The incredible shrinking federal IT market

Powerful political and regulatory cross-currents could affect acquisition strategies and impinge on federal IT consolidation in the short term, but long-term prospects for continued consolidation remain strong.

The government soon will issue small-business recertification rules for multiple-award contracts, which could affect the value for these contractors. Waiting in the wings are initiatives that would restrict the use of time and materials contracting. If enacted, they could reduce profitability and, therefore, valuations.

The government also is raising more incidences of organizational conflicts of interest, which only intensifies the attention that acquirers focus on those issues.

Political change as a result of the midterm elections and the 2008 presidential election could influence federal budget practices, outsourcing and commercial-like procurement practices.

Consolidations in the last two years have eliminated by merger several serial acquirers, including Anteon International Corp., acquired by General Dynamics Corp., and Titan Corp., acquired by L-3 Communications Corp. Rumors continue that other second-tier companies may be acquired in the near future.

But several new, financially capable, motivated buyers likely will pick up the slack. Recent initial public offerings by ICF International Inc., Science Applications International Corp. and Stanley Inc. give all three the capital and motivation to sustain an acquisition strategy that will help them meet Wall Street's growth expectations.

To the extent the new special purpose acquisition companies in the federal services sector are successful in closing their transactions, they will enjoy similar pressure from Wall Street. In addition, CoVant Management LLC, the reconstituted team of Anteon, led by Joe Kampf, and backed by Caxton-Iseman Capital Inc., the hedge fund behind Kampf and Anteon, is looking for platform companies.

Despite near-term uncertainty of regulatory and political changes and the exit of serial consolidators, the fundamentals of the federal IT marketplace will ensure an ongoing, active merger and acquisition environment. However, look for possible modifications in strategies and criteria as companies adapt to the changing environments.

Fueled by several years of robust growth and profitability, defense and government services companies are flush with cash and buying power. The big defense primes, which are aggressively driving to a 50:50 mix of platforms, products and services, have $7 billion in cash and $40 billion in borrowing capacity. The tier-two companies have an additional $10 billion in cash and $40 billion in borrowing capacity, with the primary use of proceeds being acquisitions to position themselves for the future and to meet Wall Street's expectations.

Most of the tier-one and tier-two companies are not looking to add critical mass, but to fill strategic gaps in their business plans by adding key contracts, new customers and capabilities they can leverage so they may grow organically. Thus, acquisitions are much more targeted and focused.

From the sell-side perspective, set-aside companies and large primes continue to squeeze midtier companies. They have lost 20 percent of market share overall, and 40 percent in IT services. Sixty percent of the services market cannot be addressed because of extant contracts with option years, and half the balance involves multiple-award contracts. To continue to grow, companies must buy other companies.

However, the most significant underlying factor favoring consolidation is the continued outsourcing of governmental functions to the private sector. The long-term drivers are the retiring federal workforce, increasing need for complex technology solutions and modernization, requirements of homeland security and the war on terror, and the need to cut costs and improve operations.

Accelerating outsourcing initiatives will attract capital markets to federal IT, as well as fuel consolidation activity in areas where outsourcing spending will continue to grow.

Richard Knop is senior managing director and co-head of the defense and government services group at BB&T Capital Markets/Windsor Group, Reston, Va.