avascent defense quarterly€¦ · b/e aerospace inc. beav bombardier inc. bbd.b cae inc. cae cpi...

PRIVATE & CONFIDENTIAL

4Q and Full Year 2012 Results

March 8, 2013

Avascent Defense Quarterly

NOTICE:

This document has been prepared and issued by Avascent on the basis of publicly available information. The opinions presented herein are those of the

authors, are not meant to be comprehensive, and are for informational purpose only. No party should treat any of the contents herein as advice. No part of this document is to be reproduced without written permission from

Avascent.

© Copyright The Avascent Group (2013). All rights reserved.

AVASCENT | 2

Agenda

• Methodology – The Avascent Indices

• Sector Financial and Market Performance

• 4Q and Full Year 2012 Sector Analysis

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Methodology: The Avascent Indices

Company TickerBAE Systems plc BA.General Dynamics Corp. GDLockheed Martin Corporation LMTNorthrop Grumman Corporation NOCRaytheon Co. RTN

Booz Allen Hamilton Holding Corporation BAHCACI International Inc. CACIKBR, Inc. KBRManTech International Corporation MANTNCI, Inc. NCITSAIC, Inc. SAIThe KEYW Holding Corporation KEYWVSE Corp. VSECEngility EGL

AeroVironment, Inc. AVAVAlliant Techsystems Inc. ATKElbit Systems Ltd. ESLTExelis, Inc. XLSFinmeccanica SpA FNCFLIR Systems, Inc. FLIRGenCorp Inc. GYHuntington Ingalls Industries, Inc. HIIL-3 Communications Holdings Inc. LLLThales SA HOQinetiQ Group Plc QQ.

About the Avascent Defense IndexAvascent Defense Index

• The Avascent Defense Index is composed of 25 publicly traded companies with annual revenue ranging from ~$100M to ~$45B

• To be included in the Avascent Defense Index, companies must generate the majority of their revenue (over ~65%) from defense and security business

• The index includes both pure services and hardware companies, as well as foreign companies with significant presence in the US defense market

• For an in-depth, sector-by-sector analysis, the Avascent Defense Index is broken down into three sub-indices:

— BIG 5: 1st tier prime contractors with annual revenue above $20B; these firms have significant services and hardware business portfolios

— Avascent Services: Providing DoD customers with services contract support; specialization varies from high-end support and solutions to low-end MRO and facilities support

— Avascent Hardware: These firms provide DoD customer with hardware and equipment ranging from legacy platforms such as ships and vehicles to new platforms such as UAS, robotics, and IT hardware

BIG-5

AVASCENT HARDWARE

AVASCENT SERVICES

AVASCENT | 4

Methodology: The Avascent Indices

Company TickerAAR Corp. AIRAir France-KLM SA AFB/E Aerospace Inc. BEAVBombardier Inc. BBD.BCAE Inc. CAECPI Aerostructures Inc. CVUCurtiss-Wright Corp. CWDucommun Inc. DCOEmbraer SA ERJEsterline Technologies Corp. ESLFinmeccanica SpA FNCGKN plc GKNHEICO Corp. HEIHexcel Corp. HXLLMI Aerospace Inc. LMIAMoog Inc. MOG.AParker-Hannifin Corporation PHPrecision Castparts Corp. PCPSafran SA SAFSpirit AeroSystems Holdings, Inc. SPRTriumph Group, Inc. TGIUnited Continental Holdings, Inc. UAL

About the Avascent Aero Index

• The Avascent Commercial Aero Index is composed of 22 companies with varying exposure to different elements of the commercial aerospace sector and supply chain

• The index is primarily comprised of four types of companies: 1) Tier 1 original equipment manufactures; 2) component and coating manufactures; 3) distributors of aerospace fasteners and other consumables; and 4) aftermarket service providers

• While financial performance is tracked for all 22 companies, Avascent has focused on four firms (B/E Aerospace Inc.; Curtiss-Wright Corp.; Spirit AeroSystems Holdings, Inc.; and Triumph Group, Inc.) for thematic sector analysis

