Targeting M&A Opportunities in the Defense Industry

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coupled with the development of significant aviation, electronics, and naval programs have provided steady growth in the North American and European defense markets. Governments from emerging markets across the BRIC (Brazil, Russia, India and China) countries, the Middle East, and Southeast Asia have also been investing, particularly in aircraft fleet upgrades. Yet just as the commercial and business aviation segments have begun their recovery, the defense market is becoming more uncertain, particularly in developed markets.

Operations in Iraq and Afghanistan are slowly, but inexorably, winding down. At home, the impact of the financial crisis is being felt in Western defense budgets. New programs are being trimmed or eliminated. Assets are having their service lives extended or are being slated for early retirement. Programs are being scrutinized and even summarily terminated, even in the face of political opposition.3 The picture in emerging markets is promising, yet similarly uncertain. The areas of greatest economic growth may yield only limited sales to Western defense companies for reasons that range

Life in a post-program world – Approaches to growth in the defense industry

Business and commercial aviation markets are both moving towards recovery, Both manufacturers’ and independent forecasts see emerging market growth and fleet renewal driving a doubling of commercial aircraft production over the next two decades, indicators that are only strengthened by the strong bookings recorded at the 2011 Paris Air Show.1 Even business aviation, which suffered both financially and in the court of public opinion, is forecast for double-digit compound annual unit growth over the next five years.2 Sales and production are only two indicators. Air cargo volume has risen to serve the economic recovery, particularly in Asia. Commercial and business aviation manufacturers are investing. From continued work on new platforms to fleet upgrades, original OEMs and their suppliers are investing to support growth in commercial aviation. While much work remains, confidence in the commercial segment is gaining momentum.

Then there is defense. Over the course of the past five to ten years the defense segment has supported consistent industry growth. Ongoing military operations in Iraq and Afghanistan,

The beating taken by credit, consumption, and investment during the recession of 2008-2009 left few industries unscathed. The aerospace and defense industry, no stranger to the business-cycle rollercoaster, was no exception. From plummeting demand in business aviation to cancelled orders for commercial aircraft, the industry felt the direct consequences of the collapse of credit and spending. Yet with Western economies slowly on the mend and emerging markets continuing their surge forward, the future challenge to expanding industry value may arise in an unexpected place: the defense segment.

from local competition to national security concerns. To successfully navigate this environment, Western defense companies will therefore need to do two things well: first, develop an individualized personal blueprint for acquisition and market entry and second, take advantage of the market for service and support.

The defense environmentNorth American and European defense industry incumbents find themselves in an interesting position. From Washington D.C., to London, to Berlin, Paris, and beyond, budget austerity and calculated investing are in vogue. The defense markets in the United Kingdom and the Eurozone are experiencing the greatest impact from the contraction of domestic military spending, which is also accelerating the decline of their share of global military spending. While the Eurozone, United Kingdom, and United States still comprise the majority of global military spending, the United States is the only one of the three that has grown in parallel with emerging economies. Figures One and Two opposite illustrate this trend.

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$700,000

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$

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Figure 1 - Historic Defense Spending 2000 - 2009 (2008 USD Million)

U.S. Euro Zone

BRIC U.K.

Figure 2 - Relative Defense Spending in Major Markets, 1999-2009

Source: Stockholm Institute of Peace Research, US Department of Defense, UK Ministry of Defense

Source: Stockholm Institute of Peace Research, US Department of Defense, UK Ministry of Defense

0%

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

7% 7% 7% 7% 7% 7% 6% 6% 6% 6%

13% 14% 15% 15% 14% 15% 15% 17% 17% 18%

20%21%22%22%23%24%26%28%29%30%

50% 50% 50% 51% 54% 56% 56% 56% 56%55%

6%

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As with other industries, spending on defense is on the rise in emerging markets. Unlike other industries, however, the path forward for developed market companies seeking to engage in these regions may be more of a mixed bag. The emerging markets conversation begins with the BRIC countries. Yet the similarities between defense and the rest end there.

