With the March 4^th submission of the fiscal 2015 budget approaching, more information detailing plans of future spending and potential cuts continue to be determined.  Among the departments soon to realize their respective fates, the Air Force is expecting to take severe cuts to personnel and platforms.  The overall theme of the budget is the question of capability and necessity today or in the future, creating a difficult landscape as current and previous programs are being cut to keep future modernization programs, such as the KC-46A tanker and F-35 joint strike fighter programs, moving forward.  Air Force Secretary Deborah Lee James confirmed that service personnel will decrease to sustain a smaller force in the near term in order to resource needed modernization programs.  Some of the cuts do not come as a surprise, including the A-10 platform in favor of multifunction platforms, as well as the KC-10 and MC-12 aircraft and surveillance platforms.  Other notable changes include shifting funding from the highly-favored U-2 manned spy plane program to the Global Hawk long-range drone system and reducing the number of Reaper and Predator unmanned combat air patrols.  However, even with program and funding cuts, Air Force officials remain confident that the department will remain sharply focused and highly capable on the cutting edge of new technology to meet the country’s needs moving forward.

Engility Holdings, Inc. completed its $120 million acquisition of Dynamics Research Corporation, Inc. (“DRC”) on January 31st.  Investors have responded positively to the acquisition, with Engility’s stock price up ~21% since the deal was announced on December 23^rd.  The acquisition is expected to be immediately accretive to Engility’s full-year 2014 earnings, and expands the company’s presence within high-end defense, intelligence, and healthcare markets, as well as its access to key prime contract vehicles such as CIO-SP3.

Big Movers

MAXIMUS, Inc. (Up 11.5%) – Shares were up this week after the Company announced positive fiscal quarter results with $406.6 million in revenue, a 42% increase from the same period last year.

Spirit AeroSystems Holdings, Inc. (Down 20.2%) – Shares were down this week after the Company reported disappointing fiscal quarter results, which included a net loss of $587 million.

Relevant Transactions

CapitalWorks, LLC acquired Meriwether Capital’s Capewell Components Company, a provider of specialized industrial, commercial, and military components and tools for the aerospace and defense industry.  Terms of the deal were not disclosed.

Héroux-Devtek, Inc. acquired BBA Aviation Plc’s APPH Ltd. and APPH Wichita, Inc., providers of landing gear and hydraulics systems and assemblies for original equipment manufacturer and aftermarket applications.  Héroux-Devtek paid $124 million for the acquisition.

Wesco Aircraft Holdings, Inc. to acquire Haas Group International Inc., a provider of chemical management, product distribution, and supply chain management for the aerospace, defense, electronics, and manufacturing industries.  Wesco will pay $550 million for the acquisition.

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Bombardier’s rough beginning to 2014 continues as the company announced it would lay off approximately 1,700 employees from its aerospace division, or 4.4% of its aerospace workforce, due to continued difficulties within the tough market and ongoing delays of its CSeries line of aircraft.  Company spokesmen stated that the cuts are part of a companywide cost-containment plan, which has been in place since late 2012 and are not necessarily linked to delays with the CSeries.  Of the affected employees, roughly 1,100 in the Montreal region will be affected while the remaining 600 are in North America, primarily Wichita, Kansas.  Bombardier stated it delivered a total of 238 aircraft in 2013, five more than the previous year, but still 10 fewer than its original forecast.

Following funding cuts in the recently approved omnibus budget bill, the U.S. Army’s Ground Combat Vehicle program has come to a halt.  The Army requested $592 million in its fiscal 2014 request for the continued development of the program, but after Congress slashed $492 million from the request, the next-generation infantry carrier has become no more than a technology development and study program.  Senior officials hope the remaining funding will allow the Army to continue developing technology so that the service can be revived in the future.

Following last week’s passage of the FY14 omnibus spending bill, the White House announced on Thursday that it will release the President’s Budget Proposal for FY15 on March 4^th.  According to the announcement, the proposal will incorporate elements of the budget deal reached in December, which set FY15 discretionary spending at a total of $1.014 trillion.  The Administration noted the partial relief from sequestration achieved by the budget deal would have to be worked into the President’s budget, which had previously assumed steeper spending cuts.

Big Movers

Parker-Hannifin Corporation (Down 10.0%) – Shares were down this week after the Company offered an updated fiscal year 2014 earnings per share outlook that was well below forecasts and analyst estimates.

Moog Inc. (Down 8.1%) – Shares were down this week after the Company announced fourth quarter earnings below analyst estimates, resulting in the Company issuing lower than expected fiscal year 2014 earnings and revenue guidance.

Relevant Transactions

Astronics Corporation to acquire EADS North America Test & Services, Inc., a provider of engineered automatic test systems, subsystems, and instruments for the semi-conductor, consumer electronics, commercial aerospace, and defense industries.  The deal is worth an estimated $53 million.

AVX Learning, LLC acquired Adayana, Inc., a provider of human capital development and organizational performance improvement solutions to various industries including healthcare and the U.S. federal government.  The deal is worth an estimated $5 million.

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Boeing started the year on a high note as the Company announced it set a new record of deliveries in 2013 in addition to coming to an agreement with machinist union members surrounding assembly work for the new 777X.  Driven by high production rates on the 737, 777, and 787 lines of aircraft, which the OEM has been steadily ramping up over the past few years, Boeing delivered 648 commercial aircraft in 2013.  This is the second time Boeing has exceeded 600 deliveries, with the first time just last year in 2012 when the Company delivered 601 aircraft.  Deliveries of the 737 made up the majority with 440 units while the 777 contributed 98 deliveries.  As orders continue, specifically for the newest 777X, Boeing was able to come to an agreement with union members to keep assembly work in the state of Washington, following two months of speculation.  The agreement, which passed in the slimmest of margins, extends current contracts by eight years through 2024.  Among the agreements in the contract, workers will receive a 4% general wage increase as well as replacing pension-plan accruals in 2016 with defined-contribution savings retirement plans.  Boeing is now expected to start construction in November of the new 1.1 million square foot wing manufacturing site in the Puget Sound area.  The site requires $4 billion in new investment and will employ up to 3,000 workers while the current Everett site will house the 777X final assembly line.