Harris Corporation HRSHoneywell International Inc. HONOshkosh Corporation OSKRockwell Collins Inc. COLTextron Inc. TXTThe Boeing Company BAUnited Technologies Corp. UTXNavistar NAV

AVASCENT HYBRID

AVASCENT AERO

About the Avascent Hybrid Index

• The Avascent Hybrid Index is composed of 8 companies with both commercial and defense & security portfolios

• While these firms are a critical part of the US defense-industrial base, their portion of defense revenues did not meet the 65% criteria to be included in the defense index

• The diversified business structure (both commercial and defense portfolios) is a viable structural option for many defense contractors seeking to minimize their defense exposure

Note: EADS was excluded from this analysis due to different financial reporting standards

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Agenda




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Analysis

Over the past decade the Avascent Defense Index outperformed the broader market and continues to do so despite the threat of sequestration

• Defense equities outperformed the S&P 500 over the past 12 years

• While the Avascent Defense Index declined between the end of 2007 and April 2008, it still trades well above its 2000 levels

• Defense shares grew at a high rate in the 2002-2008 time frame, but no longer enjoy such good performance

• Defense stocks today generate significant yields, which help support share prices and are considered a “value play” by investors

Percentage Change in Share Price: 2001-2013

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013Avascent Defense Index S&P 500 Index

VALUE PLAY

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Overview of Quarterly Performance (1Q12/1Q13E)

Overview of Quarterly Performance (4Q11/4Q12) 4Q 2012 Highlights

4Q 2012 was tough, 1Q 2013 will be tougher

• The Big-5 saw revenue, operating profit, and margin drop in 4Q12 compared with same quarter last year

• The Services Index experienced revenue decline but managed to increase operating profit and margins compare with 4Q11

• The Hardware Index saw increased revenue and operating income but lost ground on margins

• The Hybrid Index saw strong revenue and operating income gains and modest margin improvement YoY; margin pressure was experienced by companies with relatively higher DoD exposure, specifically in the land/vehicle systems business (OSK, NAV)

1Q 2013E Highlights

• Based on the Street’s expectations, the Big-5 index will experience revenue, operating income, and margin declines in 1Q13 compared with 1Q12 – signaling that cost saving initiatives by prime contractors may have run their course

• The revenue declines picture could deteriorate further if programs continue to get pushed to the right, as was the case in the last quarter of 2012

• The Avascent Hardware Index is expected to recover some margins lost during 4Q 2012

BIG 5AVASCENT SERVICES

AVASCENT HARDWARE

Source: Cap IQ; Avascent analysis

AVASCENT HYBRID

BIG 5AVASCENT SERVICES

AVASCENT HARDWARE

AVASCENT HYBRID

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Industry profitability, in terms of operating margin and ROIC, is holding up and equity analysts expect profitability to continue to hold over the near future

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Avascent Big 5 Index Avascent Services IndexAvascent Hardware Index Avascent Hybrid Index

• Average Big-5 OM declined slightly from last quarter but up YoY

• Hybrid companies have performed on par with the Big-5 pure-play defense index

• The Hardware Index seem set to give up some margin gains made over the past few quarters but is expected to bounce back in the second half of 2013

• Services firms trail their peers but were able to preserve margins for the year

Sectors Operating Margin (OM)

Sectors Return on Invested Capital (ROIC)

• The Hardware companies, the most capital intensive firms, recorded the lowest ROIC over the past 5 years

• Services firms, the least capital intensive firms, outperformed the rest of the Avascent indices but began to lose ground in 2010 and 2011

• Wall Street estimates show the sector is likely to maintain current ROIC levels in the coming years

Source: Capital IQ; Avascent Analysis

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Avascent Hardware Index Avascent Hybrid Index

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Industry strategy to date has to ensure ROIC and Margin levels are on par with perceived peer; once market uncertainty subsides, the name of the game will be differentiation

BA.GD

LMT

NOCRTNBAH

CACI

KBR MANTNCIT

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KEYW

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EGL

AVAV

ATK

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UTX

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KOG

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EBITDA Margin 2012Services Hardware HybridBig 5


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Defense equities track closely with the broader market, likely to a Fed-induced rally in equity markets

