Navigate the path to sustainable earnings

Companies in the government services market face a growing number of challenges in the current environment. After a prolonged period of consistent budgetary growth, government agencies are facing budget pressure and cost-cutting requirements. In Washington Technology’s June 2010 Top 100 issue, executives from the Top 100 companies cited the federal budget and deficit as the greatest challenges that the industry faces. The government services industry faces additional headwinds, including greater Defense Contract Audit Agency scrutiny, changing procurement policies, contract award protests, delays in contract awards, set-aside contract issues, insourcing and increased focus on organizational conflicts of interest (OCI). As a result of the uncertainty those challenges create for a business, the ability to clearly articulate future revenue streams and demonstrate sustainability of earnings is increasingly important.

Although budget cuts and insourcing are devouring certain segments of the market, there are many segments in which growth opportunities continue to abound. Consequently, many companies are assessing their capabilities and customer mix to set a strategy that hedges risk in areas of concern while aligning growth opportunities with the most attractive segments of the market. They are reshaping their business portfolios by divesting noncore or conflicted business units and actively pursuing acquisition candidates in desired areas. Northrop Grumman Corp.’s recently completed divestiture of TASC and Lockheed Martin Corp.’s announced intent to divest two businesses illustrate that trend. At the same time, financial-buyer activity remains high in the government services market. Financial buyers also seek to gain access to attractive market segments in addition to acquiring assets that might be creating OCI issues for the larger prime contractors.

Businesses that garner the highest level of interest in the merger-and-acquisition market are those that provide visibility and certainty into future revenue and earnings. The ability of sellers to demonstrate a sustainable earnings profile is more critical than ever to maximizing shareholder value in a sale transaction. In more scrutinized markets, the inability to present such a sustainable earnings picture can be detrimental to a sale process. Industry rumors of buyers walking away from transactions or seeking to renegotiate prices on deals precipitated by due diligence findings are becoming more common.

Our most successful transactions are with clients who understand the importance of constructing a detailed and well-thought-out contract waterfall and bid-and-proposal pipeline schedule. The contract waterfall schedule sets forth all of the details of a company’s signed contracts and estimates the revenue and earnings of each contract over several years. The bid-and-proposal pipeline schedule provides details about the company’s recompete and new business pipeline. Each opportunity is assigned a probability weighting, and the schedule reflects the financial potential of each opportunity during the next several years. Taken together, those schedules provide the detailed support for a company’s financial projections moving forward.

Buyers spend a great deal of time in diligence assessing the risk of attaining those earnings and using that risk assessment to justify their proposed purchase price. Part of the risk analysis buyers perform includes an assessment of insourcing, set-asides, OCI and other risks that might be inherent in the seller’s contract base. Savvy, well-prepared sellers have thought through such issues in advance, in addition to positioning prospective synergies with buyers, particularly related to new customers, capabilities and cross-selling opportunities that could result from a combination of two organizations. Although this type of preparation can be onerous and time-intensive, it ultimately instills confidence and enthusiasm from buyers and enables them to maximize price and the probability of closing a transaction.