M&A goes on a roller coaster ride

Public equity markets have experienced significant fluctuations in the values of major stock indexes this year

It can easily be said that the current economic recession has been one of the worst in recent history. Although the federal contracting sector is not immune to the effects of the recession, it has been somewhat insulated relative to other industries as it correlates to the federal budget more so than the overall economy. Since the beginning of 2009, the public equity markets have experienced significant fluctuations in the values of major stock indexes, in addition to indexes for government information technology services and aerospace and defense large prime contractors.

By the end of the first quarter of 2009, our government IT services index of the median enterprise value (EV) to earnings before interest, taxes, depreciation and amortization decreased more than 16 percent to 8.1 times EBITDA, while the same measure decreased 21 percent for our aerospace and defense large prime contractor index. During this same quarter, merger and acquisition activity also decreased significantly to a total of 14 federal government-oriented transactions, well off the pace of previous years.

By contrast, the second quarter was a period of stabilization in the overall capital markets, with increasing equity values. Our government IT index clawed back with a gain of 16 percent to reclaim its first-quarter loss with a median EV to EBITDA multiple of 9.4 times. The large aerospace and defense prime contractors regained 20 percent with their EV to EBITDA multiple of 5.9 times. During the second quarter, we saw 22 M&A transactions, a 57 percent increase compared to the first quarter.

Large prime contractors have led the charge in the M&A markets in the first half of 2009, seeking to reposition their portfolios of business lines because they face the risk of significant spending cuts in their major weapons systems platforms. Boeing Co., Lockheed Martin Corp. and Harris Corp. announced or closed three M&A deals so far this year. General Dynamics Corp. announced the acquisition of Axsys Technologies Inc., a small-cap publicly held defense electronics company, supporting our thesis about an expected continuation of consolidation of publicly held government contractors.

Private equity firms continue to provide a solid source of liquidity for sellers in this market and have become buyers in eight M&A deals during the first two quarters of 2009, including another new entrant. Snow Phipps Group acquired IT Solutions Inc., its first company in this sector. And a GTCR-backed management team recently closed its first deal as Six3Systems Inc. acquired Harding Security Inc. in late July.

Most notable during the first two quarters of 2009, small- and mid-cap contractors have not been active in the M&A markets. For comparison purposes, we surveyed Washington Technology’s reported M&A activity for the 2005 to 2007 period. During that time, the most active small- and mid-cap consolidators included QinetiQ North America with nine acquisitions, Science Applications International Corp. with nine, CACI International Inc. with eight, Alion Science and Technology Corp. with eight, SRA International Inc. with five, L-3 Communications Corp., with five, and ICF International Inc. with five.

Other active acquirers included Dynamics Research Corp., Mantech International Corp., NCI Information Systems Inc., Stanley Inc., Argon ST Inc., and Teledyne Corp. Nevertheless, during the first half of 2009, a number of companies with a history of acquisitions including Alion, Argon ST, CACI, DRC, L-3, SRA, and Stanley did not announce or complete a transaction. With the exception of SAIC and ICF, most of the transactions completed by the small- and mid-cap companies were relatively small, less than $50 million in revenue, with most less than $20 million, such as DDK Technology Group Inc., TRS Consulting Inc. and Atlan Inc.

A stronger banking and valuation environment for the small- and mid-cap consolidators will allow them to become more active and serve as a catalyst for federal contractors in the M&A market in the two remaining quarters.

About the Author

John Hagan is head of the defense and government services group at BB&T Capital Markets | Windsor Group.

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