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Avascent Hybrid Index Avascent Comm. Aero Index Big 5 Avascent Services Index Avascent Hardware Index

2012 Share Price Performance: Avascent A&D Sub-Indices

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Avascent Defense Index S&P 500 Index

2012 Share Price Performance: Avascent Defense Index vs. S&P 500


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Year-to-date share performance reflects short-term uncertainty and bearish industry guidance for 2013

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Avascent Defense Index S&P 500 Index

YTD Share Price Performance: Avascent Defense Index vs. S&P 500

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Avascent Hybrid Index Commercial Aero Index Big 5 Avascent Services Index Avascent Hardware Index

YTD Share Price Performance: Avascent A&D Sub-Indices

Source: Capital IQ; Avascent Analysis

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Defense Valuations at Pre-GWOT LevelsIs the drawdown fully discounted or will valuations drop further?

*Note: Excluding Tech-Bubble Period

AVASCENT | 13

4Q and Full Year 2012 Defense Industry TrendsSeveral outstanding questions remain for companies’ financial and market performance

Are defense equity valuations already discounted for sequestration?

– Valuations have been driven down since January by uncertainty and a lack of clarity into depth and timing of actual reductions for any particular market, company, or technology

– But private deal valuations are still running at a 15-20% premium to market valuations

Will valuations go up or down based on the release of additional sequestration detail?

– Current valuations are reactionary to the overall budget environment but lack a financial fundamental foundation

– Therefore release of actual budget information, presumably in early April, would change valuation dynamics across industry

What is the most advantageous timeframe for acquiring companies affected by sequestration?

– Opportunities for great bargains due to market and budget uncertainty should be highest till the next mid-term elections in November 2014

AVASCENT | 14

Agenda




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BIG-5 Summary

4Q11/4Q12 % Change in Revenue

4Q11/4Q12 % Change in EBIT

TTM Revenue and EBIT

Source: Cap IQ; Avascent analysis; Note: BAE was excluded due to half-year reporting periods

• Topline Revenue Decline: 4Q revenue was down for most companies across the sector with executives citing reduced customer spending, delayed procurements, general market uncertainty, and increased pressure to reduce unit procurement costs as the primary reasons for revenue declines— In particular, declines in IT & Technical Service business units (LM, NOC, GD)

and land vehicle segments (BAE, GD) significantly impacted corporate performance

— For the year, with the exception of Lockheed Martin which experienced a YoY increase of $683M in total sales, all other members of the Big-5 experienced revenue declines in 2012, primarily driven by reduced spending in core defense businesses

• Varied Margin Performance: Despite strong macro headwinds and declining topline sales, companies have executed differing strategies to offset falling revenues and preserve profitability to varying degrees of success— Companies such as LM, NOC, and BAE had relatively stable margin

performance in Q4 and for the year LM and NOC achieved significant margin expansion due to extensive efficiency measures

— However, GD and RTN, which experienced sharp declines in operating margin in Q4, were late to act, and have since announced cost cutting measures aimed at improving operating efficiency

• Sequestration: While sequestration remained a constant topic of conversation in both management discussions and analyst Q&A, companies in this sector did not anticipate that it would be enacted and FY13 guidance did not account for additional spending cuts, making changes to guidance in Q1 and Q2 likely — However, management did speculate that if sequestration were enacted, it

would disproportionately impact task order driven work in IT & TS business units, as these areas were the most susceptible to near-term cuts

• M&A: Firms continued to state that near-term M&A will focus on adding niche capabilities in growth sectors (cyber, analytics, health) but some (RTN) expressed that they would wait for prices to come down, while GD expressed that its acquisition process was broken and M&A was not likely in the near-term

• Pension Contributions: Funding outstanding pension obligations remains an area of focus for all companies; significant worry regarding asset performance in 2013 is driving companies to plan for additional contributions in 2013

4Q 2012 Highlights

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LMT

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GD

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AVASCENT | 16

Avascent Defense Services Summary

4Q11/4Q12 % Change in revenue




• Macro Budget and Sequestration: Management remains concerned with future market uncertainties; delayed procurements and undefined future budgets limited contractor confidence and adversely impacted Q4— Additionally, management indicated that in a sequestration environment,

task order and contract activity in the first half of 2013 would be strongly impacted as procurement officials delay new awards while the funding environment is sorted out and priorities are determined

