Market Watch: BAE steps up with DigitalNet acquisition

BAE Systems Plc. announced this month that BAE Systems North America, its wholly owned U.S. subsidiary, has entered into a definitive agreement to acquire DigitalNet Holdings Inc. This prospective merger appears to be a good one for BAE strategically as well as accretive to earnings, while rewarding DigitalNet shareholders with an attractive price.BAE Systems will pay $30.25 per share, or $500 million in the aggregate, to DigitalNet shareholders -- a 29 percent premium above the closing price the day before the announcement. BAE will assume approximately $93 million of interest-bearing debt.BAE Systems Plc. is a U.K. multinational aerospace and defense technology company with trailing 12 months revenue of $15 billion. Its U.S. subsidiary in Rockville, Md., has about $5 billion in revenue, derived principally from defense electronics, information systems and technical services, primarily delivered to U.S. government customers. BAE North America is involved in most major command and control programs, having strong offerings in communications, imagery and intelligence systems integration. The company estimates that, combined with DigitalNet, its federal sector IT sales will exceed $1.2 billion.DigitalNet's IT expertise in managed network services, information security and application development complement BAE's communications offerings and extend its reach to additional federal agencies. The principal strategy of this combination is to grow BAE's federal IT business by 50 percent, while adding more than 2,000 employees, two-thirds of which have security clearances. About half of DigitalNet's revenue -- annual pace of about $360 million -- is derived from defense and intelligence agencies. While BAE will remain considerably smaller than Lockheed Martin Corp., Northrop Grumman Corp. and General Dynamics Corp. in the federal IT segment, it now has a technology services base larger than its pure-play federal IT competitors.Most significantly, BAE enlarges its footprint, workforce and customer base in line with the priorities of U.S. defense and intelligence agencies.DigitalNet, established in September 2001, combined the investment acumen and financial resources of GTCR Golder Rauner LLC with the federal technology business experience of Ken Bajaj. The principal components of the business were acquired in the purchase of Getronics Government Solutions in November 2002. Additional investors joined in at and after the company's initial public offering in October 2003. The company issued 5,75 million shares of common stock at $17 per share, raising more than $89 million. In the first quarter of 2004, DigitalNet acquired User Technology Associates, adding about $60 million in revenue at a cost of $50 million. In less than one year, shareholders buying in at the IPO price and selling out to BAE will have achieved gains of more than 80 percent. Founding investor gains will be substantial as well.From a financial perspective, the BAE-DigitalNet deal reflects a valuation within the recent range achieved by well-positioned federal IT companies serving priority defense and intelligence markets. The enterprise value paid--nearly $600 million--when divided by trailing 12 months performance fundamentals, produces the following pricing multiples: 12.2 times EBITDA, and 17.7 times EBIT. The equity value of $500 million is approximately 23 times 2005 net income. These multiples are about 20 percent above the public market medians for DigitalNet's peer group, and about parallel with CACI International Inc. and SRA International Inc. The company's long-term earnings growth rate expectation (five-year forward) at 16 percent is consistent with most of its peers, while its profit margins are in the top quartile of its group. Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.