Geopolitical and national security concerns remove the Russian and Chinese markets from consideration for Western defense firms. On the other hand, Brazil and India have been more welcoming to foreign partners. Fighter aircraft competitions in both countries, the sale of maritime patrol and heavy lift aircraft to India, the tight integration of Brazil’s Embraer into the global aerospace industry, and US-Indian nuclear agreements illustrate the growing opportunities for Western defense firms in these markets. Today’s increased engagement is a marked contrast to Brazil’s period of military rule and India’s longtime role in the non-aligned movement.

Yet despite these openings, significant growth for foreign defense firms may prove elusive in Brazil and India. Both countries are strongly committed to developing their domestic aerospace industries and that goal is likely to have considerable influence on future defense procurement decisions. While neither Brazil nor India yet possess mature defense industries at the scale of more developed economies, their commitment to improving domestic capacity and quality may well limit the opportunities available to foreign firms. Rigorous offset requirements, mandated technology transfer, and other policy tools will serve to blunt the penetration of foreign firms in these markets. Looking to other emerging markets, the recent popular unrest in the Middle East and North Africa will also diminish defense opportunities for Western firms. Finally, and pragmatically, none of these markets will match the scale of spending in Western countries for some time, if ever. With European spending in stasis, American defense spending will become even more central to value creation in the defense industry.

The search for valueWith that being the case, where should defense companies look to maximize value? Like all enterprises, defense firms have two primary levers for increasing enterprise value. They can improve their overall returns on capital and they can grow their businesses organically or through acquisition. The immediate response of defense companies to the macroeconomic environment has been a renewed focus on operating margins and capital efficiency. Lean manufacturing has become leaner. Supplier contracts have become more stringent. Outsourcing and risk sharing have increased. These efforts will yield continued operational improvements and differentiate competitors in contract competitions. They will not, however, create growth.

The rise of servicesOrganic growth in mature defense markets has traditionally arisen from new programs and more recently, from the growing market for sustainment, service, and support contracts. Taking the United States market as an example, it is no surprise that such contracting

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vehicles have garnered so much interest. US defense “maintenance and operations” spending consumes higher proportion of overall spending than new development program and procurement. Ongoing budget debates have increased the uncertainty of the future direction of US defense spending. The US Department of Defense (DoD) is changing its view of where procurement and maintenance and operations spending will go in the near term. Figure Three illustrates the difference between the DoD’s 2010 and 2011 estimates of these spending buckets.

While there are clear differences between the estimates, both suggest that maintenance and operations will continue to claim the greater share of spending. The lines on Figure Three, particularly maintenance and operations, are the focus of increased competition between US defense companies and their European competitors. European firms have targeted the US for organic growth, teaming with US partners or going alone to bid on lucrative contracts. However, organic growth is more restricted, competitive, and risky than it has been in recent memory. In

light of this, firms are turning their attentions to the other major lever of value creation, mergers and acquisitions (M&A).

A number of factors continue to make M&A an increasingly attractive option for defense firms. The increasingly competitive environment for organic growth brought about by the reduction in new programs is but one of these factors. Solid cash on hand, the recovery of financial markets and the growing availability of credit combine to make M&A look a more favorable financial proposition than even just a few months ago. The question is where to focus M&A activity? For many defense companies, the answer is the United States.

The US defense industry has undergone several cycles of consolidation, most recently in the aftermath of the Cold War. Yet today’s M&A environment has a different feel compared with the past. While geopolitics and customer needs are part of the difference, a critical element is the shift of M&A focus away from products and toward service and support. Historically, defense M&A has

served to consolidate prime contractors. Over the past two decades, market forces and federal encouragement have led to a material drop in the number of US prime contractors across several categories of military systems.

The number of prime contractors in each category suggests that strategic concerns would render further consolidation across US prime contractors unlikely. Prime contractors are focusing on core competencies and adjusting their business models. As companies shift and divest businesses they deem outside their selected service strategies, they provide the wider market with new acquisition opportunities. Given the decline in major new programs coming to bid and the continued pace of maintenance and operations spending, the more present acquisition opportunity would appear to lie in assembling portfolios of businesses that target maintenance and operations spending.