• Margins Performance: Service companies continue to struggle with margins; creative accounting (e.g. minimizing ODCs) helps to mitigate margin drawdown from a transition away from T&M and towards fixed-price contracting— Firms continue to increase direct labor headcount (BAH, MANT, KEYW) and

are willing to use unique staffing models to maintain work share and margins; however, near-term improvements are muted

— For Q4, firms with high commercial exposure, such as KBR, outpaced the market, while DoD centric firms with OPTEMPO exposure, such as MANT and EGL, continue to struggle with customer cost pressures and program cuts

• Acquisition Environment Remains Opportunistic: Across the services sector, large companies continue to sit on cash and boast large lines of credit which positions them well for opportunistic acquisitions — Companies indicated that they will continue to make small acquisitions if they

are able to obtain increased technical capabilities in growth markets (e.g. Cyber, Health)

— Sector management indicated they remain open to the possibility of larger buys if terms are favorable; however, many indicated they would wait for macro conditions to become more clear before acting

• Large Backlogs: Companies across the services sector are boasting historic backlogs due to the sluggish approach of government contract execution — However, much of this backlog remains unfunded, leaving companies

vulnerable to additional cuts and unrealized revenue— Additionally, management at multiple companies indicated that they expect

many of the task orders and contracts that are scheduled to be awarded this year to slip until 2014 given government delays and funding uncertainty

4Q 2012 Highlights

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NCIT

EGL

KBR

MANT

VSEC

CACI

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SAI

KEYW

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MANTEGLKEYWCACINCITSAIBAHVSECKBR

450500550600650

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4Q11 1Q12 2Q12 3Q12 4Q12 1Q13E 2Q13E

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AVASCENT | 17

Avascent Defense Hardware Summary

4Q11/4Q12 % Change in revenue




• Continued uncertainty over sequestration: Throughout Q4 calls, management has emphasized the uncertainty over whether sequestration will occur and how it will impact demand for HW; executives cited DoD’s limits on new program starts and hesitation to outline a clear path forward for platform acquisition as obstacles to accurate forecasting

• Margins: Q4 margin performance was particularly negative for US firms, as Gencorp, Thales, and QinetiQ were the only companies to achieve margin growth when compared with 4Q2011— The analyst community remains concerned with margin erosion and

management teams across the sector are working to address the issue— Of particular concern is the need to balance IRAD strategies with ROI,

exemplified by AVAV, which was decimated by contract delays after having made significant upfront investments and capital outlays for material

• Corporate Restructuring: Several companies discussed efforts to streamline corporate structure, improve manufacturing processes, and refinance debt in order to reduce overhead expenditures and maintain profitability

• Pension Contributions: Funding outstanding pension obligations remained an area of concern for several manufacturers (ATK, Exelis, LLL); significant worry regarding asset performance in 2013 is driving companies to conserve cash in anticipation of the need for large contributions in 2013

• Pursuit of Adjacent Market Growth: In Q4 management continued to discuss focused efforts on increasing sales channels to address commercial/international markets as well as leveraging current manufacturing lines for new pursuits— For the year, strong international and commercial sales helped to offset

uncertainty in the defense sector in 2012; companies indicated an effort to build on this momentum and shift corporate resources and investment to emphasize these growth areas

— L-3 seeks to grow int’l and commercial sales to 30-35% of revenue in five years, while ATK is repurposing manufacturing space for commercial use

• Supply Chain Pressure: Additionally, companies with heavy exposure to subsystem development indicated that they were experiencing less visibility into program outlooks and were being squeezed by primes who are passing on pricing pressure to their supply chain

4Q 2012 Highlights

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AVAVHIIATKESLTLLLFLIRXLSQQ.GYHO

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AVASCENT | 18

Avascent Defense Hybrid Index


• Revenue Growth: In contrast to pure play defense companies, several firms in the Hybrid Index were able to achieve significant revenue growth in Q4 when compared with the same period in 2011— Led by strong growth in commercial verticals United Technologies and Boeing

achieved double digit improvements in margin performance over 4Q2011 — Textron (Cessna) and Honeywell (Transportation Systems) continued to

experience some headwinds in their commercial verticals while also encountering a more austere defense environment which lead to moderate quarter over quarter revenue growth

