EBITA Vd EBITDA - AD Insights Vernacular of Valuation 1209

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On the Vernacular of Valuation in A&D

A dening eature o the current economic crisis is that it has thrown all asset values

into commotion. Te value o public equities in aerospace and deense companies is no

exception, having only recently moved o the bottom o a precipitous 40 percent drop

in 2007 2008 despite a 2009 o tumultuous news ow in their end markets. Similarly,

attempts to draw reliable indications o value rom mergers and acquisitions in the sectorhave been undermined by the dearth o deals over the past two years. In addition to the

credit crisis itsel, the sharp divergence o buyers and sellers over the valuation o A&D

assets has impeded the establishment o a momentum in the trend o M&A transactions

involving A&D assets. Sellers have been holding out or 2007 prices while buyers have

been holding on or the lower prices they expect to emerge in 2010 and beyond.

However, two acquisitions announced within the span o a week last montho Northrop

Grumman ASC by KKR/General Atlantic and GE Security by United echnologies

suggest that the mass o capital stored on corporate balance sheets and in private equity

unds may begin deploying to restructure the capitalization o A&D assets and adjust

corporate portolios ahead o the inection in demand that commercial aerospace andmilitary markets are both now acing. Against this backdrop, valuation trends will now

be closely watched to determine i 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 rom

the insight that the diversity o asset-types comprising the A&D sector is now very wide.

First, reocus attention rom prices paid to what those prices imply or the underlying

rates o growth and risks acing dierent asset types in dierent market segments. Second,

against the commonplace shorthand use o EV (enterprise value) divided by EBIDA

(earnings-beore-interest-taxes-depreciation-and-amortization) to guide the emerging

consensus, employ EBIA (earnings-beore-interest-taxes-and-amortization) instead as the

relevant measure o return. As a consequence o the sectors increasing diversity o xed

asset intensity, the corresponding range o sustaining capital expenses necessary to keep

these businesses going (as opposed to catalyzing their growth) conounds the shorthand

use o EBIDA as a reliable measure o earnings, cash ow, and value. Adopting a

vernacular o valuation based on EBIA to characterize transactions better enlightens

an understanding o the actual dynamic interplay o prices, returns, growth, and risk,

which is where leading-indicator insights are more likely to be revealed than rom simple

comparisons o EBIDA multiples.

December 2009

The author:

Charles Armitage

Principal

London

+44 20 7664 3671

[email protected]

CRA Insights:

Aerospace & Defense


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On the Vernacular of Valuation in A&D | 2

A tale of two transactions

As a starting point, consider the two recent transactions.

On November 8, Northrop Grumman announced the sale o

a collection o technical services businesses it organized under

its ASC brand to a partnership o the private equity rms

KKR and General Atlantic. Four days later, General Electric

sold its Security business, a security products manuacturer, toUnited echnologies. able 1 depicts the customary valuation

analysis eatured in most reporting about the deals, together

with an estimate o each companys operating cash ow.

On the basis o EV/EBIDA multiples, it would appear

that the private equity rms paid a 37 percent premium or

ASC relative to the valuation by which United echnologies

was able to acquire GE Security. Conversely, on the basis

o operating cash ows, which are nearly identical at these

two businesses, it would appear that United echnologies

valuation o GE Security represents a 10 percent premium

to the corresponding price paid by KKR/General Atlantic.

Whats a discerning observer o A&D asset values to conclude

rom these ostensibly leading-indicator transactions?

