CRA Insights:

Aerospace & Defense

December 2009
The author: Charles Armitage Principal London +44 20 7664 3671 carmitage@crai.co.uk

On the Vernacular of Valuation in A&D

A defining feature of the current economic crisis is that it has thrown all asset values into commotion. The value of public equities in aerospace and defense companies is no exception, having only recently moved off the bottom of a precipitous 40 percent drop in 2007 2008 despite a 2009 of tumultuous news flow in their end markets. Similarly, attempts to draw reliable indications of value from mergers and acquisitions in the sector have been undermined by the dearth of deals over the past two years. In addition to the credit crisis itself, the sharp divergence of buyers and sellers over the valuation of A&D assets has impeded the establishment of a momentum in the trend of M&A transactions involving A&D assets. Sellers have been holding out for 2007 prices while buyers have been holding on for the lower prices they expect to emerge in 2010 and beyond. However, two acquisitions announced within the span of a week last monthof Northrop Grumman TASC by KKR/General Atlantic and GE Security by United Technologies suggest that the mass of capital stored on corporate balance sheets and in private equity funds may begin deploying to restructure the capitalization of A&D assets and adjust corporate portfolios ahead of the inflection in demand that commercial aerospace and military markets are both now facing. Against this backdrop, valuation trends will now be closely watched to determine if theres any more reliable answer to the question, Whats an A&D asset worth? As attention turns to this question, we have two recommendations, both arising from the insight that the diversity of asset-types comprising the A&D sector is now very wide. First, refocus attention from prices paid to what those prices imply for the underlying rates of growth and risks facing different asset types in different market segments. Second, against the commonplace shorthand use of EV (enterprise value) divided by EBITDA (earnings-before-interest-taxes-depreciation-and-amortization) to guide the emerging consensus, employ EBITA (earnings-before-interest-taxes-and-amortization) instead as the relevant measure of return. As a consequence of the sectors increasing diversity of fixed asset intensity, the corresponding range of sustaining capital expenses necessary to keep these businesses going (as opposed to catalyzing their growth) confounds the shorthand use of EBITDA as a reliable measure of earnings, cash flow, and value. Adopting a vernacular of valuation based on EBITA to characterize transactions better enlightens an understanding of the actual dynamic interplay of prices, returns, growth, and risk, which is where leading-indicator insights are more likely to be revealed than from simple comparisons of EBITDA multiples.

A tale of two transactions

As a starting point, consider the two recent transactions. On November 8, Northrop Grumman announced the sale of a collection of technical services businesses it organized under its TASC brand to a partnership of the private equity firms KKR and General Atlantic. Four days later, General Electric sold its Security business, a security products manufacturer, to United Technologies. Table 1 depicts the customary valuation analysis featured in most reporting about the deals, together with an estimate of each companys operating cash flow. On the basis of EV/EBITDA multiples, it would appear that the private equity firms paid a 37 percent premium for TASC relative to the valuation by which United Technologies was able to acquire GE Security. Conversely, on the basis of operating cash flows, which are nearly identical at these two businesses, it would appear that United Technologies valuation of GE Security represents a 10 percent premium to the corresponding price paid by KKR/General Atlantic. Whats a discerning observer of A&D asset values to conclude from these ostensibly leading-indicator transactions?
Table 1: Valuation and cash flow analysis of TASC and GE Security

