Make no mistake, M&As are hotter than ever

Market Watch | Financial views of a competitive environment

During the past year and, the past several months in particular, there has been increased volatility and a decline in the valuation multiples for publicly traded government services companies. In February 2006, these companies were trading at 12.6 times earnings before interest, taxes, depreciation and amortization (EBITDA). Today those same companies are trading at 9.2 times EBITDA – a 27 percent decline.

The largest declines were experienced by CACI International Inc. and SRA International Inc. because of revised guidance predicting reductions in revenue and earnings per share. CACI's stock lost nearly 20 percent of its value from six months earlier and SRA's stock recently fell to its 52-week low. The declines are thought to be primarily because of the impact of increased spending on the Iraq war and reductions in budgets for information technology modernization and civilian agencies.

ManTech International Corp.'s stock, on the other hand, has maintained its price level after it announced that it expects at least 10 percent growth in revenue and earnings in 2007. The bulk of ManTech's revenue is derived from the intelligence community and mission-critical defense customers. It appears that institutional investors in publicly traded government services companies are becoming more discerning.

Despite the recent downturn in valuations for publicly traded defense and government services companies, mergers and acquisitions activity and multiples for private companies remain at historically high levels.

A number of factors contribute to this valuation gap.
  • Access to capital.
  • Abundance of buyers.
  • Pressure on public companies to fill the growth gap.
  • A reduction in the number of quality companies for sale.
The amount of capital available on attractive terms to fuel acquisitions is substantial at this time. Debt is plentiful at attractive interest rates and multiples of EBITDA. Public equity is also available with three initial public offerings in this sector in 2006 and expected IPOs and secondary offerings in 2007. Private equity also is available for new platform companies and add-on acquisitions. Finally, we estimate that the top 30 publicly traded companies that buy defense and government services companies have nearly $20 billion in cash on their balance sheets and more than $90 billion of buying power.

There is an abundance of diverse buyers, too. Large contractors continue to acquire companies to fill specific niches and diversify into IT and non-IT services.

Private equity groups are more active than ever in seeking platform acquisitions and management teams to build a significant portfolio
company.

A recent phenomenon is an accelerated number of cross-border deals involving primarily United Kingdom-based companies buying U.S. defense and intelligence companies partially because of favorable exchange rates. Two recent transactions were QinetiQ Group plc's announced acquisition of Analex Corp. and Global Strategies Inc.'s acquisition of SFA Inc.

Continued pressure from Wall Street is causing middle-market publicly traded companies ? $250 million to $1 billion ? to increasingly supplement organic growth and diversify their customer base to reduce risk through acquisitions.

Another M&A driver is the lack of quality companies for sale that fit the acquisition criteria of many buyers. Because of M&A activity during the past two years, there are fewer companies with revenues from $100 million to $1 billion. There is also a lack of companies for sale that have a higher percentage of intelligence agency and homeland security revenue or the ability to serve as platforms in markets that will benefit from the base realignment and closure process, such as Huntsville and San Antonio.

Finally, a number of owners of companies with long-term small-business contracts are attracting interest from buyers seeking to close such deals before the new recertification regulations kick in June 30.

About the Author

Rick Knop is senior managing director and head of international banking investment at BB&T Capital Markets, of Reston, Va.

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