smiths spent $1.4 billion on eight acquisitions in the U.S.--five of those deals adding to sales in the arms and homeland security markets. The price may sound a bit low by the billion-dollar standards of the larger players in the military-industrial complex. But there's another $1.4 billion in Smiths' kitty, and few doubt it will go to more buys on U.S. turf.

Nearly all of Europe's leading defense firms are pressing for more U.S. military and civil business. Italy's Augusta Westland scored the latest contracting coup along with Lockheed Martin when the Pentagon's $1.5 billion award was denied incumbent Sikorsky (parent: United Technologies), of Connecticut. But very few have gobbled up as many U.S. companies in the past five years as spotlight-shy Smiths. Buoyed by strong sterling and motivated by a shrinking U.K. defense purse, Smiths has closed more than a dozen deals since 2000. The U.S. now contributes 57% of the firm's revenues.

Deficit-plagued Washington's checkbook remains open to military contractors. Not that this means easy pickings: Foreign ownership--either directly or through a U.S. subsidiary--means scrutiny over and above what a purely domestic buyer can expect. A U.S.President can use the threat of national security as a reason to suspend or prohibit any foreign acquisition, merger or takeover of a domestic company. The U.S. Department of Defense reviewed 53 such proposed purchases in 2004 and called for mitigations in 40% of the deals in order to reduce risks to and influence on national security. "The issue can add several weeks to negotiations," says R. Jerry Grossman, managing director of aerospace and defense at investment bank Houlihan Lokey Howard &Zukin.

After deals close, the paperwork doesn't end. Due to strict U.S. rules on military exports and technology transfers--it mostly fears leakage of advanced systems to China or other suspect users--Smiths must run a gauntlet of administrative exercises courtesy of the International Traffic in Arms Regulations (ITAR). The burdensome regulation governs the release of unclassified technology--and doesn't include exemptions, even for friends who marched with the U.S. in Iraq. In his first term President George W. Bush--like his predecessor, Bill Clinton--sought to make ITAR less onerous. But he has changed course. "We feel the burden of the rules," laments Ferrie, "every time one of our American businesses innovates and wants to share it with counterparts in our U.K. businesses."

Because of sloppy recordkeeping at the Pentagon and inconsistent reporting by contractors, no one knows the extent of foreign subcontractor activities, said a 2004 U.S. Government Accountability Office report. However, the report did peg a high-end estimate of the foreign subs' work at $10 billion in 2002, up from $2 billion in 1990.

Smiths is the fourth-largest supplier by content for the Northrop Grumman X-47B, a combat drone, including the vehicle management computer, remote interface devices, mission computers, ground-based data link computer and electric power generation and distribution.

Smiths also has a front-row seat for civil aviation's highly anticipated showdown between the soon-to-launch Airbus A380 and Boeing 787--it will supply to both models a combined $4 billion worth of parts, including landing gear, cockpit video-recording system and flight computers.

Supplying the top dogs has its perks, says Philip Finnegan of the Teal Group, a defense consultancy in Arlington, Virginia. Generally subcontractors like Smiths "earn better profit margins than primes in the aircraft business"; as a sub, Smiths can avoid the temptation of vertically integrating--a practice that, by creating captive suppliers, has distorted costs for prime aerospace and defense contractors, Finnegan adds.

Still, that can lead to relative anonymity compared with foreign-rooted "prime," or lead, military contractors such as BAE of Britain or France's Thales. Smiths was left off a recent ranking of the 25 largest U.S. defense contractors--not that it matters much to DavidKuckelman, vice president and general counsel, North America, Smiths Group, who helps arrange buyout offers. "I think we're 26th according to aerospace sales, and not many people generally think of us," he admits.

But Ferrie, with a doctorate in engineering, has left plenty of U.S. footprints. He joined Smiths in 2000 after 35 years at Rolls-Royce, including a long run overseeing operations of an aircraft engine plant in Indianapolis. His habit of improving the efficiency of Rolls' shop floors--under his watch he minimized the number of steps employees needed to take to perform manufacturing tasks by reconfiguring machines and exacting the spacing between them--underscores his distaste for waste. One of his first moves at Smiths was shedding $2 billion in non-core assets.

Since then he's been remaking the company with his acquisitions, part of a larger phenomenon of consolidation among domestic defense companies. Last year witnessed around 280 buyouts of U.S. firms; 190 were classified under defense and aerospace. In the government information technology services category 106 buyouts occurred, up from 45 transactions in 2001.Growing through acquisitions is becoming an expensive sport, and carrying too high a profile can prompt a target to drive up an asking price, says investment banker Grossman.

But even at relative bargain prices, American purchases like the ones Smiths has made carry not just regulatory risk: Further dollar devaluation would hit repatriated profits. Compared with 2003, Smiths' operating performance was adversely affected by the weaker dollar, which reduced sales by £140 million and operating profits by £20 million.

So far investors have shrugged off such anxieties, sending the stock up 31% from the end of 2003, tripling the appreciation of London's FTSE 100 index. Why not? In the same period, despite the dollar drag, earnings per share have climbed 110%.

If spending on arms and security continues to rise elsewhere as fast as it has in the U.S., from John Ferrie's perspective it may not matter so much what currency trouble that causes.

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