Jerry Grossman | Acquisition path under major construction
Market Share | Financial views of a competitive environment
We can expect to see larger merger-and-acquisition transactions in the federal market during the next 12 to 24 months. The aggregate dollar volume of deals is likely to increase while the number of transactions may decline a bit from recent levels. Several factors will contribute to this result. These factors include:
- Slowing federal budget growth.
- Procurement-driven changes to the competitive environment.
- Political impacts ? unending investigations and election-year spending disruptions
- Small-business recertification rules.
- Huge "winner-take-all" agencywide and government-wide contracting vehicles.
These factors will reinforce the bipolar M&A market that has emerged during the past year. Large and midsize acquisition targets are commanding double-digit pricing multiples, 10 times to 14 times earnings before interest, taxes, depreciation and amortization. Meanwhile, small targets with meaningful small-business preference contracts in their portfolio are facing skeptical buyers, discounted pricing or offers with material contingent payments. This environment is likely to create a brighter line of separation, and pricing differentials, between higher-growth and stagnant-growth public companies.
Federal budget growth has slowed from double-digit annual expansion from 2002 to 2006, to mid-single-digit levels in 2007 and the long-range forecasts. This slowdown is evidenced in the revenue patterns of the six pure-play federal information technology companies that have traded in the public markets since 2002. Profits were rising faster than revenue through 2004 as companies expanded their EBITDA margins into the 10 percent to 11 percent range in 2004. These margins have fallen in 2006 and 2007 to the 9 percent to 10 percent range.
Procurement-driven changes continue to challenge the mid-tier companies and raise the bar as to what constitutes a tier-two services company. A few years ago, pure-play public companies saw a $1 billion revenue level as the minimum size necessary to compete with large systems integrators. Agencywide, multiple-award, task-order vehicles have changed the landscape, expanded the depth and breadth of capabilities and market reach required to compete with tier-one primes, most public federal IT companies. Most believe that tier-two status, within a few years, will require $5 billion or more in annual revenue.
The political environment remains a negative. Congressional investigations show no sign of abating. Polarized positions on the Iraq war and spending priorities in general make spending patterns more difficult to project. Federal spending tends to get sluggish until the election results are in.
Small-business recertification requirements, effective July 1, have made most buyers of companies with major preference contract positions cautious and skeptical.
Some buyers are passing on small-business sale opportunities; others are discounting their offers.
The growing list of huge agencywide, multiple-award task-order vehicles tends to divide industry players into the haves and have-nots. High growth potential, for many companies, depends on winning or buying positions on these large, multiyear contracts. The process required to develop a winning proposal often favors the larger prime contractors, particularly in the full-and-open component of these contract vehicles.
Collectively, these factors suggest fewer but larger deals ahead. Strong industry balance sheets and cash flows, along with willing support from capital sources, sets the stage for some interesting deals through and beyond the elections.Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin. He can be reached at email@example.com