AEROSPACE & DEFENSE OUTLOOK MERGERS & ACQUISITIONS UPDATE 2018 Capstone Headwaters www.capstoneheadwaters.com Aerospace & Defense Outlook | 2018 Annual Report AEROSPACE & DEFENSE OUTLOOK Mergers & Acquisitions Update 2018 TABLE OF CONTENTS INTRODUCTION Introduction We are pleased to present our 2018 Aerospace & Defense Outlook: Mergers & Acqui- M&A Overview sitions Update. M&A Update The year 2017 saw steady sector Merger & Acquisition (M&A) activity, with transaction Market Outlook trends highlighting the underlying structure of an industry dominated by OEMs and - Commercial Aerospace the reactive efforts of a fragmented supply base fueled by private capital, increased - Defense defense spending, and technology advances. - Government IT - Cybersecurity Our report provides a wealth of Aerospace, Defense, Government & Security transac- - Simulation & Training tion data and also discusses: Closing Words Recent Transactions The outlook for M&A activity Structural industry themes highlighted by M&A Financial buyers’ role as consolidators of the supply base CONTRIBUTORS Company founder exits and perspective Valuation trends in public and private markets Ian Cookson | Managing Director Commercial Aerospace outlook and dependencies 617-470-9338 Changing emphasis of the defense budget [email protected] A resurgence in Government IT Tess Oxenstierna | Managing Director Cybersecurity escalation and consolidation 203-524-0888 Advances in Simulation & Training [email protected] David Brinkley | Managing Director To learn more about Capstone Headwaters’ Aerospace, Defense, Government & Se- 917-817-0375 curity (ADG&S) Practice or to discuss the content of this report please do not hesitate [email protected] to get in touch. Tom McConnell | Managing Director 303-951-7125 [email protected] Ted Polk | Managing Director 312-674-4531 [email protected] 2 www.capstoneheadwaters.com April 2018 Aerospace & Defense Outlook | 2018 Annual Report MERGERS & ACQUISITIONS OVERVIEW Last year’s Aerospace & Defense merger & acquisition activity highlighted the underlying structural characteristics of an indus- try dominated by an airframe duopoly, powered by a handful of engine makers, and the reactive efforts of a vast consolidating supply base. Airbus and Boeing sought to expand their dominance by: completing transactions with smaller regional aircraft, bringing work back in house, and extending profitability over the life of an aircraft. Meanwhile, suppliers worked to counter balance OEM pressures by combining and building out complete systems capabilities. Private equity investors have become integral to the consolidation of a previously highly fragmented supply base, enabling founders to retire from companies which in many cases have expanded beyond the financial suitability of individual ownership. The number of Aerospace & Defense M&A transactions in North America remained broadly stable in 2017 increasing 2.0%. This com- pares to a 16.0% decline in the prior year when component man- Structural factors underlying sector ufacturing transactions retreated from extraordinary peaks and are M&A of dominant OEMs and a con- well above the 10.0% decline in the number of North American M&A “ solidating supply base are likely to transactions across all industries. continue for years to come. Howev- er, the level of activity is likely driven Public company valuation multiples increased to pre-financial crisis by economic temperature, ambitions highs on flat earnings. In private M&A transactions the spread in of industry participants, and is par- multiples between large and small companies continued to widen as ticularly sensitive to potential Asia large businesses have become increasingly sought after. Pacific shocks In Commercial Aerospace, industry sales rose slightly and production ” increases are expected as orders picked back up. Backlogs at Boeing and Airbus average eight years but mask a decades-long shift to single aisle aircraft. Worldwide airline passenger traffic grew 7.5%, far exceeding long-term 4.5% growth forecasts. Such expectations are increasingly dependent on the expansion of the Asia Pacific fleet, with the region projected to account for 40.0% of new deliveries—more than the mature markets of Europe and North America combined. The other glaring 40.0% customer dependency is to the leasing industry, which is reliant on a continual inflow of fresh funds to support purchases and where capital has been pouring in, again from Asia Pacific sources. Although U.S. airline profitability has risen to a level where alternative financing options are available if needed, the same is not true of the rest of the world where margins remain half those of the U.S. In defense, the President’s 2019 Budget