Hail EBITA, to hell with EBITDA

To begin with, the discerning observer of A&D asset values would note how very diverse asset types have become in what generally has been treated as a homogenous, industrial market sector. In turn, one should infer that the corresponding asset resourcing and financing requirements of these business types also have become widely varied. Consequently, because the measure of EV/EBITDA obscures differences in sustainment capital expenditure, which may be quite significant from one A&D company to the next, the comparison of valuation multiples that rely only on this metric may be misleading. In relatively asset-heavy businesses such as GE Security, the use of cash flows to sustain operations is a non-discretionary part of continuing to operate, as reflected in significant and recurring sustainment capital expenditure (capex) cash outflows. In these types of businesses, EV/EBITDA multiples will tend to make valuations look comparatively cheap. In asset-light businesses such as TASC, the sustainment capex constitutes a negligible draw on the companys cash flows. So, in these types of A&D businesses, EV/EBITDA multiples will tend to make valuations look comparatively expensive. And thats why viewing these two transactions from the different lenses of EV/EBITDA and cash flow multiples suggests such different indicators of value. So, how should the discerning observer measure the returns from diverse A&D assets for the purpose of understanding value (when the kind of detailed due diligence afforded actual acquirers is not possible)? We believe that EBITA is usually the more useful metric for two reasons: Its a fairer estimate of operating cash flows. In the cash flow statement, capex is a single line item, and it gives no indication whether it is to allow growth in the company or just to sustain current operations. For example, a company that invests heavily in growth would not be differentiated from a heavily capital intensive company which needed an equally high level of capex simply for business as usual. Because splitting out sustainment capex from growth capex is not straightforward, we treat depreciation as a reasonable proxy for the recurring capital expenses needed to sustain the business. By measuring earnings after depreciation, EBITA takes account of the cash outflow required to sustain the operations of a business as is, and therefore can be a more proximate operating cash flow metric than EBITDA.

Northrop Grumman TASC

Price paid Estimated 2009 EBITDA EV/EBITDA Estimated sustainment capex Approx operating cash flow* EV/Op cash flow Estimated EBITA EV/EBITA $1,650m

GE Security
$1,820m

TASC Premium

$148m

$225m

11.1x $3m

8.1x $81m

37%

$145m 11.4x $143m 11.5x

$144m** 12.6x $144m 12.6x -9% -10%

*assumes no working capital changes **assumes sustainment capex equals depreciation Sources: Bank of America Merrill Lynch, CRA analysis

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 Its a fairer measure of the returns on investment. Looking down the profit and loss statement, one starts off with sales revenues and the costs of running the business generally, before arriving at operating profit, or EBITA, from which the costs of financing the business need to be paid. Accordingly, the more comprehensive measure of profit available as a return on the sources of financing is not EBITDA but its close cousin, EBITA. To see the simple significance of this otherwise pedantic argument, consider again the recent transactions to acquire GE Security and Northrop Grumman-TASC, but this time, look at them through the lens that views EBITA as the measure of return. The final rows of Table 1 show the two transactions EV/EBITA multiples. Compared on that basis, TASC now appears 9 percent less expensive than GE Security, an observationno surprisealso nearly identical with a view of the valuation using the two companies cash flows.

Only the first two of these factors ever make it into most vernacular discussions of valuation, begging questions about the key underlying factors of growth and risk. Does a low multiple simply indicate the asset was acquired on the cheap; does it instead reflect a company or asset in terminal decline, or just one facing a very risky outlook? Conversely, does a high multiple signal an asset or company with high growth prospects arising from great exposure to a growing market, strong synergies between the target and its acquirer, very low exposure to risk, or is there some other explanation for its premium pricing? To visualize the dynamic interplay of these four factors, consider Figure 1, which depicts an array of risk profiles that would be associated with different EBITA multiples (i.e., EV vs. returns), as a function of growth. While one may choose any number of indications of the risk profile of an asset, for the purpose of this illustration, we employ weighted average cost of capital (WACC) as the measure of that risk, as it is intended to represent the expected return required to induce an already diversified investor to expose a portion of his portfolio to the risk inherent in the given asset.2
Figure 1: Valuation multiple as a function of growth rate, as related to WACC
15x GE Security 12x TASC
EV/EBITA multiple
WACC 12%

So what? Focus on growth and risk

Moreover, even using EV/EBITAs measure of value to characterize transactions still renders ambiguity about what these multiples actually can tell us about what to expect around the A&D markets next bend. After all, no matter what techniques are used to manipulate and relate financial metrics in a valuation, they all attempt to resolve into an expression of present value the dynamic interplay of four factors: Enterprise value (EV),1 compared to returns, and taking account of acquisition synergies (variously measured, preferably by a true expected value of cash flows, but if you need a shorthand, use EBITA), amplified by expectations of growth, and discounted by risk.

