While the total value of mergers and acquisitions (M&A) in the aerospace sector may temper somewhat from the record $120 billion conducted in 2018, M&A activity remains strong in both the commercial and defense markets this year, a leading investment banker says.
Last year was marked by “some very large-ticket deals,” such as the $18.7 billion merger of Harris and L3 and the $11.1 billion Melrose acquisition of GKN, said Michael Richter, managing director and head of the aerospace and defense group for investment banker Lazard. “We’re coming off a very strong year in 2018.”
Lazard, which has been involved in more than $91 billion in transactions since 2013, has a number of deals announced in 2018 set to close, including Spirit AeroSystems’ $650 million acquisition of ASCO and Smiths Group’s $345 million buy of United Flexible.
Although the dollar value may not reach last year’s totals, the M&A momentum has carried into 2019 with nearly 130 in the works so far leading up to the Paris Air Show. “This is a rare time where all cylinders are firing in the commercial and defense sectors,” Richter said. “It is very robust.”
Some of these are high profile, such as Parker Hannifin’s $3.7 billion acquisition of Lord Corporation, he added. By late May the aerospace and defense announced M&A activity in 2019 totaled $8.3 billion.
Activity Drivers
Richter points to all-time-high order backlogs as helping to drive this activity on the commercial side. Order backlog exceeds 14,000 aircraft and some 38,000 are expected to be produced globally over the next 20 years. “We are seeing a lot of activity in the middle market as the supply chain responds to get stronger to the needs of the industry operating at rate,” he said.
These deals are important to OEMs looking to prevent dislocation of the supply chain, Richter added. “When you have a disparate number of mom-and-pop operators that are undercapitalized and under-managed, there is a greater risk of a single point of failure,” he said. “There is a desire to deal with a fewer number of better qualified and better-capitalized players. We still have a very fragmented aerospace supply chain, so the market is responding with consolidation.”
He acknowledged OEMs “don’t love” potential pricing issues that could arise from suppliers gaining strength and breadth in the marketplace. But the OEMs would “rather have that than another major dislocation in the supply where a $100 million jet order can be delayed because of a $20,000 part. There is a desire to have a stronger, more battle-hardened supply chain to be able to deliver at increasing rates of production.”
From the supplier standpoint, consolidation isn’t necessarily about survival but more about expanding their reach, becoming more competitive against larger suppliers and the OEMs themselves, solidifying resources in the face of workforce shortages, and gaining important capital to keep up with the investments necessary to maintain a higher level of production rates.
The strain to keep up with the swelling backlogs has been evident with the 737 Max production cuts, he explained. “[Suppliers] had a sigh of relief because they had a few months to catch up on this growing order backlog. That’s why you haven’t yet seen a major impact on the supply chain: because they were operating in arrears so significantly.” Eventually, though, suppliers will catch up and if the 737 Max is still not flying, the supply chain will begin to feel that pinch, Richter added.
Another key driver in the feverish pace of M&A is the availability of capital to finance the deals. A significant amount of capital is available from U.S. and international financial sponsors, global strategic buyers, sovereign wealth funds, and pension funds, he said, adding that they all are looking for a home in the aerospace industry.
Richter called the global aerospace industry “one of the single brightest stars in the capital goods food chain” and added, “It is still one of the best opportunities, and there just hasn’t been enough supply to satiate the needs; there are tens of billions of dollars sitting idly on the sidelines looking for a home.”
These pools of capital are competing to get an asset, driving volume and pushing prices well beyond expectation. “It is really a perfect storm because the debt markets are supporting financial sponsor participation at record levels in M&A. [Sponsors] are still able to get historically low-interest rates with minimal covenants. If they can get 6X leverage on a company with minimal covenants, that’s incredibly lucrative for a financial sponsor.“
Targets of Opportunity
As far as what is in demand, the MRO market remains in the spotlight, perceived as a sustainable cash-flow source that is more dependent on fleet sizes than delivery schedule. Richter also pointed to “USMs” or used serviceable material companies. These are attractive as airlines and operators look at more effective ways to source parts. “This part of the market is very vibrant as driven by longer-than-expected utilization of current-generation assets,” he said. “You think everyone is changing out to the newer platform but that is not necessarily what is happening.”
In addition, pilot training remains a focus of M&A activity, Lazard believes, as the global pilot shortage remains acute. In tandem, autonomy technologies are gaining increased interest.
On the defense side, companies are benefitting from stronger defense department budgets “that really have seen a movement away from the sequestration environment.” This is leading to ramp-up for large prime contractors and Tier 2 providers.
However, the top of the M&A “food chain” on the defense side includes companies involved in new technologies such as unmanned aerospace vehicles, cybersecurity, and sensors. “High-tech products are the ones sought after,” he said.
While Richter was hesitant to make predictions for the M&A market over the next few years, he did say, “I see no reason why there would be any change in the strength of the market in the foreseeable future. There are literally still hundreds, if not thousands, of companies in the [aerospace and defense] food chain that are extremely interesting from an M&A perspective. We see no shortage of assets to feed this beast.”
