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June 29, 2020 | Local, Aerospace

After The Shock: Implications For M&A In The Aerospace & Defense Market

By Adil Khan, Jim Adams and Steve Beckey Forbes; KPMG Contributor

Jun 23, 2020

The current economic disruption—coming on the heels of the 737MAX suspension—has varying impact across A&D segments. The impact on commercial aerospace has been immediate and extensive, while the defense sector has largely remained unscathed. However, it is hard to see how it will remain so, given the extensive fiscal measures being taken. What will this mean for M&A in A&D? Some trends are beginning to emerge that will affect the entire deal life-cycle (from deal strategy through integration and value creation). Yet, as in other times of economic disruption, new opportunities will emerge, which leads us to believe that the slowdown of M&A activity will be short-lived. As we enter this next phase, deal makers who adapt quickly to the realities of the new industry landscape could be well positioned to maximize value.

Pre COVID-19 environment

Not too long ago, commercial aerospace was booming, with year-over-year ramp ups in build rates and record backlogs. There were expectations of another golden decade — further extending the unprecedented 14-year “super up-cycle”, defying the long-standing cyclicality of the sector.

However, in 2019, the historic correlation between GDP, air-traffic growth, carrier profitability, orders and build rates was suddenly disrupted. GDP and airline profitability levels remained relatively healthy, but new orders and build rates dropped as the industry grappled with the 737MAX shock, as well as a slowdown in the twin-aisle segment. Other undercurrents also emerged — slowdowns in world trade from escalating tariff tensions, weakness in high-growth geographic markets such as China and India, and declining consumer confidence.

In contrast, U.S. defense spending was on the rise, averaging 4 percent1 annual growth over the past 5 fiscal years; the $738 billion FY2020 defense bill2 ensured this momentum would continue. The government services sector was also set to benefit from continued funding increases to modernize IT infrastructure and address evolving national security challenges.

With general confidence in the long-term fundamentals of the sector and a favorable budgetary environment, players in certain A&D segments pursued M&A to build scale. Others “re-realized” that content matters and initiated vertical and horizontal integration strategies to capture more value and drive cost competitiveness, or acquired targeted niche capabilities and emerging technologies. We also saw the emergence of Super Tier I's through scale-driving consolidation aimed at broadening capabilities and potentially exerting greater influence on OEMs.

Deal volume in the A&D sector reached record levels — almost doubling over the last 5 years and outpacing the broader M&A market by 40 percent.3 Valuations remained elevated on the strength of high bidder interest, limited supply of attractive assets, high A&D stock valuations (which outperformed the S&P 500 by 8 percent),4 as well as healthy balance sheets and strong cash positions. TEV/EBITDA multiples for A&D transactions averaged 11x,5 outpacing increases in the overall M&A market. Although, deal volumes moderated in the second half of 2019, amid elevated uncertainty about defense spending heading into a presidential election year, the overall outlook remained optimistic.

COVID-19 impact

COVID-19 caused a precipitous collapse in air traffic. With travel restrictions and stay-at-home orders, carriers around the globe made unprecedented cuts to capacity, idled fleets, and began deferring or canceling new aircraft deliveries. Also, the MRO (maintenance, repair, and overhaul) and aftermarket segments, which had benefited from the prolonged 737MAX grounding and high fleet utilization, suddenly faced stiff headwinds.

Thus far, the defense industrial base has not experienced a COVID-19 demand shock. There is no noticeable disruption in appropriations or major delays and cancellation of military programs. However, as in the commercial sector, defense contractors are actively monitoring their supply base and taking steps to preserve liquidity, minimize supply chain disruption, and taking measures to comply with CDC and local government guidelines. The range of scenarios for defense spending is bookended by two scenarios: an elevated national security threat that would preserve or accelerate funding, or a reordering of budget priorities to fund social and other mandatory programs, resulting in sequestration-type measures, similar to 2011.

With these developments, volatility in the financial markets, lack of access to financing, alternative more pressing liquidity needs by corporates and most importantly, uncertainty in the marketplace, deal flow in A&D has come to an immediate standstill. Several “in-flight” processes have been halted, new deals in the pipeline have been deferred, and even some announced transactions terminated. Access to the new public offering market is effectively closed.

The gap in expected valuations between buyers and sellers has widened considerably, due to disparate perceptions of the extent of economic disruption caused by COVID-19; contrasting views on reopening of the economy and the pace of return to normal; and diverse perspectives on what the post-COVID-19 new reality looks like. This has rendered financial forecasts and pre-COVID-19 market perspectives obsolete. Further, the extent and nature of unusual and non-recurring events6 impacting financials, present considerable challenges for deal makers to form a credible view of normalized earnings and cash flows.