request was for a 10.0% increase, with a transition in spending to Great Power com- petition rather than terrorism as the primary focus of U.S. national security. Notable areas of increase are therefore in Ground Forces, Space Systems, Missiles & Munitions, and RDT&E. M&A activity has followed, with Northrop acquiring Orbital ATK to gain launch & propulsion, missiles, and space systems capabilities, while smaller transactions have been to build out systems in defense electronics and C4ISR/Geointelligence. Defense spending increases have also fueled a step up in Govern- ment IT Services, as revenue expectations have improved, together with increased budgetary visibility, and a commitment to IT systems infrastructure, modernization. These macro trends, combined with historic valuations, profitability and cash balances have broadened M&A activity. Acquisitions have expanded beyond portfolio re- organization and are adding capabilities in high growth areas of cybersecurity, cloud computing, data analytics, intelligence, C4ISR, and firms holding strategic contract vehicles. As the sector heats up, we are witnessing activity by a wider group of buyers, including non-traditional and financial players, attracted by a significant uplift in the defense IT market and targeting more diversified IT service organizations. Cybersecurity has seen exceptional growth as breaches continue to escalate, while the world becomes ever more reliant on inter- 3 Aerospace & Defense Outlook | 2018 Annual Report net connectivity and secure data flow. The cybersecurity industry is expected to grow 12.0-15.0% annually over the next five years and government expenditure rose over 35.0% last year. M&A activity fol- Increases in defense spending are fuel- lowed suit with an almost 50.0% increase in the number of cyber ing expectations of M&A in defense and “defense IT, while technology advances deals and a doubling in the value of transactions as start-ups mature and consolidators seek to broaden their solutions, simplify customer are also driving acquisitions as: prime purchasing, and gain economies of scale. defense fill gaps in Great Power; IT pro- viders access growth areas; cyber players consolidate solutions; and simulation Simulation & Training has also seen significant activity bringing im- methods evolve proved technology capabilities and cost advantages to both com- mercial and military markets. Large strategic and private equity play- ers have made acquisitions in commercial flight simulation to access ” a sizeable market and target pilot shortages, while strong growth has been seen in military adoption as improved reality and gaming technologies have met greater training needs and increased availability. Looking to the future, the structural factors underlying sector M&A of dominant OEMs and a consolidating supply base are likely to continue for years to come. However, the level of activity is driven by the economic temperature and ambitions of industry participants. Private equity has even greater amounts of capital to put to work, and while news from Commercial Aerospace continues to be good, the sector is highly susceptible to Asia Pacific shocks due to its dependency on the region for fleet expansion and aircraft lease financing. Increases in defense spending are fueling expectations of increased M&A in Defense and Defense IT, while technology advanc- es are also likely to drive acquisitions as: Prime defense companies fill gaps in Great Power competition priorities. IT providers access growth areas. Cyber players build out product capabilities and consolidate customer offerings. Advances bring new simulation and training methods. 4 Aerospace & Defense Outlook | 2018 Annual Report MERGERS & ACQUISITIONS UPDATE Structure of Industry Highlighted By M&A Major industry themes highlighted by Aerospace & Defense merg- er & acquisition activity in 2017 were illustrative of an introductory economics class, demonstrating the underlying structural character- Last year’s M&A activity highlighted istics of an industry dominated by an airframe duopoly, powered by underlying structural characteristics of a handful of engine makers, and the reactive efforts a vast and frag- “an industry dominated by an airframe mented but consolidating supply base: duopoly, powered by a handful of Airbus and Boeing sought to secure their dominance, through engine makers, and the reactive efforts combinations with makers of smaller regional aircraft: Airbus a vast fragmented but consolidating agreed to buy a 50.0% stake in the Bombardier CSeries program supply base and Boeing seeks formal ties with Embraer. ” OEMs also looked to capture more profit per plane and expand input over the life of the aircraft as illustrated