Prices hold firm for government M&A deals

Since 2004, the price-to-performance multiples of publiclytraded government technology services companies havetrended downward, while the valuations of mergers andacquisitions have held their ground. Is this an anomaly, areflection of the ? until recently ? easy money market conditions,or are there other factors at work? Just as important, is it rational,sustainable and likely to continue through this year and the next?Although these questions were raised in2007, the credit market turmoil in the pastsix months has prompted renewed examinationof expected trends in transaction volumesand pricing levels. The impact of equityprices and debt market trends is not uniform.As usual, the effects will depend on theattributes of the buyer and seller. Various factorswill drive transaction terms in the nearfuture. We expect the number of transactionsto decline in 2008 relative to 2007, particularlyin the smaller business segment of themarket. But larger, high-quality companieswith transferable contracts and sustainablecustomer relationships will continue to commandstrong valuations.As of Dec. 31, 2006, the enterprise values ofpublic government technology services companieswere peaking at 15 times to 18 timesearnings before interest, taxes, depreciationand amortization (EBITDA). At present, theseEV/EBITDA multiples for the public peergroup are in the 9 times to 11 times range,representing a decline of about 40 percent.Slowing growth in government budgets, alongwith many other factors, has led to dampenedearnings forecasts from many of the publicacquirers. Because buyers seek to close dealsthat are accretive to earnings, a commonexpectation would be that acquisition multiplespaid in M&A transactions also shouldhave declined during the past three years. Forthe most part, that has not happened.There are several reasons for this, ofwhich two are most significant. First, a significantsupply-to-demand imbalance exists.The buy-side demand has continued to rise,while the supply-side ? the number of goodquality companies for sale ? has notincreased. In many sectors that buyers prioritizein their acquisition criteria, the numberof attractive companies for sale has declined.Second, acquisitions have become a morecritical component of the growth strategies ofmany industry buyers. Slowing growth infederal spending reduces organic growthpotential, leaving acquisitions to plug theearnings growth gap, the difference betweeninvestors' double-digit earnings growthexpectations and the single-digit organicgrowth opportunities available in the realworld.Other factors contributing to strong M&Apricing are afoot here. Achieving above-marketorganic growth requires companies tohave a position on several mega-size, multiple-award, task-order contracts. Acquisition isan alternative means of getting those positions.The weak dollar has increased theacquisition capacity of foreign buyers, agroup that represented more than 20 percentof transactions last year.Engineering and construction companiesand commercial technology companieshave been pursuing federal market companies,too. Last, most of the active strategicindustry buyers have strong balancesheets and cash flows, eliminating the negativeimpacts of recent turbulence in thedebt markets on most strategictransactions in the sector.The environments in whichpricing has softened recentlyinvolve small-business sellers orfinancial buyers using substantialdebt in their capital structure. Assmall deals ? those involving companies thathave less than $50 million in revenues ?represent more than two-thirds of transactionseach year, expect fewer of these deals toclose.Looking ahead, the excess of buy-sidedemand exhibits no sign of shrinking intoalignment with the supply of quality companiesfor sale anytime soon. For buyers, payinga little more for the right company can bethe better alternative for their shareholdersthan a stagnant or shrinking business.