Table 1: Valuation and cash ow analysis of TASC and

GE Security

Northrop

Grumman

TASC

GE

Security

TASC

Premium

Price paid $1,650m $1,820m

Estimated 2009EBITDA

$148m $225m

EV/EBITDA 11.1x 8.1x 37%

Estimatedsustainment capex

$3m $81m

Approx operatingcash ow*

$145m $144m**

EV/Op cash fow 11.4x 12.6x -10%

Estimated EBITA $143m $144m

EV/EBITA 11.5x 12.6x -9%

*assumes no working capital changes**assumes sustainment capex equals depreciation

Sources: Bank of America Merrill Lynch, CRA analysis

Hail EBITA, to hell with EBITDA

o begin with, the discerning observer o 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 iner that the corresponding asset

resourcing and nancing requirements o these business types

also have become widely varied. Consequently, because themeasure o EV/EBIDA obscures dierences in sustainment

capital expenditure, which may be quite signicant rom

one A&D company to the next, the comparison o valuation

multiples that rely only on this metric may be misleading. In

relatively asset-heavy businesses such as GE Security, the use o

cash ows to sustain operations is a non-discretionary part o

continuing to operate, as reected in signicant and recurring

sustainment capital expenditure (capex) cash outows. In these

types o businesses, EV/EBIDA multiples will tend to make

valuations look comparatively cheap. In asset-light businesses

such as ASC, the sustainment capex constitutes a negligible

draw on the companys cash ows. So, in these types o

A&D businesses, EV/EBIDA multiples will tend to make

valuations look comparatively expensive. And thats why

viewing these two transactions rom the dierent lenses o

EV/EBIDA and cash ow multiples suggests such dierent

indicators o value.

So, howshouldthe discerning observer measure the returns

rom diverse A&D assets or the purpose o understanding

value (when the kind o detailed due diligence aorded actual

acquirers is not possible)? We believe that EBIA is usually the

more useul metric or two reasons:

Itsafairerestimateofoperatingcashows.Inthecash

ow 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 dierentiated

rom a heavily capital intensive company which needed an

equally high level o capex simply or business as usual.

Because splitting out sustainment capex rom growth capexis not straightorward, we treat depreciation as a reasonable

proxy or the recurring capital expenses needed to sustain

the business. By measuring earnings ater depreciation,

EBIA takes account o the cash outow required to sustain

the operations o a business as is, and thereore can be a

more proximate operating cash ow metric than EBIDA.


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Itsafairermeasureofthereturnsoninvestment.Looking

down the prot and loss statement, one starts o with

sales revenues and the costs o running the business

generally, beore arriving at operating prot, or EBIA,

rom which the costs o nancing the business need to be

paid. Accordingly, the more comprehensive measure o

prot available as a return on the sources o nancing is

not EBIDA but its close cousin, EBIA.

o see the simple signicance o this otherwise pedantic

argument, consider again the recent transactions to acquire

GE Security and Northrop Grumman-ASC, but this time,

look at them through the lens that views EBIA as the

measure o return. Te nal rows o able 1 show the two

transactions EV/EBIA multiples. Compared on that basis,

ASC now appears 9 percent less expensive than GE Security,

an observationno surprisealso nearly identical with a

view o the valuation using the two companies cash ows.

So what? Focus on growth and risk

Moreover, even using EV/EBIAs measure o 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. Ater all, no matter

what techniques are used to manipulate and relate nancial

metrics in a valuation, they all attempt to resolve into an

expression o present value the dynamic interplay o ouractors:

Enterprisevalue(EV),1

comparedtoreturns,andtakingaccountofacquisition

synergies (variously measured, preerably by a true

expected value o cash ows, but i you need a shorthand,

use EBIA),

ampliedbyexpectationsofgrowth,and

discountedbyrisk.

Only the rst two o these actors ever make it into most

vernacular discussions o valuation, begging questions about

the key underlying actors o growth and risk. Does a low

multiple simply indicate the asset was acquired on the cheap;

does it instead reect a company or asset in terminal decline,

or just one acing a very risky outlook? Conversely, does

a high multiple signal an asset or company with high growth

prospects arising rom 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 or its

premium pricing?

o visualize the dynamic interplay o these our actors,

consider Figure 1, which depicts an array o risk proles that

would be associated with dierent EBIA multiples (i.e., EV

vs. returns), as a unction o growth. While one may choose

any number o indications o the risk prole o an asset, or

the purpose o this illustration, we employ weighted averagecost o capital (WACC) as the measure o that risk, as it is

intended to represent the expected return required to induce

an already diversied investor to expose a portion o his

portolio to the risk inherent in the given asset.2

Figure 1: Valuation multiple as a function of growth rate,

as related to WACC

1 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, nancial and capitalized operating

leases; even government-nanced 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, signicant changes in the forecast of working capital may make an important difference to

cash ows but are treated as steady-state in the use of EBITA as a measure of returns for valuing transactions at arms length.

