Prices hold firm for government M&A deals

Market Watch | Financial views of a competitive environment

Since 2004, the price-to-performance multiples of publicly
traded government technology services companies have
trended downward, while the valuations of mergers and
acquisitions have held their ground. Is this an anomaly, a
reflection of the ? until recently ? easy money market conditions,
or are there other factors at work? Just as important, is it rational,
sustainable and likely to continue through this year and the next?

Although these questions were raised in
2007, the credit market turmoil in the past
six months has prompted renewed examination
of expected trends in transaction volumes
and pricing levels. The impact of equity
prices and debt market trends is not uniform.

As usual, the effects will depend on the
attributes of the buyer and seller. Various factors
will drive transaction terms in the near
future. We expect the number of transactions
to decline in 2008 relative to 2007, particularly
in the smaller business segment of the
market. But larger, high-quality companies
with transferable contracts and sustainable
customer relationships will continue to command
strong valuations.

As of Dec. 31, 2006, the enterprise values of
public government technology services companies
were peaking at 15 times to 18 times
earnings before interest, taxes, depreciation
and amortization (EBITDA). At present, these
EV/EBITDA multiples for the public peer
group are in the 9 times to 11 times range,
representing a decline of about 40 percent.

Slowing growth in government budgets, along
with many other factors, has led to dampened
earnings forecasts from many of the public
acquirers. Because buyers seek to close deals
that are accretive to earnings, a common
expectation would be that acquisition multiples
paid in M&A transactions also should
have declined during the past three years. For
the most part, that has not happened.

There are several reasons for this, of
which two are most significant. First, a significant
supply-to-demand imbalance exists.
The buy-side demand has continued to rise,
while the supply-side ? the number of good
quality companies for sale ? has not
increased. In many sectors that buyers prioritize
in their acquisition criteria, the number
of attractive companies for sale has declined.

Second, acquisitions have become a more
critical component of the growth strategies of
many industry buyers. Slowing growth in
federal spending reduces organic growth
potential, leaving acquisitions to plug the
earnings growth gap, the difference between
investors' double-digit earnings growth
expectations and the single-digit organic
growth opportunities available in the real
world.

Other factors contributing to strong M&A
pricing are afoot here. Achieving above-market
organic growth requires companies to
have a position on several mega-size, multiple-
award, task-order contracts. Acquisition is
an alternative means of getting those positions.
The weak dollar has increased the
acquisition capacity of foreign buyers, a
group that represented more than 20 percent
of transactions last year.

Engineering and construction companies
and commercial technology companies
have been pursuing federal market companies,
too. Last, most of the active strategic
industry buyers have strong balance
sheets and cash flows, eliminating the negative
impacts of recent turbulence in the
debt markets on most strategic
transactions in the sector.

The environments in which
pricing has softened recently
involve small-business sellers or
financial buyers using substantial
debt in their capital structure. As
small deals ? those involving companies that
have less than $50 million in revenues ?
represent more than two-thirds of transactions
each year, expect fewer of these deals to
close.

Looking ahead, the excess of buy-side
demand exhibits no sign of shrinking into
alignment with the supply of quality companies
for sale anytime soon. For buyers, paying
a little more for the right company can be
the better alternative for their shareholders
than a stagnant or shrinking business.

Jerry Grossman (jgrossman@hlhz.com) is managing
director at Houlihan Lokey Howard and Zukin.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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