COMMENTARY

Government sector is a bright spot during in tough times

Services contractors outshine slow organic growth and government spending cuts

The prevailing headline for 2009 was the challenging economic environment that had a significant impact on the capital markets, including public equities, capital raising, and mergers and acquisitions. The government services sector was certainly not immune to the broader market conditions, but it did have a number of bright spots. Notably, M&A deals in high-growth sectors of the market traded at or above historical levels, capital raises for large industry players were completed at strong leverage multiples, and several companies were successful in raising public equity capital to support liquidity and acquisition strategy.

Although the government services industry underperformed compared to other sectors in the public market for the year, much of its performance is indicative of what makes it an attractive sector for investments — stability. The equal-weighted stock price index of government services companies was slightly up for the year (up 1 percent), compared to pricing for prime contractors (up 9 percent), defense electronics companies (up 15 percent), diversified commercial companies (up 22 percent) and the S&P 500 (up 23 percent) for the year. Although they never fell to the lows experienced by the broader markets, government services companies did run into their own unique challenges in 2009: stock prices for the government services group suffered from modest growth. There is a sense that organic growth will continue to slow, because of a combination of contracting delays, protests and federal insourcing initiatives, in addition to some spending restraint caused by huge deficits.

Even with such modest stock performance for the government services industry, its pricing multiples fared better than other sectors. At year end, median enterprise value to next fiscal year earnings before interest, taxes, depreciation and amortization (EBITDA) for government services companies was 7.8x, compared to 5.9x for the primes, 7.3x for defense and 6.8x for the diversified commercial group. At this pricing, the government services EBITDA multiples are 27 percent lower than 10-year historical averages.

Optimism has grown in the public markets. In 2009, 53 initial public offerings were completed, up from 33 in 2008. Given the financing market challenges and cost of debt capital, public companies were eager to tap into the secondary market to raise additional funds. The public markets are receptive to equity offerings by government and defense firms — large and small — to raise capital for shareholder liquidity or fund acquisitions.

Also last year, there were 60 M&A transactions announced in the government services market, down 29 percent from 2008. Small, focused companies characterized the acquisition target universe, as 83 percent of the deals were less than $100 million in transaction value. Valuations of companies in high-growth sectors of the markets were up, not down, in 2009, driven by well-capitalized, patient buyers looking for must-have deals. The scarcity value of high-growth companies drove up pricing for deals in markets such as cybersecurity; command, control, communications, computers, intelligence, surveillance and reconnaissance; or other technology areas.

Key attributes driving double-digit EBITDA valuations in M&A include contract visibility, contract transferability, and technology/product/service differentiation. Private equity continues to be an important player in the space, although private equity platform deals accounted for only 11 percent of total transactions in 2009, compared to 19 percent in 2008. Although much of this downturn in private equity activity can be attributed to the challenges in the financing market — specifically availability and cost — some of the bellwether transactions have demonstrated a strong appetite in the market for large companies with a diversified and long-term contract base.

During 2009, companies in the government services sector exhibited strong resilience under volatile economic and market conditions. An air of optimism has replaced the uncertainty experienced in the first half of the year. Certainly, 2010 will present unique challenges. However, if 2009 is any indication, the industry will be able to adapt and thrive.

About the Author

Jean Stack (Jstack@hl.com) is the director of the aerospace, defense and government group at the investment bank Houlihan Lokey.

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