Approaching acquisitionsThe shift to services across the aerospace and defense industry has spawned a growing and higher margin

Figure 3 - U.S. Maintenace and Operations v. Procurement Spending FY00-FY15 (2010 and 2011 Estimates)

Sources: National Defense Budget Estimates for FY2011. Office of the Under Secretary of Defense (Comptroller). March 2010. pp. 64-66. National Defense Budget Estimates for FY2011. Office of the Under Secretary of Defense (Comptroller). February 2011. p. 15.

$350,000

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market for operational support. Some of these solutions are tied to the ongoing maintenance and support of assets and systems. Others are niche, but high value, solutions in themselves. Examples of these might include communications, intelligence, and other data-intensive solutions. These types of high value areas are likely to be the focus of acquisition activity over the coming months.4

The shift to services also presents an attractive market proposition for prospective acquirers. While it is wise to be cautious about examining financial indicators in isolation, the recent market performance of services and solutions-focused aerospace and defense companies adds to the attractiveness of services-focused companies for potential acquirers. Figure Five illustrates the relative financial performance of services and products-focused aerospace and defense companies.

The business proposition of services and the ongoing strength of the US defense market relative to other developed markets have placed US companies at the center of the acquisition arena.

However, prospective acquirers are both domestic and international. While American companies are the incumbent acquirers in the domestic market, international, particularly European, companies are demonstrating greater interest in establishing or broadening their US presence. Table one illustrates the three strategies that companies have generally taken as they seek to expand through acquisition.

The DevelopersLegacy product companies are leading the way in the development of new service offerings. In part this is a diversification of product-centric revenues and in part a move towards higher margin services businesses. Because those companies that acquire in an effort to develop new service offerings are often structured to engineer and build products, they must acquire the full range of people, approach, and capabilities required to provide services and solutions. The challenges of merging cultures and business approaches while entering a new market means that acquisitions to build new service offerings require significant investment in post-merger

integration, coordination, and executive sponsorship in order to meet any merger’s financial goals.

The ExpandersAcquiring to expand and enhance service portfolios is a strategy for those that have already established the foundation of a services and solutions offering. While the companies that take this approach are already pursuing service and solution opportunities, the balance between expansion and enhancement will differ according to where a company is on its services journey.

Source: 1990 and 1998: Nayantara Hensel. “Can Industry Consolidation Lead to Greater Efficiencies?” Business Economics. Vol. 45. No. 3. 2010. 2011: Accenture research.

Figure 4 - Number of United States Prime Contractors by System

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Expendable Launch Vehicles

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Figure 5 - Total Return to Shareholders and Revenue CAGR 2005-2010, Across Twenty Represenative Aerospace & Defense Companies

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Moving ForwardWith fewer new programs in the pipeline and budgets on the chopping block, defense companies are searching for growth where they can find it. Increasingly, this is in the area of service and support. Emerging markets’ desire to develop domestic industries and Western concerns over sharing sensitive technologies will limit opportunities. While emerging markets will figure in the organic growth strategies for most Western aerospace and defense companies, they will also look to their traditional markets to identify opportunities for growth through acquisition.

”Expanders” often have a service and solution strategy in place and are looking to move to new markets or platforms. While these companies have experience of deploying and running services businesses they seek new expertise to enter new markets or strengthen existing offerings. In such cases, acquisitions add to the existing portfolio and may initially be allowed to operate as independent subsidiaries, with links to the new corporate parent for financials, strategy development, and performance monitoring and management. Over time, they are typically assessed to determine if they should be more tightly integrated with the parent company.

The EnhancersCompanies making acquisitions to enhance their portfolios are typically mature service and solution entities that are looking to bolster their presence in a given market or to intervene to prevent competitors from improving their position. Enhancement acquisitions typically embed the acquisition within an existing business unit, but in some cases may operate the acquisition as

a separate entity for a limited period. These acquisitions are typically, though not always, smaller and more frequent than the “typical” industry acquisition. Companies that seek to enhance their capabilities through acquisition must be well-practiced in not only post-merger integration but also in managing dispersed and complex organizations.