— However, firms with more significant defense exposure such as Oshkosh, Rockwell Collins, and Harris performed more closely to pure play defense firms and struggled with similar reductions in topline revenue

• Margin Performance: Following the trends of topline revenue performance, firms with more significant commercial exposure achieved stronger profitability and demonstrated high single digit improvements over the same period in 2011— For Textron in particular, a 50% increase in Bell Helicopter deliveries enabled

Textron to achieve a 19% increase in EBIT over the same period in 2011— Additionally, United Technologies, Oshkosh, Honeywell, and Boeing were all

able to achieve margin growth by emphasizing the commercial aspects of their portfolios and adjusting resources accordingly

— Harris and Rockwell Collins are experiencing similar challenges as peer companies in the Defense Hardware Index; weakening demand, supply chain stress, uncertain customer requirements, and OEM driven pricing pressures

• Portfolio Reshaping: Firms in the Hybrid Index have taken advantage of continued growth in commercial markets, driven by OEM aircraft sales and strong international demand to examine their businesses and begin to reorient corporate portfolios to favorable growth markets— In particular, management of several firms indicated that anticipated

weakness in core DoD markets has prompted inward reviews of operational efficiency, resulting in margin expansion across the industry

— For example, weakness in core DoD avionics (due to lack of new builds) and tactical communications (due to lifecycle transition) markets have led Honeywell and Rockwell Collins to base a significant portion of their FY13 guidance on Boeing 787 & Bombardier 7000/8000 deliveries

4Q 2012 Highlights4Q11/4Q12 % Change in revenue



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COLBAHONOSKUTXTXT

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OSKCOLHRSHONTXTBAUTX

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AVASCENT | 19

Avascent Defense Commercial Aero Index


• Revenue Growth: In Q4, companies in the commercial aero sector achieved relatively strong topline sales growth, which reflects increases in aircraft delivery schedules and backlogs and significantly outpaces defense sector peers

• Margin Performance: Margin performance was also strong, with the exception of Spirit AeroSystems, which saw sharp declines in Q4 operating margin driven by operational and supply chain problems occurring at its wing facility in Tulsa

• Revenue Diversification through M&A: Management of companies in this sector have indicated a preference for revenue diversification through inorganic expansion, choosing to rebalance portfolios by investing in favorable market verticals to dilute the firms exposure to more volatile sectors— Several companies have sought to lower their exposure to defense markets

by inorganically growing other segments— For example Curtiss-Wright completed 9 acquisitions in FY12, including 7 in

Q3 and Q4 in order to decrease defense exposure from 37% to 30% by adding companies focused on energy and industrial end markets

• Margin performance is tied to Risk-Reward of New Build Programs: Operational risks derived from taking on significant engineering challenges for new-build production programs can significantly impact corporate performance— In order to get in on the ‘ground floor’ of production for major new-build

aircraft like the 787, some Tier 1 providers have agreed to shoulder much of the design and development work for large integrated structures (fuselage sections, fully integrated wings)

— However, this strategy entails significant operational risks, as Spirit discovered when a key supplier failed to deliver on commitments for Gulfstream-280 and -650 integrated wings and management was forced to move production in-house at much higher costs

— Alternatively, firms that can secure ‘meaningful content’ on large programs without the risks of committing to production of major structures (i.e., Triumph’s role on the G650) can achieve significantly higher margins than other competitors; Triumph management has asserted that EBIT will likely surpass 18% by the end of next fiscal year while Spirit had margins of less than 2% for FY12

4Q 2012 Highlights4Q11/4Q12 % Change in revenue



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PHSPRERJMOG.AHEIESLAIRGKNHXLTGIPCPCWDCOBEAVLMIACVU

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UALPHHEIDCOMOG.AAIRCWTGIHXLLMIAPCPERJGKNSPRBEAVCVU

PRIVATE & CONFIDENTIAL | AVASCENT | 20

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