Jerry Grossman | Disciplined acquisition strategy required

Forecasting business and market performance is much harder these days. Federal information technology executives and investors seeking to set strategies and expectations have many more considerations than usual.

The normal issues related to government priorities, funding levels and competition now also include a major political transition and huge new federal bailout commitments, driven by unprecedented market turmoil and a deepening recession.

The decreased availability of capital and its increased cost are influencing growth strategies and pricing decisions.

Buyers are cautious, lenders are traumatized and deals require much more time.

In most instances, the transactions getting done have contingent elements, noncash components and reduced value. The pace of mergers and acquisition transactions has slowed.

The slow pace of change in federal acquisition patterns suggests that no revolutionary adjustments are imminent.

However, as we proceed through the next 18 months, the probable effects of political change, massive federal deficits and market realignments on industry growth potential and M&A markets will become clearer.

Amid a global repricing of all asset categories, the federal government has undertaken major rescue operations, with estimates of these bailouts generally falling in the $2 trillion to $3 trillion range.

For now, it’s likely that federal spending will remain at current levels for most programs.

The incoming administration and congressional Democrats appear to support a more activist government, increasing spending to jump-start the economy while regulating business activities more aggressively. The influence of the new administration relative to new priorities will begin to emerge during the appropriations process for the 2010 budget.

However, during the near term in the capital markets, fear and volatility rule the day. Traumatized equity markets, accompanied by frozen debt markets, have had clear effects on valuations of industry companies, both in public markets and M&A transactions. Among active buyers of federal IT companies, both the aerospace/ defense prime contractors and the diversified IT companies have suffered large declines in price/performance ratios.

For example, in the public markets, the enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) multiples for these active buyers of federal IT businesses has declined 40 percent or more during the past year.

The same measure for public federal IT companies has declined about half as much, reflecting the market view that major weapons programs are at greater risk of reduction than are government outlays for IT and other services.

Declines in public market price/ performance ratios, such as price/earnings, suggest a higher cost of equity capital.

Relative to cash flows of borrowers, providers of debt capital are advancing only half the funding they were providing a year ago.

In addition, the cost of debt capital has increased. The effect of these changes has produced a 25 percent to 40 percent increase in the weighted cost of capital.

All things equal, company valuations move inversely to capital costs.

The combination of these factors has created greater strategic and financial uncertainty in the minds of capital providers and buyers. Accordingly, prospective deals involve much greater scrutiny and deeper due diligence by buyers and lenders, require more time and effort, and result in more structured outcomes at lower effective valuations.

As a result, the pace of government services M&A activity in the last half of 2008 dropped to the lowest level in six years.

In this environment, corporate development strategies will be more focused, acquisition targets more selective and pricing more disciplined as major contractors rethink and reshape their portfolios in line with emerging market realities.