While these approaches may differ in appearance and execution, domestic and international companies have used them all to support their acquisition activities in the US. As scrutiny of defense spending grows, the ability to build a portfolio of businesses that can more efficiently provide service-based solutions such as performance based logistics (PBL) or power by the hour (PBH), may become a differentiator for companies competing to support the DoD. With the US providing the greatest opportunity for new acquisitions in the near future, these strategies will only grow in importance as global companies seek access to one of the few remaining, albeit shrinking, growth opportunities in the defense segment.

Expansion Strategy What Why

Develop New Service Offering Companies create a new product or service offering that combines existing and /or recently acquired capabilities

To respond to crowding out or decrease in new contracts for physical assets or to minimize capital investments

Expand Portfolio Companies acquire new or additive capabilities, products and/or services that add to their existing portfolio

To capture new or emerging market opportunities or to acquire specific entities to meet strategic or revenue goals

Enhance Portfolio Companies acquire to expand the depth of their existing portfolios in a specific market segment

To acquire a specific set of customers and/or contracts that fit existing portfolio

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Figure 6 Acquistion Strategies in the Service Life Cycle

Services differentiate

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As companies determine which capabilities are central to their service portfolios, they will seek to divest those portions of their businesses that do not support their strategies. These divestitures will only serve to increase options for acquirers as niche capabilities filter onto the market. The identification of operational synergies aligned to the chosen service strategy and the accurate assessment of a target’s financial fit are the minimum requirements for successfully selecting an acquisition partner.

Once a target has been determined to be a fit, foreign companies looking to make acquisitions in the US must be aware of the additional regulation and authorizations required by the Committee for Foreign Investment in the United States (CFIUS). Even the most trusted foreign defense partners must be run through this vetting process for each transaction they pursue, adding time and sometimes additional cost to the process. Yet to date it has not slowed their appetite for investment. At the opening of the 2011 Paris Air Show, Airbus Chief Executive Louis Gallois stated “In the US, it’s not so easy,” but continued to say “You will see more acquisitions,”

citing confidence in his firm’s ability to close key acquisitions in the future.5

Despite its own cutbacks, the US will continue to offer the best opportunities for defense companies seeking to expand, largely owing to its continued spending on maintenance and operations, its relative global scale, and potential barriers in emerging markets . Successful acquirers will develop portfolios of service offerings that provide diversified sources of higher margin revenue. To achieve this they will select an acquisition approach that fits with their positioning in the service and support market. Whether they are a new offering, expanding into new areas, or enhancing existing strengths, acquisitions must not only be market relevant but also fit into an overall strategy for addressing the shrinking number of new large scale programs with a balanced portfolio of service offerings.

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Footnotes1 From Boeing and Airbus market forecasts. For the Paris Air Show: http://www.aviationweek.com/aw/generic/story_generic.jsp?topicName=paris_2011&id=news/awst/2011/06/27/AW_06_27_2011_p24-340208.xml&headline=Paris Orders Recast Airliner Battlefield or for future indicators, American’s launch of its narrowbody fleet replacement process: http://www.cnbc.com/id/43821395/American_Airlines_Orders_460_Narrowbody_Aircraft?

2 Forecast International. Aviation Week and Space Technology. January 24, 2010. Vol. 173, No. 4. p. 141.

3 For example, the alternate engine for the Joint Strike Fighter: http://www.reuters.com/article/2011/04/25/us-ge-engine-idUSTRE73O56G20110425.

4 Service-oriented acquisitions are particularly attractive for those with a small to medium footprint across major programs. For example: http://www.saabgroup.com/en/About-Saab/Newsroom/Press-releases--News/2011---6/Saab-to-Acquire-Sensis-Corporation/.

5 Bradley Peniston. “EADS Seeks U.S. Acquisitions.” DefenseNews Online June 18th, 2011 <http://defensenews.com/blogs/paris-air-show-2011/2011/06/18/eads-seeks-u-s-acquisitions/>

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Contributed by Craig Gottlieb and John “Jack” Edmonson from Accenture Aerospace and Defense practice.