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This month saw the announcement of two proposed deals in the US that hold significance for the defence and aerospace supply base, especially but not confined to the US. The merger of L3 and Harris promises a $10 billion giant in defence communications and electronics, while the acquisition of Esterline by proprietary component maker TransDigm would result in a new Tier 2 component supplier to the aerospace and defence market who nevertheless would have around $6 billion of revenues.
Overview of the Proposed Transactions
1- L3 and Harris
- Harris is tactical communications provider whose main customer is the US DoD. It’s main products are tactical communications solutions and radios for the military and blue-light services.
- L3 is a leading electronics manufacturer and systems integrator with a somewhat diverse portfolio, built up since the company was started in 1997 and grown through multiple acquisitions to become a leader in sensors, electronics, avionics and communications for the defence and aerospace markets.
- L3 ($6 billion) and Harris ($4 billion) would be a $10 billion business making it approximately No. 10 in the world of global defence suppliers.
2- TransDigm and Esterline
- TransDigm has grown with considerable success in a manner similar to L3, that is through the steady and strategic addition of revenue by acquisition. It has focussed on proprietary, single-source products to the civil aerospace market where it is exposed equally to new-build and aftermarket cycles (approximately 30% each). It also has 34% of revenues associated with defence.
- Esterline has also grown through the acquisition of a broader portfolio of aerospace, industrial and defence businesses.
- The acquisition of Esterline (approximately $2 billion) by TransDigm ($3.5 billion) would create a supplier of critical proprietary components of around $6 billion, very large for effectively a Tier 2-level supplier in aerospace and defence. TransDigm has valued Esterline at $4 billion, a premium of 38% for a business that was already valued at 56x current earnings at the time the deal was announced.
Rationale for the Proposed Transactions
1- L3 and Harris
- Harris and L3’s product portfolio is largely complementary although also closely aligned within defence electronics more generally. As such, there is a good fit between the two in terms of products and skill-sets.
- Nevertheless, the driving logic of the deal is more likely defensive. Both companies were valued below 20x current earnings before the announcement and both have reported flat-ish top-line growth for the past 3 years. For businesses of their size, it is getting harder to grow by taking market share and a combined entity may well have deeper resources to win larger contracts as primes rather than Tier 1 suppliers.
- Furthermore, US defence spending has seen a significant boost during the Trump presidency but this is likely to peak in 2020 before a much more restricted fiscal stance exerts a moderating pressure on future defence spending. As such, this proposed consolidation is also about future-proofing the two businesses for when defence spending moderates post-2020.
2- TransDigm and Esterline
- The fit between Esterline and TransDigm is very strong in a number of respects. Firstly, they both have very similar business models in that they both are serial acquirors of businesses that then are allowed to run themselves with little integration into the corporate structure.
- Both businesses serve similar markets with a strong focus on aerospace as well as defence, the only difference being Esterline’s interest in the industrial space.
- As well, Esterline and TransDigm have complementary ranges of products but of the same nature i.e. engineered system components often with significant replacement rates and often as a sole-source supplier.
- Ultimately, both businesses see the value in the current environment of maximising ship-set value on civil aviation platforms which currently enjoy historically high production back-logs.
Implications of the Proposed Transactions
1- L3 and Harris
- Does the news of this merger mean the start of another round of defence restructuring? The have been some who have seen this announcement as signalling the start of another wave of defence restructuring in the US. This remains unlikely as the rationale for the merger was much stronger for the segment where Harris and L3 are present (defence electronics and communications) than for the wider market. The big players such as Lockheed Martin, Northrup Grumman, BAE Systems and Boeing have been achieving much more consistent growth than L3 or Harris and have market valuations that reflect their better performance and prospects.
- Does this indicate the peak of US defence spending is in sight? Probably, yes. Much of the Trump administrations proposed 5% real-terms uplift has been brought forward due to the perceived increase in the general global threat environment. After 2020, spending would have been likely to be much flatter in any case, but the likely rise in interest rates by the Fed makes this even more likely. For every 1% rise in interest rates the cost of servicing US government debt increases by $200 billion. This is equivalent to a quarter of the total federal budget. This money would have to be found from somewhere and it is likely that defence will have to make a contribution, particularly after a recent boost. All in all, although the near-term spending outlook looks rosy for US defence contractors, that could change markedly after 2020.
2- TransDigm and Esterline
The TransDigm/Esterline tie-up has a much better chance of enhancing the growth prospects for both companies. As far as the portfolio businesses of both companies goes, given the similar light corporate control for both entities, not much will change and TransDigm in particular has been performing very strongly. In fact, too strongly in the view of some, as Congressman Ro Khanna has asked for an investigation of TransDigm’s defence business as he suspects it is in some areas a virtual monopoly, hidden by the multiple different companies that produce the same components that TransDigm owns. But in civil aerospace greater ship-set value on key platforms whose production will run well into the future means that in strategic terms the acquisition is a sound move.
Another aspect is that both companies share a significant interest in the aerospace aftermarket where margins are often higher and demand is maintained over the very long-term. The aftermarket for components in aerospace has shown signs of reviving finally after several years where the focus was on production. The new entity will therefore be well positioned to take advantage of this as demand in the aftermarket strengthens.