With the lack of reliable projections, it is nearly impossible to form a credible view on valuations let alone bridge this gap. Additionally, although M&A teams have attempted to navigate through practical challenges with offsite due diligence, virtual facility tours, video conferences, etc., adapting to a virtual M&A environment, especially for cross-border deals, has been challenging.

Developments to watch as economies reopen

Given the health concerns, changes in social behaviors (some of which may be slow to reverse) and anticipated lead-time to an effective vaccine, a V-shape recovery in air traffic appears increasingly unlikely. As governments move from combating coronavirus to reopening economies, the pace and extent of the economic recovery is expected to vary significantly around the world. Further, some long-lasting or permanent developments may trigger some dramatic shifts in the sector:

KPMG

Implications for M&A trends and outlook

KPMG

Although we probably do not expect to see M&A activity return to the pre-crisis levels immediately, we expect M&A activity to drive realignment of the industry landscape in the post COVID-19 environment.

Implications for M&A Capabilities

As we enter the next phase, deal makers will need to adapt to the realities that impact how deals get done. Examples include:

KPMG

While the challenges are intimidating, the opportunities will be vast, and those who move quickly and decisively are likely to be rewarded for years to come. Those who take this unique opportunity to prepare and are ready to act will stand ready to reshape the A&D industry.

1. 2019 DoD Comptroller Data (Green Book)

2. Department of Defense

3. CapIQ, Institute for Mergers, Acquisitions, and Alliances

4. Year return, S&P A&D index vs S&P 500

5. Trailing 12-month average to June 2019 and avg. 16x for deals >$500M in value; CapIQ, Dacis Company reports and Press releases

6 Worker furloughs, facility shut-downs, loss of business or order cancellation, idled or underutilized facilities, CARES Act funding, changes to performance-based compensation structures or payouts, health and sanitization related measures, IT infrastructure investments to adapt to remote working environment, deferral of payroll taxes, carryback of NOLs, increased interest expense tax deduction, etc

KPMG Contributor

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  • Vision 2025: AIAC spearheads initiative aimed at protecting Canadian aerospace

