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Market Watch | Financial views of a competitive environment

Defense Department annual spending has exceeded $500 billion in recent years and is expected to maintain current levels for the foreseeable future. However, the defense and government services industry has faced significant budgetary constraints during the past year as funding has been diverted to combat operations in Iraq and other security efforts. Budget pressures have resulted in reduced earnings guidance or disappointing results from CACI International Inc., SRA International Inc., MTC Technologies Inc. and others during the past six months.

ManTech International Corp., whose strategy has focused predominantly on high-growth intelligence markets, became one of the few public companies in the government services space delivering positive news to Wall Street when it recently increased revenue guidance for 2007. ManTech's stock has increased by about 12 percent since the beginning of the year, relative to a nearly 10 percent decline for the rest of the sector during the same time period.

Although big-picture fundamentals in the government-contracting industry remain positive, it is becoming increasingly apparent that not all segments of the industry are created equal. Several government priorities have been largely insulated from budgetary pressures. In all likelihood, contractors that help the government address the following themes and challenges will garner increasing market share in a fiercely competitive environment:
  • Military readiness and logistics.
  • Intelligence operations and analysis.
  • Network-centric solutions.
  • Information interoperability.
  • Base realignment.
  • Military health care modernization.

One particular area of emerging government priority spending worth noting is cybersecurity, which has become a critical priority for the Defense and Homeland Security departments and the intelligence community. Companies that can provide these solutions will enhance shareholder value and become prime acquisition targets.

In the merger and acquisition arena, acquirers are becoming increasingly discriminating about acquisition targets. A company's size is no longer the sole driver of M&A activity. It is still important, but sellers' positioning within the market relative to government priorities has become an even more important determinant.

A recent example is Honeywell International Inc.'s announced purchase of Dimensions International. While DI possesses significant scale, with nearly $200 million in annual revenue, the company is also positively situated within an attractive segment of the government market. As a provider of logistics services, DI's capabilities are favorably aligned with the military's focus on force readiness, which motivated Honeywell to acquire the business at an attractive valuation. Likewise, Northrop Grumman Corp., which has been relatively quiet on the acquisition front during the past few years, acquired Essex Corp. at a premium valuation. Northrop Grumman was attracted by the company's focus on signal and image processing and intelligence community support.

L-1 Identity Solutions Inc.'s acquisition of Advanced Concepts Inc. is another example of where the high barriers to entry in the intelligence market and limited supply of sizable stand-alone, intelligence-focused companies resulted in an attractive value. Acquired for more than 1.7 times its revenue, ACI provides information technology and network security solutions exclusively to the U.S. intelligence community and employs 250 professionals with top-secret and higher security clearances.

We expect this trend to continue, particularly given the scarcity of sizable mid-market acquisition candidates and the recent consolidation in the upper tier of the industry.

For the time being, government services companies will continue to face challenges with the current funding environment. The ones that seek and find such diamonds in the rough will achieve the greatest success.

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