2 These iso-curves of WACC are constructed from the terminal value model for cash ows in perpetuity 1/(WACC-Growth), regulated by a couple modest assumptions about cash

conversion80 percentand tax rate35 percent.

0x

3x

6x

9x

12x

15x

0% 2% 4% 6% 8%

Perpetuity growth rate

EV/EBITAmultiple

WACC

10%

WACC

8%

WACC

14%

WACC

12%

TASC

GE Security


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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 o value to

relatively small changes in growth, abetted perhaps by

synergies, and risk. For example, a one percentage point

change in expectations o long-term growth (a 20 percent

increase) above 5 percent or an asset with a very ordinary

10 percent WACC adds 2.6x to the EBIA multiple

(a 25 percent increase). Conversely, and more prooundly,

the sensitivity o 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 o valuation, what a depiction

like that in Figure 1 does is help inorm understanding

about the underlying signicance o transaction values

or growth and risk in the diverse marketplace or A&Dproducts and services. Consider the representations o

the transaction multiples or ASC and GE Security in

Figure 1. At an EBIA multiple o 11.5x, what does

KKR/General Atlantics valuation o ASC say about its

expectations o underlying growth and risk: above-average

growth at an ordinary WACC o 10 percent, or more

ordinary growth entailing lower risk (say, a WACC o 8

percent)? Similarly, one can examine the range o possible

expectations underlying the somewhat higher 12.6x

valuation multiple paid or GE Security, to include

potential synergies with United echnologies Fire and

Saety business.Strictly speaking, even at arms length, one

could make a rigorous estimate o these assets WACCs,

and know the implied growth rates more precisely. But the

larger point is that the valuation multiple itseleven

measured by EBIA rather than EBIDAholds almost

no signicance, except in relationship to the rates o

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 ater sensible perspectives on the value o these businesses

and the signicance o those values or whats on the other side o

the market inection now beore us. We would posit that or this

purpose it is difcult to see the advantages o using EV/EBIDA,

the bankers preerred shorthand, and observe several signicantdisadvantages brought about by the now-wide diversity o asset

types and market participation models within the sector. I one

must use a shorthand, these changes are better accommodated by

recognizing depreciation as a proxy or sustainment capex, and

regarding EBIA as the better approximation o cash ows

and returns on investment. More importantly, the use o EBIA

to approximate returns also acilitates the exploration and

understanding o what transaction values may indicate about the

disparate potential or growth and exposure to risk now acing

dierent assets and businesses in aerospace and deense.

How Charles River Associates can help

Aerospace and deense consulting at Charles River Associates

brings signicant experience to clients across a broad range o

activities related to M&A, rom the development o enterprise

growth and acquisition strategies, through detailed business due

diligence and valuation o potential acquisitions, to navigation

o the government regulatory approvals necessary to conclude a

transaction. Our capabilities combine theory with pragmatism

and experience and draw upon the rms strengths in strategy,economics, nance, and public policy, coupled with our

consultants strong industry-specic backgrounds and expertise.

We provide corporations, investors, and their legal counsel

with knowledge that allows them to overcome the challenges

posed by capital transactions. o learn more about CRAs

acquisition strategy and transaction advisory services and

capabilities, please visitwww.crai.com/aerospace.

3 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.

EBITA Vd EBITDA - AD Insights Vernacular of Valuation 1209

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