    November 14, 2018 | Local, Aerospace

    Vision 2025: AIAC spearheads initiative aimed at protecting Canadian aerospace

    by Chris Thatcher Whether he looks ahead or behind, Jim Quick can see the squeeze coming. Ahead, countries with well-established aerospace industries are developing long-term strategies to strengthen their positions and capitalize on new technologies. Behind, emerging markets are aggressively pursuing entry into the sector, expanding aircraft production and staking a claim to the lucrative maintenance, repair and overhaul business. “The global aerospace industry is growing and evolving at an unprecedented rate,” said Quick, the president and chief executive officer of the Aerospace Industries Association of Canada (AIAC). “New markets are opening up everywhere. New technologies are disrupting our industry [and] shaping a global landscape.” More and more countries in Asia and Africa can see a potential future in the aerospace sector and are investing, in some cases heavily. “There are emerging economies that feel that having aerospace is a key economic driver critical to their economical and industrial success,” he observed. Canada may be ranked fifth among global aerospace markets, and a leader in aircraft-related productivity and research and development, but it's a position that could quickly wane if industry and government lack a long-term plan to guide investments. Look no further than space, where Canada's investment as a percentage of GDP has slipped noticeably from 8th place in 1992 to 18th today. “We have a strong industrial base. We are some of the greatest R&D contributors globally from an aerospace perspective. All the fundamentals are there and our companies have worked hard to put those fundamentals in place,” said Quick. “We have an opportunity to leverage that competitive advantage to grow and innovate. [But] if we don't do that, I think we are at risk of following behind.” AIAC in October launched Vision 2025: Beyond Our Imagination, an industry-led initiative intended to spark a conversation among industry, government, the public, and other stakeholders that will lead to recommendations to shore up Canada's future in the aerospace sector. The initiative is being led by Jean Charest, a former federal cabinet minister and provincial premier, and currently a partner with McCarthy Tétrault in Montreal. Charest served as premier of Quebec between 2003 and 2012, a period following the downsizing of the 1990s when responsibility for many programs shifted from federal jurisdiction to the provinces. Investment in aerospace was one such area and Charest steered several strategic bets in the sector, including support for Bombardier. “I believe in this industry. I certainly have a pretty good understanding of how important the role of government is in this. Whether it is R&D or procurement, this is an area where governments have a pretty key role to play,” he said. “What I also remember from that experience is that we never lost money. Whether it was through the Export Development Canada or other ventures, the governments of Canada never lost money in the industry,” he added. “It has created thousands of good paying jobs [and] it has been part of the branding of the country. When you look back, it is unusual to have a country of 36 million people for this type of industry. The only way for us to support it is to be able to sell abroad. We are exceptional in that way because we built this industry without having an internal market.” Over the next four months, Charest will be conducting a series of meetings and roundtables across Canada, beginning with the Canadian Aerospace Summit in Ottawa Nov. 13 to 14, to engage industry, government and other stakeholders, including the public, in a discussion about the future of the sector. The roadshow will include stops in Toronto and Montreal in December, and in Vancouver, Winnipeg and Halifax in January. The intent is to gather the key elements industry is looking for and make the case to government about the importance of the sector to the country. Charest has already meet with Navdeep Bains, Minister of Innovation, Science and Economic Development, and said the government will be following the process closely. “I want to get the provincial governments involved. They have a big stake in this,” he added. The roundtables are also an effort to connect Canadians to the legacy of aerospace and secure broader support for more investment. “We want to bring something constructive to the government,” said Charest of the final report, which is expected in late February or early March, in part to coincide with the budget debates and the looming 2019 election campaign. “Hopefully, the government and the political parties will take up some of the ideas that will come from our report.” That not only includes a discussion about the impact of emerging technologies such as artificial intelligence (AI), quantum computing, additive manufacturing, big data and greater analytics, but also assurances from government and educators that the people and skillsets will be there to capitalize. “The employees we have today may not be the employees we have in the future,” said Quick. “The World Economic Forum is telling us that over 40 per cent of the people that work in aerospace may not be working in aerospace in 10 to 12 years' time. And 70 per cent of those in the industry will have a different job in the industry. The disruption of some of the technologies is really going to transform how we are doing business.” Charest suggested the federal government's February announcement of a$950 million investment in five innovation superclusters was “a moment of truth for the industry.” Several aerospace companies, with AIAC support, had banded together to propose a supercluster. “It was a realization that if we really want to take hold of these new technologies, then we have to get better organized and make a stronger case to the government [about] what role they need to play in order for us to take advantage of things like AI,” he said. The aerospace sector last went through a similar exercise in 2012 when David Emerson, a former federal minister of Industry and of International Trade, led a program and policy review of aerospace and space. The aerospace report, titled Beyond the Horizon, painted a picture of a sector at a critical juncture. “If the sector is to continue to thrive and to benefit the country as a whole, all players–companies, academic and research institutions, unions, and governments–must understand and adapt to changing realities. Success depends on developing the technologies of tomorrow and securing sales in a highly competitive global arena,” Emerson wrote at the time. “Private aerospace companies will ultimately drive competitive leadership in the new global economy. But thoughtful, focused, and well-implemented public policies and programs can play a critical role in facilitating this success, by encouraging aerospace innovations involving enormous financial risk and long timelines; improving industry's access to global markets and supply chains; leveraging government procurements to support industrial development; and helping to build a skilled, adaptable workforce.” The space industry report, Reaching Higher: Canada's Interests and Future in Space, was even more stark, arguing that “business as usual will not be good enough.” To foster a competitive Canadian space industry “will require resolve, clear priorities that are set at the highest levels, and effective plans and programs to translate these priorities into practice,” stated Emerson. Both Quick and Charest believe the findings are still relevant and the sector needs a long-term vision. “That is the sense in the industry and it's enhanced by the story of the C Series, which has arrived at the end of its development,” noted Charest. “The engineers, for example, who have worked on that project are going to be looking for work. And if we are not able to give them new projects to work on, they are going to go elsewhere. That speaks to where we are right now in the industry.” “I think we are at a crossroads,” added Quick. “Space is a good example. While our competitors are growing and commercializing their space sector, we're actually falling behind. We have some space companies in Canada that are moving capacity and capability to other countries because they have long-term space programs that have been costed and that have a multi-year vision.” Though the initiative is titled Vision 2025, the intent is to begin acting on the recommendations as soon as possible, said Quick. “2025 is significant only because we feel there's going to be a pivot in our industry from a civil aviation perspective.” The subtitle, Beyond Our Imagination, was added in the hope of encouraging thinking “outside the box,” he said. “Our goal is to ensure ... we have a long-term strategy for the future, and we have policies that help us compete in a very fierce, competitive global environment,” he concluded. https://www.skiesmag.com/news/vision-2025-aiac-spearheads-initiative-aimed-at-protecting-canadian-aerospace