WACC 8%

WACC 10%

9x

6x

WACC 14%

3x

0x 0%

2%

4% 6% Perpetuity growth rate

8%

Having touted EBITAs superiority as a measure of returns in the vernacular of valuation, wed be remiss not to mention that even this measure glosses over a whole number of details that may be important to achieving precision in valuation, when its required. To begin with, enterprise value (EV) itself can hardly be taken at face value, no matter what the preferred measure of return, but instead needs to take account all the forms of funding which represent a draw on the companyequity, debt, cash, of course; but also pension underfunding, financial and capitalized operating leases; even government-financed launch aid, where applicable. Remember too that depreciation, our proxy of the capital expenditure required to keep a company going, is just a proxy and may be affected by different depreciation policies or historical bases in cost accounting. Finally, of course, significant changes in the forecast of working capital may make an important difference to cash flows but are treated as steady-state in the use of EBITA as a measure of returns for valuing transactions at arms length. These iso-curves of WACC are constructed from the terminal value model for cash flows in perpetuity 1/(WACC-Growth), regulated by a couple modest assumptions about cash conversion80 percentand tax rate35 percent.

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What about the relationship between value, returns, growth, and risk does this depiction reveal? For starters, one can better understand the high sensitivity of value to relatively small changes in growth, abetted perhaps by synergies, and risk. For example, a one percentage point change in expectations of long-term growth (a 20 percent increase) above 5 percent for an asset with a very ordinary 10 percent WACC adds 2.6x to the EBITA multiple (a 25 percent increase). Conversely, and more profoundly, the sensitivity of value in that same scenario to even a percentage point increase in risk (a 10 percent increase in WACC) reduces the valuation multiple by 1.7x (a 16 percent decrease).3 But as regards the vernacular of valuation, what a depiction like that in Figure 1 does is help inform understanding about the underlying significance of transaction values for growth and risk in the diverse marketplace for A&D products and services. Consider the representations of the transaction multiples for TASC and GE Security in Figure 1. At an EBITA multiple of 11.5x, what does KKR/General Atlantics valuation of TASC say about its expectations of underlying growth and risk: above-average growth at an ordinary WACC of 10 percent, or more ordinary growth entailing lower risk (say, a WACC of 8 percent)? Similarly, one can examine the range of possible expectations underlying the somewhat higher 12.6x valuation multiple paid for GE Security, to include potential synergies with United Technologies Fire and Safety business. Strictly speaking, even at arms length, one could make a rigorous estimate of these assets WACCs, and know the implied growth rates more precisely. But the larger point is that the valuation multiple itselfeven measured by EBITA rather than EBITDAholds almost no significance, except in relationship to the rates of growth and risk they imply, or in relationship to other assets addressing exactly the same market segment.

In sum
As transaction activity begins to heat up again, everyone will be grasping after sensible perspectives on the value of these businesses and the significance of those values for whats on the other side of the market inflection now before us. We would posit that for this purpose it is difficult to see the advantages of using EV/EBITDA, the bankers preferred shorthand, and observe several significant disadvantages brought about by the now-wide diversity of asset types and market participation models within the sector. If one must use a shorthand, these changes are better accommodated by recognizing depreciation as a proxy for sustainment capex, and regarding EBITA as the better approximation of cash flows and returns on investment. More importantly, the use of EBITA to approximate returns also facilitates the exploration and understanding of what transaction values may indicate about the disparate potential for growth and exposure to risk now facing different assets and businesses in aerospace and defense.

How Charles River Associates can help

Aerospace and defense consulting at Charles River Associates brings significant experience to clients across a broad range of activities related to M&A, from the development of enterprise growth and acquisition strategies, through detailed business due diligence and valuation of potential acquisitions, to navigation of the government regulatory approvals necessary to conclude a transaction. Our capabilities combine theory with pragmatism and experience and draw upon the firms strengths in strategy, economics, finance, and public policy, coupled with our consultants strong industry-specific backgrounds and expertise. We provide corporations, investors, and their legal counsel with knowledge that allows them to overcome the challenges posed by capital transactions. To learn more about CRAs acquisition strategy and transaction advisory services and capabilities, please visit www.crai.com/aerospace.

We note that because of the power of compounding growth rates in perpetuity, as those values approach WACC, the implied valuation multiple becomes less stable, exceedingly high, and of arguable utility (e.g., a 6 percent annual rate of growth compounded over 100 years results in a value 2.6 times larger than a 5 percent rate). Still, asset sales do transact at multiples high enough to thereby focus attention on just how feasible is the implied combination of growth and risk.

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