In the aerospace industry and throughout the global economy, merger and acquisition (M&A) activity can serve as a barometer for economic health. During times marked by strong market fundamentals, M&A activity tends to accelerate as healthy balance sheets make companies ripe for dealmaking. Today, the aerospace business finds itself in a tepid M&A environment, thanks largely to the increased cost of capital wrought by inflation and soaring interest rates.
According to a recent report by KPMG, M&A activity plunged by nearly 20 percent from 2019 to 2020 with the onset of the Covid pandemic, which forced aerospace and defense companies to cut production and capacity. Now, persistent supply chain constraints, the war in Ukraine, and labor shortages have largely offset the resumption of air travel and resurgent demand for aircraft.
Meanwhile, high borrowing costs resulting from elevated interest rates have depressed profits and reduced cash flow throughout the industry. Consequently, OEMs have pressed suppliers to improve efficiency and increase output. Smaller companies, in particular, have shown an inability to respond to the pressure as their weak balance sheets and low cash reserves make the high cost of capital even more burdensome.
According to KPMG, last year saw M&A activity in aerospace and defense fall by more than 23 percent after reaching 566 transactions in 2021, while estimated deal value plunged by more than 60 percent. Since the pandemic, the consultancy added, private equity dominated buy-side deal activity, driving consolidation in government IT services, cyber and intelligence, electronics, space systems, machined and cast parts, and MRO and logistics. In fact, during that time PE firms took some companies such as Signature Aviation.
Alex Krutz, founder of Orange County, California-based consultancy Patriot Industrial Partners, explained how the M&A environment has evolved over the past decade or so, starting with the period before Covid, when “cheap money” encouraged dealmaking.
“If you take a step back when interest rates were at zero, half a percent, one percent, the cost of money was very cheap. So that’s when we saw leveraged buyouts and heavily debted transactions where you have minimal equity,” he told AIN. “So when you have cheap money in the marketplace, it facilitates lots of transactions and leads to overvaluations of some companies, where double-digit multiples were paid for companies that didn’t warrant it.
"Because of that, more people have access to debt and liquidity for deals, so that drives up competition and incentivizes owners and businesses to do transactions where they could sell their assets at premium dollars.”
But as Covid took its toll on the global economy and backlogs shrunk, airlines, most notably, canceled orders for new aircraft and cut orders for spare parts, leading to a 20 percent decline in M&A activity between 2019 and 2020. Then, as governments injected liquidity into economies to counter the effects of Covid, a rebound ensued in 2021, leading to a short period of frenzied activity.
“Now we have a byproduct of Covid that liquidity dump in the form of inflation, leading to increased interest rates,” explained Krutz. “And so financial pressures are building on some of these companies. The cost of capital's more expensive, balance sheets might not be as healthy, and then also regional banks that deal with a lot of these small and mid-cap companies are getting more risk averse and tighter on their lending.”
Projecting into the near-term future, Bloomberg Intelligence senior aerospace analyst George Ferguson told AIN that he sees companies whose inability to accelerate production to levels required by OEMs and upper-tier suppliers become targets of acquisition.
An example of this was Bombardier's decision to reinforce its supply chain through the acquisition of Latécoère’s electrical wiring interconnection system (EWIS) business in Querétaro, Mexico
Such strategic buys will likely predominate, he added, as aerospace manufacturers look to fix disruptions in their supply chains.
“And I think when you look at...the private equity folks, they're going to be rolling around looking for where in this industry do we have multiple suppliers that are supplying things that are similar, that we can cobble together and we can turn into a company with more operating leverage, with more economies of scale,” said Ferguson.
According to the KPMG report, while private equity will continue to concentrate on middle-market growth-oriented acquisitions using “creative financing” due to the tight lending environment, OEMs and tier 1 suppliers will focus on niche “tuck-in” deals that involve complementary technologies and vertical integration of strategically important vendors.
In fact, according to Krutz in a recent article in Forbes, while OEMs over the past decade shrunk as they divested what they considered non-core assets, tier 1 suppliers grew, a trend he said “dramatically transformed” the aerospace and defense industries.
The creation of RTX serves as a prime example, he added. Known as Raytheon Technologies, RTX resulted from Raytheon Company’s 2020 merger with United Technologies, which itself acquired Goodrich in 2012, B/E Aerospace in 2017, and Rockwell Collins in 2018. RTX, which now consists of Collins Aerospace, Pratt & Whitney, and Raytheon, generated revenues of $67 billion in 2022, compared with Boeing’s $66.6 billion during the same period, noted Krutz.
Even while the Justice Department required divestitures of defense-related assets by both Raytheon and UTC as a condition of its merger approval, mixed reaction came from the Trump administration at the time, which expressed concern over its potential effect on the competitive landscape. Ferguson, though, explained that strategic investors benefit from mergers’ ability to drive cash flow at stressed suppliers even as some express concern with price increases they might effect.
“The way I want to say it is definitely [favorable to the industry] for here and now, for post-pandemic,” said Ferguson. “Raytheon provides some nice stability to the business because they are in good financial shape…It doesn't come without a cost, and so [the OEMs] may not get the absolute best price on everything they procure out of Raytheon. But in my view, stability is more important right now.”
RTX, however, continues to see a drag on its performance in the form of Pratt & Whitney, whose well-documented reliability problems with the GTF engine haven’t abated, he added. “[RTX subsidiary] Collins appears to be performing fine,” said Ferguson. “But the drag has been Pratt and it continues to be Pratt.”
The latest problem involves what Pratt & Whitney calls a rare condition with the powder metal it uses in various PW1100G engine parts for the Airbus A320neo. As a result, operators will need to remove some 600 to 700 engines beyond initial forecasts for shop visits between 2023 and 2026, costing it between $3 billion and $3.5 billion over the next several years.