Even before the upheaval of the global economy with the COVID-19 (coronavirus) pandemic, the aerospace industry was trying to recover from the 737MAX suspension at the end of last year by Boeing.
Boeing selected numerous dates for the plane’s return but failed to meet those deadlines and saw the Federal Aviation Administration to refuse to agree to its suggested schedule. As a result, the airline and aerospace industry looked to no longer believe Boeing’s claims.
The economic disruption that the industry and the rest of the world is now facing has had varying impact throughout aerospace and defense segments. The impact on commercial aerospace has been drastic; however, the defense sector has largely seen little negative consequences.
Experts say that some trends are beginning to appear that will have an impact on the entire deal life-cycle—from deal strategy through integration and value creation. Nonetheless, insiders believe that new opportunities will crop up. This gives many the hope that the slowdown of M&A activity will be short-lived. In the aftermath of COVID-19, those deal makers who adapt quickly to the realities of the new industry landscape may be well-suited to maximize value.
The Aerospace Outlook Prior to COVID-19
Before the coronavirus struck, commercial aerospace was thriving and enjoying year-over-year ramp ups in build rates and record backlogs. Many believed it would be another golden decade that would continue to extend the unprecedented 14-year “super up-cycle”, defying the long-standing cyclical nature in this business sector.
But in 2019, the historic correlation between GDP, air-traffic growth, carrier profitability, orders and build rates was suddenly interrupted. GDP and airline profitability levels remained relatively healthy; however, new orders and build rates decreased because of the impact on the industry of the 737MAX, along with a decline in the twin-aisle segment. There were other undercurrents that emerged, such as downturns in world trade from escalating tariff tensions, weakness in high-growth geographic markets like China and India, and declining consumer confidence.
Nonetheless, general confidence in the long-term fundamentals of the sector and a favorable budgetary environment caused players in certain A&D segments to actively look for M&A opportunities to build scale.
Other companies “re-realized” that content matters. They started vertical and horizontal integration strategies to capture more value and drive cost competitiveness, or acquired targeted niche capabilities and emerging technologies. The industry also saw the development of Super Tier I’s through scale-driving consolidation aimed at broadening capabilities and potentially exerting greater influence on OEMs (original equipment manufacturers).
The deal volume in the A&D sector hit record levels, and nearly doubled over the last five years. It outdistanced the overall M&A market by 40%. Valuations remained high based on the strength of high bidder interest, limited supply of attractive assets, high A&D stock valuations (these outperformed the S&P 500 by 8%).
While deal volumes lessened in the second half of 2019 with more questions about defense spending heading into a presidential election year, the overall outlook remained good.
The pandemic has resulted in an abrupt decline in air traffic, given the travel restrictions and stay-at-home orders. Now airline companies around the world have been to make unprecedented cuts to capacity, idled their fleets, and started to defer or stop new aircraft deliveries.
In addition, the MRO (maintenance, repair, and overhaul) and aftermarket segments—segments that had benefited from the prolonged 737MAX grounding and high fleet utilization—now, suddenly faced difficulties.
To date, the defense industrial base has not seen a COVID-19 demand shock. There has been no appreciable disruption in appropriations or major delays and cancellation of military programs. Although, the commercial sector ahs seen defense contractors actively monitoring their supply base and taking action to preserve liquidity, minimize supply chain disruption, and taking steps to comply with CDC and local government guidelines.
The range of possibilities for defense spending is set out by two scenarios. One is an elevated national security threat that would preserve or accelerate funding, and the other is a reordering of budget priorities to fund social and other mandatory programs. This would mean sequestration-type measures, similar to 2011. Given these developments, the volatility in the financial markets, lack of access to financing, alternative more pressing liquidity needs by corporations, and the uncertainty in the marketplace, deal flow in A&D has come to an immediate stoppage. Several “in-flight” processes have been halted, new deals in the works have been delayed, and even some announced transactions have been scrapped. Also, access to the new public offering market is effectively closed.
Analysts have found that the gap in expected valuations between buyers and sellers has widened significantly because of the contrasting views of the level of economic disruption caused by COVID-19; differing views on reopening of the economy and the speed with which to return to normal; and distinct perspectives on what the post-COVID-19 new reality looks like.
This has made all financial forecasts and pre-COVID-19 market perspectives of little value. Also, the extent and type of unusual and non-recurring events affecting financials create major challenges for deal makers to form a credible view of normalized earnings and cash flows.
With the lack of reliable projections, it’s nearly impossible to crate a credible view on valuations, to say nothing of bridging this gap. Additionally, although M&A teams have tried to maneuver through practical challenges with offsite due diligence, virtual facility tours, and video conferencing, adapting to a virtual M&A environment, especially for cross-border deals, has been a real test.
Although experts do not believe there will be M&A activity at the levels before the pandemic, they do anticipate M&A activity to drive realignment of the industry landscape in the aftermath of the COVID-19 pandemic.