Small Cap A&D Consolidation
Over the last three years, there has been significant consolidation in the aerospace and defense industry from both strategic and private equity buyers. Notable deals include L3Harris’ acquisition of Aerojet Rocketdyne, KKR and Circor, Arcline and Kaman, Apollo and Barnes Group, and most recently Warburg Pincus/Berkshire Partners with the announced merger of Triumph Group. The acquisition spree has driven up industry multiples and left only a few small cap aerospace and defense companies remaining. In our opinion, the push for consolidation is driven by three forces. First, the commercial aerospace industry has a decade long backlog and travel demand remains strong, this bodes well for both OEM sales and the aftermarket. Second, regulation for the aerospace industry, which is enforced by the FAA, is strict and presents high barriers to entry. In many cases, there is only one provider of a given component. Lastly, acquirers are able to drive strong synergies post-acquisition. For instance, larger companies are able to implement a more aggressive pricing strategy, which carries high incremental margins. Below we highlight the terms from the marquee deals in the industry over the last few years.
Investment Opportunities
In our opinion, the four most attractive companies are: Astronics, Ducommun, Mercury Systems, and Innovative Solutions & Support. A major theme amongst these companies is the ownership of long-term contracts with large OEMs, such as Boeing, Airbus, Lockheed Martin and Textron. This provides a clear line of sight on future cash flows. Additionally, these companies have significant intellectual property, which provides another barrier to entry. Below, we review each company and analyze the potential for an acquisition.
Mercury Systems
For the last year, Mercury had been plagued by idiosyncratic issues brought on by the overly aggressive prior management team. We think highly of new CEO Bill Ballhaus, who is an aerospace veteran and was appointed by JANA Partners. It should be noted this hedge fund has a history of putting companies up for sale, such as Whole Foods to Amazon and Frontier Communications to Verizon. Mercury was plagued by ~20 problematic classified programs that used the same technology architecture. This led to increased losses, higher working capital and ultimately significant free cash flow burn. In our opinion, the company reached an inflection point two quarters ago, whereby it generated $61m of free cash flow. While the 2025 earnings will still be depressed, we estimate a recovery in 2026 to Mercury’s record 2022, when it generated $200m of EBITDA. Given the company’s critical role on hundreds of key defense platforms, 18x 2026 EBITDA seems plausible. This would yield a share price of close to $60 per share. We think the most logical buyers would be Lockheed Martin, L3Harris Technologies or private equity.
Ducommun
Ducommun has already received formal offers from private equity firm Albion River for $60 and $65 per share, but declined both. In our opinion, the offers significantly undervalue the company. Earnings are set to increase with ramping volumes and successful restructuring efforts. A price north of $90 per share seems more reasonable, which would value the company around 12x 2025 EBITDA of $130m. Longer term, we think there is significant upside if the company is able to implement its Vision 2027 plan. This would allow Ducommun to generate sales and EBITDA of $1bn and $200m, respectively. If you apply a peer multiple of 12x to $200m of EBITDA, DCO shares would be worth an astounding $150 per share. Lastly, CEO Steve Oswald has experience selling businesses. In 2015, he was the CEO of a KKR portfolio company called Capital Safety, which was acquired by 3M for $2.5bn. In short, we think management is waiting for earnings to return to peak levels in late 2025 or 2026 so they can sell Ducommun for a more attractive price.
Innovative Solutions & Support
Innovative Solutions & Support has demonstrated impressive growth following the successful integration of two Honeywell product lines. These acquisitions have allowed IS&S to enhance its portfolio of advanced avionics and flight control systems, helping to strengthen its competitive edge. With new management taking a more aggressive approach than the company’s founder, ISSC is actively pursuing opportunities to expand its reach, streamline operations, and boost profitability. Given ISSC’s recent trajectory and the alignment of its deals with those executed by serial aerospace acquiror, HEICO, we think ISSC has become increasingly attractive as an acquisition candidate. Therefore, we apply a 14x EBITDA multiple to our 2026 estimate of $19m, which would translate to a price of $14 per share.
Astronics
Astronics has been a victim of Boeing production issues. The company has enviable positions to provide in flight power and entertainment systems. Additionally, there is an attractive and rapidly growing aftermarket as older plans are retrofitted with new inflight entertainment technology. Recently, ATRO won the contract to provide over $1m in shipset content for the FLRAA program. It is estimated over 2,000 aircraft will be made over the duration of the program. We think as earnings normalize with production rates and the UK patent litigation case is closed, Astronics will trade closer to 10x EBITDA. TransDigm would also be an obvious candidate to acquire Astronics given the two companies compete against each other in many different avionic products. In our opinion, a price of $40 per share would not be unreasonable.
Michael Burgio (914) 921-7797
Mburgio@gabelli.com
Tony Bancroft (914) 921-5083
tbancroft@gabelli.com
One Corporate Center Rye, NY 10580 Gabelli Funds Tel (914) 921-5000 Fax 914-921-5098
This whitepaper was prepared by Tony Bancroft and Michael Burgio. The examples cited herein are based on public information and we make no representations regarding their accuracy or usefulness as precedent. The Research Analyst’s views are subject to change at any time based on market and other conditions. The information in this report represent the opinions of the individual Research Analyst’s as of the date hereof and is not intended to be a forecast of future events, a guarantee of future results, or investments advice. The views expressed may differ from other Research Analyst or of the Firm as a whole.
As of September 30, 2024, affiliates of GAMCO Investors, Inc. beneficially owned 5.80% of Ducommun, 1.64% of Astronics Class A and less than 1% of Class B, 1.61% of Innovative Solutions and Support and less than 1% of all other companies mentioned.
