Midtier contractors feel the squeeze

Most observers would predict that the years of increasing defense budgets are over and that those budgets are likely to decline during the Obama administration. Combine the uncertainty of where and when defense budget cuts will take place with turmoil in the broader equity markets, and one would expect valuations for publicly held midtier government technology services (GTS) and defense electronics (DE) companies to be near all time lows.

However, with the high degree of uncertainty in the broader markets, investors are seeking refuge in the midtier defense stocks as they have a low correlation to the overall economy and are viewed as defensive to the overall market. While the S&P 500 index has decreased approximately 35.1 percent during the past year, GTS stocks have increased 9.9 percent and DE stocks have increased 4.6 percent. Although midtier stocks have held their values well, the shares of large prime contractors have not. Valuations for the primes have decreased 31.4 percent during this time frame, largely because of concerns that budget cuts will significantly affect major weapons systems.

These circumstances have resulted in unique trends in the mergers and acquisitions market for defense companies. First, M&A valuations are not longer tied as closely to the valuation multiples derived by public companies. Increasingly, buyers have been willing to accept dilutive transactions for companies that bring contracts, capabilities and technology in expected high-growth areas such as the intelligence community; logistics; command, control, communications, computers, combat systems, intelligence, surveillance and reconnaissance; unmanned aerial systems markets; and others.

This situation has led to a bifurcation in the market as an expanding universe of buyers flush with resources for acquisitions actively compete for fewer, highly specialized companies, thereby driving valuations well above the current trading multiples in the public markets. Conversely, they are paying less attention and offering less value for the many less specialized companies.

The implications of this market environment affect its constituencies in different ways. For example, highly specialized companies in the most attractive markets that aspire to become public in this environment will find a much higher value from an M&A process relative to an initial public offering. Digital Receiver Technology Inc. is a perfect example. DRT evaluated the merits of a public offering but concluded that its M&A value was so significantly in excess of the valuation it would receive from an IPO that company officials decided to sell to Boeing Co. in December 2008. The estimated premium for DRT shareholders was more than 80 percent above its estimated IPO value.

Another constituency of interest is nondefense companies with defense subsidiaries. As mentioned, although the GTS and DE public companies have maintained their values well, most industries have not. For example, commercial information technology companies trade at a 55 percent discount to their publicly held GTS peers. Essentially, their defense subsidiaries are trading at commercial IT multiples versus GTS multiples. Thus, increasingly, more boards of these companies are looking at their defense subsidiaries as possible divestiture candidates that could be sold at higher valuations when evaluating their strategic alternatives to maximize shareholder value.

A third constituency of interest is midtier defense companies themselves. As large prime contractors seek to replace business lost from potential budget cuts, they look to the universe of publicly held midtier companies as targets. The balance sheets of the prime contractors are as strong as they have ever been to execute such transactions.

Consequently, with increasing interest from the prime contractors to aggressively pursue companies with the best customer bases and product sets and continued strength in M&A multiples for these companies, boards of directors of midtier contractors are likely to be faced with decisions in the next 12 to 18 months that could lead to significant contraction in the universe of publicly held midtier contractors.

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