L-3 Communications chief executive Michael Strianese heads a $16 billion aerospace and defence business that has evolved from a loose collection of acquired operating units into a more cohesive company that generates 70% of its sales as a "prime-level" integrator. L-3 has accomplished this feat without the perceived advantage of a leadership role on an F-22- or C-17-level acquisition programme, and, as we learned, that suits Strianese just fine for now.
How do you think L-3's company strategy has changed, as it's evolved from 1997 and the 10 original operating units that L-3's original chief executive, the late Frank Lanza, started out with to where it is today?
I was there too! [Strianese was a founding member of the L-3 executive team as the first chief financial officer.]
As I recall at that time, the strategy then was focused on the acquisition of technology leaders, and to grow that way. And, now, after 2006, it seems the strategy switched from the acquisitive growth model to an organic growth model. How do you think that transition has worked out?
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I think the transition was actually very timely. Let me go back. Around 2005 we had bought Titan, and after the acquisition of Titan our revenues had just got to about $10 billion. Prior to that point, we were growing 25% a year by acquisition. At $10 billion, a 25% growth rate would imply a $2.5 billion in acquisitions a year. Even Frank, who when he was here, we knew that acquisition model was going to shift from acquisition growth to organic growth. It just had to happen. Now we're $16 billion, and we're happy to add 5% from acquisitions, but there's no way without a major business combination that we would ever be able to get back to the growth rates for M&A that we would get for only starting out at $1 billion. So that model necessarily did change.
But through 2007 we probably had 13-14 acquisitions in that time period. I even surprise myself that there were that many. We never really stopped buying companies, but it's much harder to move the needle given the size of some of these acquisitions. In 2008 and 2009 we saw valuations cresting and we became defensive in terms of what we're willing to pay. Last year was the slowest for defence M&A in almost a decade. And that coupled with the breakdown in the financial markets I think was a good place to be.
How much further can you push vertical integration within the company?
I can give you a metric. In 2005, when I took over as chief executive, in our annual report we had 11 group presidents. Today we have five. There's been a lot of consolidation. It helps that we've been able to steadily increase margins every year. It's not only a vertical play like we've done in the soldier systems area with Insight. There's also been a theme that I've been advocating to our group presidents that I've been discussing collaboration - internal collaboration across lines of business.
Project Liberty is a great example of where that's got us. This is a sole source programme that included the integrated systems business modifying the airplane. But it included our Wescam EO/IR sensor, antennas - some from within the company, some not, our datalinks our communications systems segment, and other L-3 products, some avionics and the like.
So that's the type of collaborative work that I like to see where we can really put together a system, a solution, and not just sell black boxes a la carte anymore.
If you talk about our unmanned systems business, that came about because a few years back - maybe 2006 or 2007 - a couple of these UAV companies had sold at incredible multiples that we were just unwilling to pay because we didn't see a chance of getting a return on the investment. Internally it was obvious that we had everything we needed in terms of the sensors, the comm systems, the integration capability, avionics, automated take-off and landing, and an airplane believe it or not.
Instead of spending $1 billion to buy a company we invested our own research. And for a price that probably ran $10 million or $20 million we developed what's known as the EUAS - the expeditionary unmanned system - and won a prime contract last year with special forces. It just goes to show that we didn't have to spend $1 billion to buy a company. We had it in our own backyard. We just had to put a little bit of systems engineering and a little bit of R&D behind it and come up with a very disruptive product in terms of performance and price.
Looking at challenges now in the years ahead, US Secretary of Defense Robert Gates has been very clear the DoD model for services contracting for professional services and also for sustainment services is changing. L-3 has a big stake in that market. What do you see is the risk there and how do you manage it?
There are two areas of concern. One of them has been the insourcing trend. But again that hasn't really affected us in any material way. We've got pockets of people that have been transferred into the government. But there's a conflicting message on that. Secretary Gates came out just a couple of weeks saying that the DoD has to look inside to start to reduce overhead. Now transferring contractor services to the government with the cost structure in the government is higher than industry. That's a fact. It's not a way to save money. So I don't think this insourcing [trend] is going to pick up more steam.
But I can tell you this is watched very carefully. I know some other contractors have announced divestitures or made divestitures. Northrop's selling its TASC business. Lockheed Martin announced a couple of weeks ago that it would be divesting two businesses. We don't have such a divestiture coming as of this point. That could change if the way this is being applied changes. But right now I'm not concerned.
I will tell you an area that is impacting us is the transition of contract vehicles from a single contract vehicle to what's called an ID/IQ - indefinite delivery-indefinite quantity. So I'll give you an example we've got a programme called contract field teams that ran as much as half a billion per year. Rather than going to a single winner, that contract was broken into several task orders. And the way it was competed there were a number of qualified companies that made the cut.
Once you get qualified under this programme, every time there's a task order, you're allowed to bid it and it comes down to a price shoot-out every time. The effect of that kind of mechanism is to push margins down, and that is happening. So the margins have a bit of a headwind in services. Nothing that would cause me to decide we should get out of the business and sell it. But margins are going to come in because competition has certainly been increasing in that area. Even with our services group with revenues north of $4 billion, we still earn 9% margins, which is very respectable in this space.
What about the pressure on defence budgets?
The secretary has said a number of things about cost reductions inside and outside by the DoD. I think there's very little tolerance at the DoD about programmes that overrun [costs] and are late. There's much more of a tendency to cancel programmes that are not performing. I think last year in April we saw a list of programmes cancelled that were deemed "not needed or not performing". We do see a much more aggressive stance on those types of programmes.
On top of that, we do see we have this overhead reduction initiative. Up the road there should be a savings from this planned draw-down in Iraq. Between the programmes, the overhead, the draw-down, I would expect that to generate savings. I believe it's been articulated by the DoD, by the secretary, that savings would be used to put more teeth in, more modernisation on, the existing assets, which are badly needed. What does that all put to? The hope is that puts to about 3% growth - a couple percent above inflation. So real growth, which is a cause for comfort.
If I could invoke Frank Lanza again, I believe he was asked in 2000 what is the next thing that L-3 would buy, and I think he joked that maybe the next thing the company would buy is Lockheed Martin.
That's a sibling rivalry. We're friendly with Lockheed. Bob Stevens is a former colleague of mine from Loral. I see Bob regularly. The relationship couldn't be better. I don't think that we'll be stretching to buy a $40 billion company, although I think they're a great company. I don't think that would be a realistic goal for us. But again I like our space.
So has L-3 found its - steady-state is not the right word because you continue to grow - but is this the place you want to be in - not the Lockheed or Northrop Grumman place?
That's exactly true. I'm glad I don't have shipyards. I'm glad I don't have - we have hangars but I don't have tremendous production lines that will have to be dealt with. Look at the C-17. Or the F-22. Those are painful issues to deal with. I'm not trivialising it. You know, massive facility issues that will have to be rationalised at some point. Or the fact that there is no funding that I'm aware of for a next-generation fighter or bomber on the table. For us, we can stay flexible, and say for these platforms we know they are not going away.