M&A activity in Defence sector ramps up

Canada and indeed the globe is again seeing increased activity in mergers and acquisitions (M&A) in the aerospace and defence (A&D) sector. So far this year, Canadian companies have been active acquirers, completing eight deals through June, and they’re not done yet. Compared to previous years, we’ve also seen significant foreign interest in Canadian opportunities which we expect will accelerate heading into 2020.

Globally, signs are also pointing to an upswing in mega mergers, the impact of which does spill over into Canada where the players have a local presence. For example, the recently consummated deal between L3 and Harris created a US$34 billion entity and both former companies have operations here. In that case the U.S. Justice Department weighed in and required part of the Harris business to be separated from the combined company due to anti-trust concerns. Boeing is also facing a EU antitrust investigation into its bid for a controlling stake of Brazil’s Embraer.

The proposed takeover of U.K.-headquartered Cobham by Advent International, a U.S. private equity firm, has also forced a review of the transaction by the U.K. government, in this case to consider national security interests.

Raytheon UTC merge

Raytheon and United Technologies also decided to tie the knot. When they complete their merger in 2020, they will become the second-largest U.S. A&D company after Boeing with combined revenues of US$121 billion. This comes on the heels of United Technologies acquiring Rockwell Collins in 2018. We’ve yet to see the ripple effect, with Pratt and Whitney engines and other operations in Canada.

There are several catalysts igniting this activity.

Looking at valuation multiples for A&D publicly traded companies in North America, they’re healthy, with forward EBITDA multiples averaging over 10 times the enterprise value.

Companies are facing intense competition, squeezed profit margins, and mounting pressure to meet production goals to ease backlogs in the A&D industries. Defence suppliers, aircraft manufacturers and tier 1 subcontractors are all looking for synergies, including ways to strengthen their domestic and global reach and manage their supply chains.

In the Canadian market, which with a few exceptions (such as the Bombardier carve-out sale in 2019 of the Dash 8 to Longview Aviation for US$300 million) is primarily made up of small-to-medium-sized enterprises (SMEs). This highlights the need for a robust supply chain, which Jean Charest’s recent report Charting a New Course: Canada as a Global Aerospace Champion flagged as a “critical issue.” This may help prompt mergers that enable suppliers to achieve the critical mass necessary to meet production demand.

A key enabler for deal activity is technology and innovation. Growth-driven A&D players will also likely need to broaden their focus to new markets and new innovative capabilities, as well as ability to execute non-traditional transactions, such as partnerships and alliances.

The ability to harness the power of artificial intelligence (AI), machine learning, and robotic process automation is critical for an organization to drive cost and process efficiencies. But beyond that, A&D players are now leveraging new and emerging technologies to help redefine the future battlefield and push ahead into space defence. An AI-arms race is already underway among the world’s biggest military powers.

Redefining the future battlefield

To be sure, geopolitical tensions are presenting opportunities and creating real challenges for the defence sector. While the intersection between business, technology, and security in the defence sector is always complex, deals are now coming under much closer scrutiny. All of the mega mergers noted above have come under anti-trust or national security reviews, and in Japan, the government plans to tighten rules on foreign investment in industries related to national security. Our government has undertaken similar review in previous M&A transactions in Canada.

As political tensions mount, it’s not out of the realm of possibility that defence departments will spell out the extent to which their military equipment rely on foreign components. Whether it’s wariness with over-dependence on either China or the U.S., it’s clear that nations are making strategic investments within their own countries. Canada’s close proximity to the U.S. is a clear advantage. The opportunity for homegrown suppliers to fill the gap is huge but again do they have the critical mass?

Whether you’re merging or collaborating, the challenge, as always, is in finding the right partner. There’s deal risk, and integration risk, and it’s vital to get both buttoned down tight. Sometimes size DOESN’T matter; M&A participants often say it takes the same amount of effort to do a small deal as it does a large one.

The art of the deal

A&D companies need to exercise strict discipline, evaluate the synergies carefully, and conduct robust due diligence to understand how their investments will help to achieve their revenue, profitability, and cash flow projections.

Due diligence is an essential part of the deal execution and will, when done effectively, reveal risks and allow acquirers to fully understand and tackle integration issues pre-close. As well, it’s vital to consider the tax implications from the outset, given ever-evolving domestic and foreign tax regimes.

At the same time, A&D deal-making also likely needs to evolve, in part to reflect a new type of acquisition target – one where intellectual property and talent matter more than assets and inventory.

M&A is a challenging endeavour, but the payoff can be well worth the effort.

This article was first published in the Canadian Defence Review Magazine in October 2019

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