In recent years, we have drawn considerable attention to the valuation disparity between commercial aerospace and defense markets, with defense companies facing a constrained budgetary environment and commercial aerospace companies buoyed by a seemingly endless supply of aircraft deliveries. This year brought a significant convergence in valuations between commercial aerospace and defense companies, with the median commercial aerospace public company trading multiple of 11.1x EBITDA exceeding the median defense trading multiple of 10.2x by only 9% (this compares to a 58% premium in 2013 and a 35% premium in 2014). As 2016 approaches, it appears that (at least for the time being), “Tis the Season to be Jolly” in both commercial aerospace and defense markets. The question remains, however, how long will the positive momentum last?
Defense and Government Market
In the defense and government market, one only needs to listen to the latest round of industry earnings guidance and compare current prognostications to those of the past few years to see that we may be on the cusp of a “return to growth” (insert triumphant bugle sound here). For the first time in several years, defense and government services companies have issued positive revenue growth guidance for the upcoming year, supported in large part by the recent two-year budget deal. In 2016, defense prime contractors and government services companies are expecting average revenue growth of 1.1% and 2.8%, respectively. Although the charts to the right indicate that the sector as a whole has not consistently achieved its revenue guidance estimates over the last several years, the current industry guidance certainly sends a strong, positive signal to the marketplace. Perhaps most notably, M&A has served as a critical “backstop” to stem the tide of negative organic growth, particularly in the government services sector where five of the largest companies declined from an aggregate $22.1 billion to an estimated $19.7 billion in revenue from fiscal year 2010 to 2015. During this time period, these five companies acquired nearly $3 billion in annual revenue, underscoring the critical importance of M&A activity in helping companies to reach (or at least not miss as badly) their revenue guidance.
This year saw a new wave of consolidation activity across the defense and government sector. Market leaders such as Lockheed Martin, L-3, and BAE have undertaken highly publicized “to own or not to own” analyses of their government services portfolios which may result in more than $10 billion in industry revenues either changing hands or being spun out into newly created entities (CACI’s recently announced intent to purchase L-3’s $1.2 billion National Security Solutions Division is the most recent example of this trend). At the same time, upper-tier and mid-tier companies have aggressively pursued creative merger strategies aimed at building critical mass to compete more effectively in a modest growth environment. Most notably, CSC’s Government Services business, CSGov, and SRA consummated their merger and recently began trading as a newly minted $5.5 billion pure-play government services company (CSRA).
Overall, 2015 M&A activity in the defense and government sector is up modestly from 2014 levels, building upon a much improved budgetary and business environment relative to the previous several years. From our perspective, an emerging “window of opportunity” exists for well positioned companies in the sector to pursue a variety of value creation alternatives that may not have been feasible over the last few years. In short, defense and government services companies that have patiently weathered the “storm” of 2013 and 2014 are positioned to reap the rewards of today’s much improved budgetary and valuation environment.
“Fa la la la la la la la la!”
Commercial Aerospace Market
While the defense market is still sowing the seeds of a nascent recovery, commercial aerospace companies are entering the seventh consecutive year of a robust valuation environment. Since 2010, the median valuation multiple for publicly traded commercial aerospace companies has generally exceeded 10.0x EBITDA, or at least 50% above the median 2009 valuation multiples. For a majority of companies in the commercial aerospace sector, stock price appreciation over the last several years has dramatically outpaced revenue growth. As an example, from 2010 to 2015, a period of time during which Boeing and Airbus increased their aggregate revenue by approximately 34%, these industry bellwethers saw their stock prices increase 185% and 374%, respectively. Given that the length of the last bull valuation cycle lasted only four or five years, we are asking, “How long until the music stops?”
By many measures, the sector appears poised for continued growth. Boeing, which has raised production rates fifteen times over the last four years, has throughout the course of 2015 communicated plans to increase production rates five more times over the next decade. Berkshire Hathaway’s recent $37.9 billion purchase of Precision Castparts Corp. is an unequivocal bet that the current robust valuation cycle has “legs” (who can argue with Warren Buffett, right?). Notwithstanding this bullishness, the commercial aerospace sector as a whole has seen a consistent compression in revenue growth rates in recent years, suggesting that the environment may not be
“…an emerging ‘window of opportunity’ exists for well positioned companies in the sector to pursue a variety of value creation alternatives that may not have been feasible over the last few years.”
Selected Recent Transactions
The median revenue growth rate for Bluestone’s Commercial Aerospace Index (which consists of fourteen companies) has declined from 17% in 2011 to an estimated 1% in 2015. Notably, the number of companies in the index generating double digit revenue growth declined from nine in 2011 to just one in 2015 (TransDigm). Ironically, as recently as November, TransDigm’s CEO Nicholas Howley expressed concerns about the duration of the current OEM build cycle and used the term “awful long in the tooth” to describe the length of the current bull market cycle.
2015 saw a continuation of robust M&A activity in the commercial aerospace sector, which is on pace to exceed 2014 levels. Notably, several private equity groups have sold aerospace platforms much earlier than the conventional five year holding period, suggesting that some investors are seeking to monetize well-performing assets before the cycle ends (examples include MidOcean’s sale of Noranco and Greenbriar’s sale of Parkway Products). As the public companies in the sector seek ways to generate the kinds of growth that their lofty valuations inevitably will demand, look for companies to increasingly use M&A as a means to feed investors’ insatiable appetites for growth. This bodes well for continued strength in the M&A market as we enter 2016.
In short, while there may be a number of reasons to believe that the sense of euphoria that has permeated the commercial aerospace market over the past several years will continue, there are also some cautious signs reinforcing the need for business owners to be thoughtful about their future business and liquidity plans. While the bugle may be heralding a “return to growth” in the defense and government market, there seem to be many instruments in the commercial aerospace sector’s proverbial “orchestra” competing for attention. Only time will tell how long it will take the harp to be heard. One thing is certain, though – markets move quickly, and the price that companies can pay for missing a window can be steep.
As we enter 2016, companies across the aerospace, defense, and government markets have good reason to cheer. We wish you and your families a joyous holiday season and a prosperous new year. Tis the season to be jolly!
DISCLAIMER: This material was prepared by Bluestone Capital Partners LLC, a Delaware limited liability company and a registered member of FINRA. This material has been distributed for informational purposes only and reflects the opinions of Bluestone Capital Partners. It is not intended for use as the basis of an investment decision. Information obtained from third-party sources is considered reliable, but we do not guarantee that the information herein is accurate or complete. The material presented reflects information known to the authors at the time this communication was written and is subject to change without notice.
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