Oil and water

Last week a lot of eyes were focused on a big M&A deal, Microsoft’s planned acquisition of Activision, and with good reason. The competition regulators are getting kinda silly, and are being called out for it. As they should.

But I was more focused on another deal, big in its own right, but which flew under a lot of radar screens. Forcepoint, a private equity-owned cybersecurity company, agreed to sell the government side of its business to another private equity firm for $2.45 billion in cash.

The deal might not have been quite as sexy as Microsoft’s $70 billion bid to grow its gaming business. But it did reinforce one of the most important points one needs to know before investing in the defense sector. And it offers lessons for some publicly-traded companies in the sector. Indulge me while we dive in.

Forcepoint has had a long, and at times rocky, existence. The company was founded in the 1990s and went public around the peak of the dot-com bubble. It survived, was acquired by Vista Equity Partners in the early 2010s, and Raytheon bought an 80% interest in 2015.

For Raytheon, the deal was a risky leap into a new, but adjacent, area. Raytheon has always stood out among prime defense contractors in that it didn’t make any of the big platform hardware that we think of when we think of defense primes. No tanks, no fighters, no battleships. They do missiles, communications, and electronics (to greatly oversimplify). This setup made them one of the nimbler defense contractors, but they also didn’t have the cash-cow programs others lean on.

Forcepoint was a way to generate new streams of revenue. Raytheon was already big in secure electronics, like battle-grade communications tech. The idea was to expand that military-grade secure communications to the nascent online world, and to then offer that caliber of tech to the private sector.

It never went as planned. Forcepoint for years struggled inside the Raytheon portfolio, usually viewed as the laggard with potential. Raytheon sold the business to another private equity firm, Francisco Partners, in 2021 following its big merger with the aerospace arm of United Technologies.

Francisco continued to manage Forcepoint following the same logic that Raytheon had applied. It is hard to say for sure how it was going, as Forcepoint is now a private company. But the latest deal would suggest (to me) that the results were not overwhelming.

I’m not surprised. For as long as defense contractors have existed, there has been some temptation to apply their expertise and know-how to the private sector. It has hardly ever worked out. Forcepoint, in separating out the government from the private, appears to be the latest example.

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One of the first thing defense sector investors need to understand is selling to the government is perhaps the primary core competency of this industry. Especially in 2023, with the technology available, anyone can design a boat or a helicopter. And a lot of companies can build them.

But the government is no easy customer to sell to. Process is their valentine, as the saying goes. Government procurement offices are required to follow byzantine routines set up with noble intentions, like making sure the taxpayer isn’t ripped off and making sure all potential bidders get an equal chance. But the net result is a confusing web of chaos.

The companies that rely on the government for all or most all of their revenue know how to navigate through that chaos. Or at least know enough to not be totally caught off guard. It is a strength that makes it very difficult for outsiders to penetrate the government contracting space. (Just take a look at the mess that Microsoft and Amazon stepped into trying to contract with the government.) Alas, few private sector companies do business like the government does. And when these Beltway insiders try to go out into the commercial world, they are equally befuddled.

Boeing is a rare exception, with its commercial and defense operations, but Boeing has also been a headcase for years in no small part because of the many different competing cultures contained within. Boeing keeps its defense and commercial businesses rather separate. But management often has a difficult time jumping from one side to the other or overseeing the combination. There have been some very high-profile, and tragic, examples of the mismanagement on the commercial side. Less appreciated is the mess that is Boeing Defense.

One of Boeing’s flagship defense projects, an Air Force tanker with a bidding process that resulted in the incarceration of Boeing executives, came in years late and billions overbudget and when the planes were finally delivered, the Air Force discovered debris left inside.

It has been tried many times before, from startups to the world’s largest defense contractor. History tells us, as Forcepoint has discovered, the walls that separate doing business with the government and doing business with the private sector are near-impossible to break down.

So, what’s the takeaway for investors? There are a handful of publicly-traded companies trying to walk this tightrope today. Whether the attempt is a dealbreaker is up to you, but it is at the very least something to be aware of.

Booz Allen Hamilton, a Beltway bandit (disclosure: I own stock in BAH. I don’t know if you should, and I’d never tell you to buy it), has a small but growing commercial consulting business dabbling in health care and other areas. Booz Allen management largely treats it as an afterthought, as do I. But if the day ever comes when Booz Allen is trumpeting the work at the start of their earnings call, you will probably hear me screaming from wherever you are.

Then there is Palantir. The data analytics brain that helped find Osama bin Laden. In their most recent quarter government accounted for 55% of Palantir revenue, and it is growing faster than commercial (20% year over year vs. 15%). But Palantir has spent a lot of time emphasizing the potential of its commercial business, and for good reason.

For all the benefits of being a government vendor (reliable payments, good visibility), they tend to be slow and steady, not sexy and overnight successes. Commercial companies don’t have all of those reliability benefits, but they do have the potential to grow much faster because there is a whole world of potential customers out there instead of just Uncle Sam.

Booz Allen shares trade at 1.6 times sales. Snowflake, a commercial-focused data analytics company somewhat similar (but admittedly not the same) as Palantir, trades at 25.6 times sales. If you are Palantir, commercial looks pretty attractive!

I’m not offering judgment on either valuations. To be honest, I own both stocks. Right or wrong, both Booz Allen and Snowflake are valued based on the market’s perception of their growth potential. And clearly, there is more growth potential on the commercial side. That’s the way it works.

Palantir is valued at 17.4 times sales. Sorta in the middle, which also makes sense given its revenue is 55/45 government. I guess. But even if you accept some premium is justified (and I will accept that), the ratio is way off relative to the revenue split. And again, government has actually been the more reliable grower.

Regardless, that multiple indicates the market is expecting a lot of growth from Palantir in the years to come. A lot.

The government won’t be the source of most of that growth. It just can’t be. The Pentagon doesn’t let anyone corner the market, or dole out a majority of new business to just one vendor. And there is only so much work out there to be bid on by the government. Palantir is trying to spread its wings internationally, which makes sense, but the U.S. government is pretty picky about the markets where this advanced tech can be sold. And the United Kingdom government plays by most of the same rules as the U.S. government does.

I fear that the only way Palantir can meet the market’s expectations and justify its valuation is if it is able to defy the laws of physics that has done Forcepoint and so many others in, and figure out how, as a seller to government customers for most of its history, to have success selling to corporations.

It is possible they will. And hey, I have been wrong plenty of times before. But investors who are betting heavily on that outcome should at least know the history. As Raytheon and the smart money that followed discovered, the government to commercial crossover is no sure thing.

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