Aerospace and Defense: New Business Potential in the Face of Unprecedented Uncertainty

The aerospace and defense (A&D) sector can be unpredictable for investors because of its connection to the public sector and to geopolitics. One need not look further than political instability around the globe and shifting defense budgets to understand.

To present key trends in the sector, Cronus Partners hosted its 9^th Aerospace and Defense Forum on June 25, 2014 in Hartford CT, welcoming the Rolls-Royce North America Vice President of Supply Management, Jeff McInerney, as a keynote speaker.

Below are some of the key takeaways:

A Rolls-Royce Perspective

While the development of the airplane turbine industry in the Connecticut area arose from the strong positioning by Pratt & Whitney in the market, most manufacturers have expanded their customer base to include other original equipment manufacturers (OEMs), such as Rolls-Royce and General Electric.

Rolls-Royce North America powers aircraft, ships and electrical generators, and its business is built on two technology platforms: gas turbines and reciprocating engines. Contrary to popular belief, its parent company no longer makes the Rolls-Royce automobile – that is now made by BMW! Instead, the London-based company focuses on being a global provider of complex, integrated power systems and services to the aerospace, marine and industrial market.

Mr. McInerney, who is responsible for leading the company’s supply management strategy and organization in North and South America, outlined recent developments in the Rolls-Royce aerospace business and how a consistent long-term strategy has seen revenue double and underlying profit increase five times in the past decade. The market drivers of the business are:

• more air traffic, with 3.1 billion passengers and forecast growth of 4.3% per year;
• the regionalization of airlines;
• an increase in private jets due to more wealth;
• environmental pressures;
• regional geo-political disorder; and
• cuts in defense from sequestration (the reduction alone in U.S. Department of Defense spending is equal to the total defense budgets of the U.K. and France combined).

Of most interest to the crowd of Tier I and Tier II supply chain companies attending the Cronus forum, Rolls-Royce currently buys approximately 70% of its parts from the supply chain versus internal manufacture and is moving toward more outsourcing to the supply chain. Nonetheless, the opportunities for suppliers are in select areas of competency and not every company can qualify.

OEM and Supply Chain Trends

In addition to Rolls-Royce, Cronus Partners’ Managing Director Jeffrey Rubin and Senior Advisor Joseph Lubenstein presented on the sector’s M&A and financial markets and industry performance. Advising on mergers, acquisitions, divestitures, sales, and private placement financings, Cronus Partners is an independent investment banking firm that provides financial advisory and other investment banking services. The firm has significant experience in advising both public and private companies that can benefit from middle-market transactions.

Mr. Rubin spoke to the three critical areas of the A&D sector’s OEM procurement strategy: increased financial dependence on suppliers, increased need for scheduling flexibility arising from the OEMs’ demanding and unpredictable schedules, and continued demand for quality specifications and productivity improvements. These factors influence the supply chain trends toward: consolidation and partnership; identification of efficiencies and cost reductions; emphasis on continuity of supply, craftsmanship, machine capabilities, support and engineering; and a reevaluation of financial capacity. In this environment, the key component of success for companies in the OEM supply chain is size. Economies of scale give large companies a margin advantage. Companies in the Cronus A&D Index that are under $100 million in enterprise value currently have gross margins of some 12.5% and EBITDA margins of 6%, while companies up to and above $1 billion in enterprise value have gross margins of closer to 20.2% and 24.1%, respectively, and EBITDA margins of 11.3% and 14.4%, respectively. Size does matter.

The A&D supply chain can address this inequality though M&A but must be extremely careful when doing so. Two wrongs don’t make a right – two weak companies cannot fix their problems by combining. Yet, two rights can make a wrong – two strong companies with completely overlapping expertise bring little value to a combination. Key employees are a critical resource but must be involved in the process or can become an M&A nightmare. Most importantly, financial depth is a necessity both pre- and post-merger.

Mitigating the Effects of Sequestration

Mr. Lubenstein followed with comments on the current state of the A&D market as it affects the supply chain. The commercial jet volume ramp is approaching, and primes are becoming serious about identifying detailed supply chain capacity (e.g., Pratt & Whitney’s long term agreements).  Tier II suppliers are in the best position they have been in for several years, and the next-generation turbo prop business case looks much better for the 90-110 seat aircraft, with the segment forecast at 3,000 units. Both Pratt & Whitney (with the NGRT) and General Electric (with the CPX38) are preparing for the competition.

Sequestration somehow prevailed to the surprise and dismay of the A&D sector. The F35 may just have been derailed while the U.S. Air Force tanker program and unmanned vehicles are still on track but schedules are drifting out. Defense primes continue to enjoy record profit margins, but reduced margins are likely three to four years out. With significant cash on hand, Tier I and Tier II companies intend to continue strategic acquisitions as fallout from sequestration comes into focus. While fewer than 50% of companies predict they will participate in M&A within the next two years, this may be tempered by the need to increase R&D with government R&D funds falling.

Platform/program life and volumes post sequestration are now paramount. The competition between U.S. and European companies is intensifying, with China and Russia entering the field as well. Wild card issues such as Ukraine Part 2, Iraq, and the 2016 Presidential election cloud what the future will bring. There is definitely new business potential in aerospace and defense, but it is tempered by unprecedented uncertainty. Only the brave proceed.