  • An Investment in Capability

    October 25, 2018 | Local, Aerospace

    An Investment in Capability

    If you're planning to become hopelessly lost, my advice is to do it in Norway. That was the author's conclusion after Skies was invited to the Leonardo Helicopters facility in Yeovil, England, to fly the latest variant of the AW101 search and rescue (SAR) helicopter. The machine was brand new, pending delivery to Norway, but represented a configuration that Leonardo has proposed to the Royal Canadian Air Force (RCAF) as an upgrade for Canada's fleet of CH-149 Cormorant SAR helicopters. AN OPPORTUNITY FOR THE RCAF The CH-149 Cormorant entered RCAF service in 2002. While not an old airframe by Canadian standards, the subsequent evolution of the model has left our version somewhat dated, and Leonardo maintains that obsolescence issues are beginning to adversely affect operational availability Team Cormorant is an industry consortium composed of Leonardo Helicopters, IMP Aerospace & Defence, CAE, GE Canada and Rockwell Collins Canada. The group's unsolicited proposal to the Air Force is intended to guard against creeping obsolescence and ultimately to reduce the cost of operating the helicopter. Under Team Cormorant's proposal, the RCAF would also acquire a training facility with a modern full-mission simulator, likely to be installed at 19 Wing Comox, B.C. The machine on offer to Canada is an extensively upgraded version of the RCAF's existing airframe, based upon the AW101-612 configuration; 16 of which are destined for Norway under its Norwegian All-Weather SAR Helicopter (NAWSARH) program. Team Cormorant's proposal to Canada also seeks to take advantage of nine former VH-71 Kestrel airframes from the cancelled U.S. presidential helicopter program, acquired by the RCAF in 2011. These would be used to augment the Cormorant fleet from the current 14–widely acknowledged as inadequate for Canadian SAR requirements–up to potentially 21 machines. Enhanced fleet size would allow the RCAF to base the Cormorant at 8 Wing Trenton, Ont.; a move that would improve SAR capability in the vast Trenton SAR region. Compared to in-service CH-149 Cormorants, the upgrades on offer include new, more powerful, full-authority digital electronic-controlled (FADEC) General Electric CT7-8E turboshaft engines; a more modern Rockwell Collins cockpit and avionics suite; improved aircraft management system; and a newly designed, four-axis dual-duplex digital automatic flight control system (AFCS). The sensor package promises the biggest capability upgrade, and includes an electro-optical surveillance system; a multi-mode active electronically-scanned array (AESA) radar; cell phone detection and tracking system; and marine automatic identification system (AIS) transponder receiver. AN OPPORTUNITY FOR COMPARISON In 2016, Skies dispatched me to fly the CH-149 Cormorant with RCAF's 442 Squadron at CFB Comox. 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Adding 2,000 kilograms of fuel (roughly half its 4,150-kilogram capacity) and three crewmembers brought the takeoff mass to 13,517 kilograms, which was well below the maximum allowable gross weight of 15,600 kilograms. The Cormorant that Skies flew with RCAF's 442 Squadron, although fully equipped for SAR with a standard fuel load of 2,400 kilograms and a crew of six, had a gross takeoff mass of 13,800 kilograms, which was below the maximum allowable gross weight of 14,600 kilograms. Direct comparison is difficult to establish, but the Norwegian machine is both heavier with installed systems and has more installed power than the CH-149, so the net result may be expected to be about the same operational power margin. Rapid dispatch can be facilitated by starting the auxiliary power unit (APU) while strapping in. Grant talked me through the engine starting procedure from memory. Air Force crews will use a checklist, but the procedure was quick and straightforward Engine controls consisted of three rotary knobs on the overhead panel in place of engine condition levers. I monitored the start, but Grant advised that in the event of a start-up malfunction the FADEC would shut down the engine faster than the pilots could react. We started the No. 1 engine first to power the accessory drive, providing hydraulic and electric power and bleed air. Starts of engines No. 2 and No. 3 were done simultaneously. Pre-flight checks and initialization of the aircraft management system (AMS, but think “master computer”) took Grant only minutes. Despite the functional similarity of the cockpit to the CH-149, the impression that I was amidst unfamiliar new technology was immediate. As ground crews pulled the chocks and busied themselves around the helicopter, the onboard Obstacle Proximity LIDAR System (OPLS, where LIDAR is light detection and ranging, since I needed to ask, too) annunciated their presence around the turning rotors. This system, which Grant described as being like the parking sensors in a car, provided a pop-up display and discretely-pitched audio cues depicting the range and azimuth to obstacles around the helicopter. Having come from a generation where we squinted into a landing light beam to guesstimate rotor clearance from obstacles, all I can say is, I want one! Full article: https://www.skiesmag.com/features/an-investment-in-capability

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