Description

Investment thesis

Lockheed Martin is trying to acquire Aerojet Rocketdyne for $51 per share and the FTC is expected to vote on the outcome in less than two weeks. This long-delayed $4.6 billion deal from December 2020 is trading at $43 at a spread of 18.6%. In a short period of time, this binary situation offers either a $8 gain or around $2-6 loss. The stock is trading as if the deal was off already.

Background

Aerojet Rocketdyne is a supplier of propulsion systems mainly for the missiles and space industries. This is a vertical merger. Aerojet is a supplier to but does not compete with Lockheed Martin. Lockheed is Aerojet’s largest customer accounting for a third of its sales.

Lockheed initially bid $47.50, then when Aerojet refused to even counter, increased its offer to $52 and finally to the current $56 (including the $5 special dividend already paid out for a remaining $51).

There has been a decades-long period of consolidation in the defense sector. However, now the public consensus has turned more negative and seems to have the perception of a shift in climate due to the FTC’s new leadership, especially in light of the Illumina/Grail challenge, as well as views by the loudest politicians and the FTC leadership’s conciliatory responses to such politicians. Politics is also mixed, as the Pentagon has received a letter of support of the transaction by a bipartisan group of 13 members of the U.S. Congress. The Pentagon recommendation has always carried a lot of weight in deal reviews when it is the top or sole customer/end user.

Benefits of the transaction

Northrop Grumman (after acquiring Orbital ATK) and Aerojet Rocketdyne are the only two U.S. suppliers of solid rocket motors used in ICBMs and missile interceptors. Since Northrop is much larger and with more resources and a big cost advantage, one concern in favor of the transaction is that an independent Aerojet is at an increasing disadvantage and Lockheed’s acquisition is necessary to restore competitive balance and provide more resources for research and development. The broader space industry is in turn under pressure to innovate to compete with newer entrants like SpaceX and Blue Origin.

The number of suppliers of solid-fuel rocket motors is down from seven to two due to the decline in demand over the recent decades. The market for large motors, such as the ones used in ICBMs, is even shakier as Northrop is the only option in some areas and a few years ago looked likely to become the only supplier. Aerojet recently made some investments necessary to remain in the industry but Northrop is much stronger in this space. Aerojet has a small role on Northrop’s Next Generation Strategic Deterrent program and little else in large motors. If Aerojet were to decide that it’s no longer a viable business and shuts it down then its capability could be lost. This exposes the U.S. to a number of defense-related risks such as security of supply, research and development concerns and cost increases.

At the same time, China has made big progress in solid propellant rockets in recent years. The concern is the U.S. will be left behind technologically as research and development declines further.

A consideration is also cost savings on contracts where the Pentagon currently has to pay a double markup on Aerojet engines that are supplied through Lockheed. The FTC will consider this benefit through the elimination of double marginalization as set out in its Vertical Merger Guidelines. Due to government procurement laws this effect will be real as opposed to theoretical.

Antitrust concerns

As laid out in the DOJ/FTC Vertical Merger Guidelines, the regulator’s concern is the following: “a vertical merger may diminish competition by allowing the merged firm to profitably use its control of the related product to weaken or remove the competitive constraint from one or more of its actual or potential rivals in the relevant market. For example, a merger may increase the vertically integrated firm’s incentive or ability to raise its rivals’ costs by increasing the price or lowering the quality of the related product. The merged firm could also refuse to supply rivals with the related products altogether (“foreclosure”)”.

Antitrust concerns are centered on the fact that Aerojet is a key supplier of solid-fuel rocket motors to Raytheon, Lockheed Martin and Boeing. As Raytheon, Lockheed Martin and Boeing are competitors in the missile market, the business combination would take out the last independent supplier of solid rocket motors. While Northrop provides competition, they have a different product focus and don’t fully overlap in every segment of the market. Raytheon would be forced to source solid-rocket motors from its competitor if the deal goes through. It has objected to the merger. The fact that Northrop is a much stronger player in this two-supplier market and be able to limit Lockheed’s ability to foreclose could somewhat mitigate this concern.

The traditional solution for such issues related to vertical mergers has been a behavioral remedy, especially in the defense sector. However, it has also been a popular subject of criticism among FTC chairs. Lina Khan has criticized behavioral remedies in communications with politicians and so have Makan Delrahim and Joe Simons previously and they have all talked about tightening of remedies. No regulator has a preference for behavioral over structural remedies. Yet when it comes to making settlements it still gets used. Bruce Hoffman, Director of the Bureau of Competition at the FTC, has said “in some cases we believe that a behavioral or conduct remedy can prevent competitive harm while allowing the benefits of integration”. It would be the only remedy capable of allowing for the procompetitive effects of this merger while preventing harm.

Past precedent of antitrust investigations is encouraging for approval. The FTC imposed behavioral remedies only in the Northrop/Orbital ATK deal with vertical foreclosure concerns at least as serious as in the present case. Such remedies included nondiscrimination involving competitors, firewalls to protect confidential information, a compliance monitor and regular reporting. They were later criticized because Boeing withdrew from the Ground Based Strategic Deterrent competition, claiming that Northrop’s acquisition of Orbital gave it an unfair advantage because of Northrop’s control of the production of solid-fueled rocket motors, an essential component of the system. However, Aerojet’s COO later said it is eager to provide large solid-fueled rocket motors to compete with Northrop and Boeing never asked it for pricing information. So Boeing never tested the behavioral remedies that had been implemented and the headlines are a bit of a false narrative. Aerojet later got included in Northrop’s GBSD team indicating it has the capability to supply large solid-fueled rocket motors.

An FTC merger remedy retrospective in 2017 reviewed the success of all four vertical mergers it had challenged between 2006 and 2012 with settlements involving behavioral remedies only and found that those remedies had been successful.

In United Launch Alliance (ULA), a joint venture between Boeing and Lockheed Martin, the DoD was supportive of the deal on national security grounds but concerned about vertical input foreclosure, that ULA would either favor Boeing or Lockheed vehicles or raise barriers to entry in the launch services market by refusing to buy launch services from a rival, such as SpaceX. To alleviate DoD’s concerns, the FTC required ULA to cooperate on equivalent terms with all government space vehicle providers seeking to win U.S. government procurement contracts, and to provide equal consideration, information, and resources to any launch services competitors of ULA when bidding on a delivery in orbit contract.

Aerojet is likely too small to stay independent given the above-mentioned national security considerations and yet if the merger were to be blocked there is no alternative strategic acquirer that also wouldn’t raise equivalent or more serious antitrust concerns.

Downside

The stock is only $1 above where it closed on the last trading day before the transaction was announced, December 18, 2020. Meanwhile, defense stocks have substantially appreciated since that date, providing support if the deal were to be abandoned. The only stocks with hardly any appreciation are Aerojet (without adjusting for the $5 special dividend paid out in March 2021) and Lockheed Martin. If we adjusted for the $5 dividend, Aerojet at its current price would still be substantially lagging most defense peers over this time period, so built-in expectations are low. The same can be observed if we use undisturbed Aerojet prices from earlier in 2020. As the low case scenario we have assumed no benefit from the defense sector appreciation and deducting the full $5 dividend as if the market had already counted on it prior to the announcement.

Risks

-FTC blocking the deal entirely

-FTC 2-2 deadlock and delay

Catalyst

Closing