October 2, 2017

M&A: The Next Three Aerospace & Defense Deals?

Source: Barron's
By: 

Suppliers may try to lock up deals sooner rather than later.

First, Rockwell Collins (COL) bought B/E Aerospace, and now it is being acquired by United Technologies (UTX). So what might be the next deal to happen in the aerospace and defense sector?

Vertical Research Partners' Rob Stallard has a few thoughts on that.  Stallard writes that there are plenty of reasons driving the increase in M&A in the sector,  but he focuses on structural changes in the OEM/supplier relationship, and in the aftermarket.

Original equipment manufacturers (OEMs) have the ability to pressure suppliers on price, a trend that Stallard writes has gotten worse in the last few years. In the last upcycle, suppliers could at least compensate for this thanks to robust aftermarket growth. Yet this time around, aftermarket growth is half of what it was before, challenging suppliers' margins.

Merging with other suppliers gives companies the chance to gain efficiency and pad their product portfolios, which can ease pricing pressures where the aftermarket can't. And it may be now or never, Stallard writes. given that cheap credit won't be available forever.

So who does he think is next? "In materials, we have looked at the potential acquisition of Hexcel (HXL) by Arconic (ARNC). In components, we have run the numbers on General Electric (GE) buying Meggitt (MEGGY). And finally, we have considered the potential combination of Spirit AeroSystems (SPR) and GKN Aerospace in structures." 

And he warns that investors should stay selective in the space:

Commercial aerospace demand indicators remain positive, though we suspect that too much weight is being put on raw RPM growth data versus broader airline metrics. In the absence of cycle concerns, the focus shifts to execution – and investors have rewarded aero companies that are executing well, or promising to do as much. This has left valuations generally towards the top end of the historical range (average 2018 P/E of 22x), and so our preference is for aero companies that have specific opportunities or relatively attractive valuations such as Airbus or TransDigm (TDG).  

The SPDR S&P Aerospace & Defense ETF (XAR) is up more than 26% this year.

See related post: The Best Way To Value Aerospace And Defense