A Deal Makers Balance Defense Gloom With Civil Boom
The Paris Air Show attracts not just buyers and sellers of aircraft and related equipment, but also the buyers and sellers of the companies that make them. The aerospace and defense sectors have been hotbeds of merger and acquisition (M&A) activity in recent years, and the bankers who guide and cajole these deals have once again flocked to Le Bourget.
Speaking to AIN ahead of the show, three leading dealmakers acknowledged that cuts in military budgets have created varying degrees of uncertainty among investors. On the flip side, the civil side of the business continues to be buoyed by strong order backlogs for airliners, although this situation is not without challenges.
According to Michael Richter, managing director and co-head of the aerospace and defense group with financial advisor and asset manager Lazard, M&A activity has been somewhat curtailed due to a lack of stability in the defense sector, with much of this caused by uncertainty over the U.S. government’s budget sequestration issues. “It would almost be better if the hammer [of military spending cuts] did come down and then companies would know what the future would be,” he said. “This has been a real damper.”
At investment bank Houlihan Lokey, senior managing director Anita Antenucci explained that defense companies are still waiting for the Pentagon to spell out revised budget priorities that were due to be published on May 31, but which have now been pushed back until at least early July. She indicated that the uncertainty has left prospective buyers, sellers and merger candidates uncertain as to how to proceed. “It [sequestration] clearly has an enormous impact on how companies proceed strategically,” she told AIN. “Investors [in defense companies] are saying ‘give us back the cash’ [that otherwise might have been invested in takeovers] through dividends or shares.” She added that only a few defense-focused companies have been successful in chasing other sources of income from related sectors such as homeland security.
However, David Baxt, global head of aerospace and defense investment banking at Jeffries International, expressed the view that equity markets have now largely factored in the impact of potential military budget cuts on share prices, arguably doing so in an “exaggerated” way. He added that shifting global security issues such as the threat posed by North Korea and the civil war in Syria serve as a reminder that defense needs don’t go away, but rather change. “The U.S. is still the world’s biggest defense spender, and while there is real concern over cuts in defense spending it will just be a matter of a shift in priorities to areas such as ISR and cyber [technology] to allow the military to do more with less,” he commented.
In Baxt’s view the long order backlogs in the civil airliner market are now posing their own problems for suppliers. While it suits the world’s dominant airframers to keep cash-yielding deliveries flowing fast, it doesn’t necessarily follow that it suits suppliers equally well to ramp up output rates with the investment spikes this requires. “It’s tough to run an industry with a five- or six-year backlog,” he said. “The supply chain just can’t keep up. It’s not that it’s not robust enough, but it’s reluctant to advance the build-rate. It’s a constant battle to try to increase [i.e. bring forward] delivery dates to move cash forward for OEMs.”
Baxt told AIN that he sees no let-up in the pace of new airliner sales. “Financing is only there for new aircraft. The pockets of capital for older aircraft don’t exist as much as they did,” he said. “The decision on the part of the operator to buy a new airplane has never been more secure. Boeing and Airbus are both overbooked [in terms of delivery slots] for 2013 and 2014. They could use a bit of softening [in demand].”
On the other hand, Lazard’s Richter maintained that the industry has proved to be more responsive to these challenges than might appear to be the case. “There has been huge progress over the past year in terms of improving the supply chain and significant consolidation, as well as simplified logistics and product delivery,” he said. Off the back of this trend, he predicted further M&A activity involving tier one, two and three suppliers.
Richter indicated that aerospace assets remain highly valued. “This [the strong order backlog] is a perfect storm located at a very strategic point in the aerospace cycle and investors believe there is plenty of runway left in the current cycle,” he explained. “We’ve gone from a boom and bust cycle to what I see as a super cycle.”
Antenucci shared his optimism. “The good news in terms of overall [company] valuations is that there are more buyers than sellers,” she concluded. “With the record backlogs and companies coming out of 10 to 15 years of strong performance the balance sheets are pretty clean and cash remains strong. One thing that will force further consolidation is that buyers want to use this to get their balance sheets to work better. So there is an opportunity that investors can’t ignore and with some [companies] wanting to be buyers realizing that they have to sell something first we will see a fair amount of asset swopping.”