In his new memoir scheduled to be published next week, former Secretary of Defense Robert Gates makes interesting comments on the Obama administration, specifically on defense-related issues including policy toward the war in Afghanistan.  Gates, who served as defense secretary from 2006 to 2011 under both George W. Bush and Barack Obama, is critical of Obama’s own skepticism but still considers him “a man of personal integrity”.  In a statement issued by a National Security Council spokeswoman, Obama stated he deeply appreciates Gates’ service and welcomes differences of view, which serve to broaden his options and enhance policies.

Big Movers

TASER International, Inc. (Up 19.2%) – Shares were up this week after the Company announced strong fourth quarter results with large orders from 13 customers for its conducted electrical weapons and 29 agencies deploying its next generation smart weapons.

FLIR Systems, Inc. (Up 11.3%) – Shares were up this week after the Company introduced its Lepton thermal-imaging camera core, one of the world’s smallest microbolometer-based thermal-imaging camera cores, which will be used in the new FLIR One, a smartphone case that turns phones into fully functional night vision cameras.

Relevant Transactions

Vance Street Capital LLC’s Secure Communication Systems, Inc. acquired Relativity Capital LLC’s Tactical Micro, Inc.⁽¹⁾, a provider of ruggedized electronics for military, homeland security, and transportation markets.  Terms of the deal were not disclosed.

(1)    KippsDeSanto & Co. acted as financial advisor to Tactical Micro, Inc.

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M&A activity in the aerospace / defense industry in 2013 was decidedly mixed.  The headline is that 158 industry transactions were announced during the year, down from 2012’s 177 transaction announcements (see chart below).  Essentially all of this decline in transaction volume was attributable to activity involving companies primarily serving the defense sector, where the number of deals slid from 77 to 58.  Deal volume involving target companies operating primarily in the commercial aerospace sector, on the other hand, was flat (albeit at a very high level), with 100 announced transactions in both 2013 and 2012.  Clearly, the uncertain defense budget environment had a significant impact on deal activity in 2013.

Valuations are extremely difficult to generalize since there is a greater amount of buyer selectivity than there has been in previous years.  But general valuation trends mirror the trends in volume – multiples for transactions involving defense companies settled into a lower range, while multiples in the aerospace sector remain at cyclical highs.

From a size perspective, 2013 witnessed the continuation of a trend that has prevailed in the aerospace / defense industry for several years:  the predominance of middle-market sized deals.  Fully 97% of the transactions in the industry were for enterprise values of less than $500 million (see chart below).  Moreover, mega-deals of greater than $1 billion in enterprise value were few and far between, with only two such transactions (Rockwell Collins’ acquisition of ARINC for $1.4 billion and Textron’s acquisition of Beechcraft for $1.4 billion) announced in 2013.

What do we predict will happen for aerospace / defense M&A activity in 2014?  The commercial aerospace market continues to roar along, with healthy backlog and strong visibility for years’ worth of production.  Barring an economic slowdown, we would expect transaction volume to proceed at already robust levels, with perhaps a pause in valuations that seem to be cresting.  In the defense sector, one of the factors that created the biggest drags on activity in 2013 – the lack of certainty around the budget / funding environment – has been removed with the budget deal struck in December 2013.  We predict that this will loosen the constraints on deals in 2014, providing a confidence boost to buyers eager to do strategic deals.  That said, the defense market is still in the early stages of an anemic “growth” cycle, which will put a crimp on super-premium valuations.

M&A Deals by Announce Date and Size

Source: CapitalIQ and KippsDeSanto Research

After the Senate voted to pass the 2014 National Defense Authorization Act (“NDAA”) last week, President Obama signed the legislation into law on Thursday.  The bill now assures $552.1 billion in base military spending with an additional $80.7 billion for overseas contingency operations, namely the war in Afghanistan.  Among the new legislation, President Obama praised the NDAA for allowing accelerated repatriation of detainees from the U.S. naval facility at Guantanamo Bay in Cuba as it allows greater flexibility to transfer detainees abroad and he will continue to work with Congress to take additional steps needed to close the facility.  Following months of budget uncertainty and sequestration stipulations, the newly-signed law and broader budget agreement allow for a 1 percent raise for military personnel and create top-line spending limits for 2014 and 2015, which will erase an estimated $63 billion in arbitrary spending cuts that were to take effect on January 1^st.  Most importantly, the legislation critically reduces the threat of a future government shutdown on or around January 15^th, when members from both chambers will be crafting spending bills under the new spending limits.

Big Movers

Meggitt plc (Up 4.0%) – Shares were up this week after the Company’s Training Systems division won a contract from the Australian Defence Force to provide hardware and software upgrades to training simulation facilities in a deal worth an estimated $18 million USD.

Relevant Transactions

Textron Inc. to acquire Beechcraft Corporation, a provider of turboprops, pistons, and light attack military aircraft for militaries, governments, and individuals in the United States and internationally.  Textron will pay approximately $1.4 billion to acquire Beechcraft.

L-3 Communications Holdings Inc. acquired Mustang Technology Group, L.P., a provider of radar-based sensors and systems used in precision-guided weapons, electronic warfare, unmanned systems, and other military applications.  Terms of the deal were not disclosed.

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