In an active M&A market for the industry, Michael Richter, managing director and head of Lazard’s aerospace and defense investment banking group, shares his observations from the Paris Air Show.

While mergers and acquisition activity has slowed moderately over the past 12 months, the industry continues to be robust, with favorable credit markets supporting private equity participation and a greater availability of financing.

Announced global M&A transactions in 2016 totaled US$71.7 billion in value, according to DACIS’ DM&A database. Notable transactions include Rockwell Collins’ acquisition of B/E Aerospace for US$8.3 billion and Leidos Holdings’ acquisition of Lockheed Martin’s government IT and technical services businesses for US$4.6 billion.

Transaction value remains strong year-to-date in 2017, with US$17.7 billion of announced transactions, including Safran’s acquisition of Zodiac Aerospace for US$8.2 billion and Veritas’ acquisition of Harris Corp.’s government IT services business for US$690 million.

With increasing defense budgets and shifting DoD priorities, companies are now focused on intelligence, electronic warfare, cybersecurity and C4ISR.

Defense M&A has been catalyzed recently by a positive long-term sector outlook, recovering valuations, and the availability of capital. In addition to the traditional shareholder-friendly methods of distributions and capital return, companies have recently shifted toward re-prioritizing portfolios. Expanding in core growth markets through M&A has become an equally important tool for growth. Not only is the defense sector active in product-oriented acquisitions, but the supply chain is ripe for integration and consolidation, suggests Richter.

In the commercial aerospace sector, synergy-driven value creation has always been a motivator for acquisitions, but recent M&A activity seems to be a result of more deliberate strategic reshaping activities. In the current stage of the aerospace cycle, many companies are actively seeking new growth avenues. This has involved stepping up inorganic expansion opportunities, as seen in Safran’s acquisition of Zodiac and Rockwell’s acquisition of B/E Aerospace. Portfolio reshaping has also come in the form of shedding noncore assets (e.g., Safran’s divestiture of Morpho) and mitigating OEM delivery cycle exposure (e.g., Rockwell’s investments in aftermarket content and Safran’s desire for product diversification). According to Mr. Richter, with program transitions putting pressure on margins, M&A has become a core driver of growth across the industry.

While new orders for aircraft have seen a pronounced decline in the past 12 months, backlogs of aircraft orders remain at record highs, driving high production rates and creating increased visibility in deliveries. M&A continues to play a prominent role, whether it is in ongoing supply chain consolidation, or in the inevitable sustainment benefits of MRO opportunities. With the increased pressure on the supply chain, OEMs are creating disruptions in the market, motivating suppliers to be more competitive. Continued consolidations will help cut costs and reinvigorate manufacturing innovations in order for OEMs to compete.

Suppliers, which for years have competed against one another in order to secure large future revenue streams on emerging platforms, are now focused on execution risk and delivering products efficiently as a means for increasing margin. As OEM production volumes increase, managing the risk of part shortages from suppliers will become an important component of ensuring on-time aircraft delivery to customers.

While the supply chain has entered into a new phase of the production cycle, there are now greater threats of emerging technologies disrupting suppliers’ relationships with OEMs. On next-generation aircraft, OEMs are beginning to focus more on narrowing the margin gap with suppliers by leveraging investments into new technologies such as additive manufacturing, automation and other forms of innovations that give OEMs greater negotiating power, pressuring relationships with suppliers.

These newfound pressures will drive significant R&D and capital expenditures for suppliers to compete, and resistance against OEMs may drive a new wave of consolidation. Increased scale from M&A can allow new investments to be more efficient, and deliver the pricing required by OEMs at profitability levels that can also satisfy investors.

Lazard continues to be one of the most active M&A advisers to companies within the aerospace and defense markets. With 44 aerospace and defense-related transactions (totaling over approximately US$80 billion in deal value) since 2013, Lazard has led 14 significant M&A deals since 2016, including Safran’s acquisition of Zodiac Aerospace, LMI Aerospace on its sale to Sonaca, Harris Corp. on the sale of its government IT services business to Veritas Capital, and Tronair on its sale to Golden Gate Capital.