Market watch: M&A is lifeblood of government services market

The rationale supporting acquisitions as a necessary component of business building in the government services market is often debated by executives, investors and owners. Evidence accumulated over the past 10 years confirms that the rewards of a targeted acquisition program outweigh the risks.

For the eight pure-play federal IT companies in the public markets, between 40 percent and 45 percent of their revenue is traceable to acquisitions done over the past five years.

Well-conceived acquisitions are a component of many good companies in the mid- and upper tiers of the industry for any, if not all, of three reasons:

» Organic growth in capabilities and customers is usually insufficient to sustain participation in priority federal markets.

»Organic growth fails to provide the professional and technical challenges needed to attract and retain good staff.

»Companies generate considerably more cash flow than they consume, leading, over time, to diminishing returns on invested capital and slower value growth.

Political, economic and technological factors change federal market priorities. Sustaining growth in this environment requires repositioning human resources and capabilities, usually at a faster pace than possible through purely organic development.

Such "portfolio shaping" aligns a company's expertise and staff with customer demands. A company's failure to sustain and build its competitiveness and participation in key markets can be the result of ignoring mergers and acquisitions as a corporate development tool. The cost of an unwise acquisition is stagnation or decline.

The fundamental growth engine for most companies is their people. As companies grow, they must build infrastructure, provide professional development for staff and fill key personnel slots, commensurate with the business challenges at hand. Acquisitions often help meet these challenges.

The third reason mergers and acquisitions are strategically and financially important is their affect on fundamental industry attributes. From an equity investor's viewpoint, most good companies in the federal business have revenue and margin visibility, sustainable customer relationships, highly variable cost structures and modest capital requirements. The result of these attributes is consistent, positive, free cash flow.

In the equation of equity capital and interest-bearing debt capital used to support assets, these businesses usually are too heavy on equity . Debt capital is cheaper than equity; it's about one-third to one-fourth the after-tax cost of equity capital.

The capital structure of these federal businesses could be made more optimal by adding a manageable component of interest-bearing debt capital. And the easiest way to add it is through acquisitions. Without acquisitions, companies will systematically pay down their interest bearing debt, producing a substandard capital structure.

An example illustrates this point. ABC company has $100 million in revenue, 10 percent earnings before interest, tax, depreciation and amortization (EBITDA) margins, and 10 percent annual growth. Under the acquisition scenario, ABC acquires one $35 million revenue business each year for four years, at prices of $32 million each. All purchases are financed with debt. Target companies have growth rates and profit margins equal to those of our buyer, and are bought at pricing multiples slightly less than our buyer's trading multiple, 9 times 2006 EBITDA. The buyer's debt peaks at about 3.5 times EBITDA and about 30 percent of enterprise value, reasonable levels.

We compared the equity value growth in this scenario to the organic scenario, wherein no acquisitions were done. The acquisition scenario produced a compounded annual growth rate in equity value of more than 19 percent over five years.

The organic scenario resulted in a CAGR in equity value in the same period of 13 percent. ABC shareholders achieved $60 million of incremental value under the acquisition strategy.

Don't try this on your own, but with good advisory support, the rewards could clearly be worth some added risk.

Jerry Grossman is managing director at Houlihan, Lokey, Howard & Zukin, McLean, Va. He can be reached at jgrossman@hlhz.com.