IT services sector sheds investment fear

It was a scary Halloween last year. The economy was in a tailspin and talk of another Great Depression was rampant. Although relatively healthy, defense and government services companies could not escape the fear that gripped the nation. However, this Halloween will be a treat as normalcy returns to the defense and government services sector.

Who would ever believe that a universe of public companies could lose 20 percent to 30 percent of value and still outperform the broader markets? That is exactly what happened with midtier federal information technology and defense electronics companies. In a two-week period alone last October, a comprehensive index of such companies declined 15.5 percent, while the S&P 500 lost more than 20 percent. Despite this relatively favorable performance, few in the industry felt like cheering.

Prospects in the public markets have improved significantly in recent months, with mid-cap defense and government services companies leading the way. In most cases, the share prices of these businesses are back to or above pre-October 2008 levels, far exceeding the recovery experienced in the broader markets. As a result, the initial public offering and secondary offering window is once again open for well-positioned defense and government services companies. Businesses are rushing to take advantage of this opportunity. This includes the likes of DynCorp International, which completed a nearly $200 million secondary offering in August, and Global Defense Technology and Systems Inc., a business that filed to go public in September.

Pace of M&A activity

Recent headline-grabbing transactions, such as Dell Inc.’s pending acquisition of Perot Systems Corp. and Xerox Corp.’s plan to purchase Affiliated Computer Services Inc., have caused many pundits to proclaim that deal-making is back. In reality, the pace of mergers and acquisitions has steadily climbed in the defense and government services sector for several months. The third quarter of this year saw deal activity increase nearly 100 percent relative to first quarter 2009.

Several trends have emerged or been reinforced in this new round of consolidation in the defense and government services industry. First, companies in areas widely perceived as growth segments of the market continue to attract strong interest from buyers. This includes businesses focused in areas such as cybersecurity, energy, health care, homeland security and intelligence.

Second, private-equity interest in the government sector has significantly increased ever since the economy entered the recession and has grown more intense in recent months. There were at least eight private equity-oriented acquisitions completed in the government sector in the third quarter alone, approaching the total number of such investments that occurred during the entire decade of the 1990s. Third, buyers are looking to consolidate businesses that are focused on increasing the performance, efficiency and transparency of the federal government – a priority of the current administration.

Last, government pressure on companies to mitigate organizational conflicts of interest is also driving transactions. There are an increasing number of acquirers interested in pursuing organizational conflict-of-interest consolidation strategies. This is demonstrated by the very strong buyer interest Northrop Grumman Corp. received for its TASC business unit.

Valuation environment

An influx of new capital into the market and an expanding buyer pool is creating a more favorable valuation environment for sellers. However, buyers are more discerning than in past years, so success is not guaranteed. To that end, business owners considering a sale should invest significant time assessing and improving the salability of their business before going to market.

Given all the fear in the air last year, it is truly amazing how far things have come. Without a doubt, this Halloween will be far less scary. While dangerous to say, it is quite possible that the most popular costume in town will be the bull.