Contractors prepare to face headwinds

John Hagan is co-head of the defense and government services group at BB&T Capital Markets | Windsor Group.

The beginning of the second-quarter earnings season for publicly held government contractors has reinforced the themes that have led to the sector’s recent valuation headwinds.

Those themes include defense budget pressures, tightening profit margins, lost business from government insourcing and delays in contract awards. Consequently, many companies have announced plans to adjust their overall cost structures.

In October 2009, Mike Lewis, a senior equity research analyst at BB&T Capital Markets, downgraded most of the stocks in his research coverage universe due to the concerns listed above. Since that time, valuations in the sector have decreased about 20 percent. The current median enterprise value for the latest 12 months (LTM) in the government services sector is 7.8 times the value of earnings before interest, taxes, depreciation and amortization (EBITDA), versus 9.6 times EBITDA at this time two years ago.

In 2004 and 2005, that multiple had averaged well over 12 times EBITDA.

The large prime aerospace and defense sector median LTM enterprise value to EBITDA multiple is currently 6.1 times EBITDA, versus 8.6 times EBITDA at this time two years ago. In 2004 and 2005, that multiple had averaged over 11 times EBITDA.

Expected growth and profitability were high in 2004 and 2005, as were overall merger and acquisition valuation multiples.

Currently, the greater uncertainty over growth and profitability in the government contracting sector has negatively affected valuation multiples.

ManTech International Corp. just reported second-quarter revenue below consensus estimates, though a majority of the shortfall appears to be attributable to lower-than-expected materials being passed through certain contracts. EBITDA and earnings per share were above consensus estimates. ManTech reported that it was implementing cost initiatives in the second quarter to counter expected profitability declines from certain contracts that had converted to less profitable cost-plus contracts.

Dynamics Research Corp. indicated that its results were affected by insourcing and delays in contract awards. Revenue was $2 million below estimates. However, lower-than-expected costs enabled the company to still meet its earnings estimates.

With respect to the large prime aerospace and defense contractors, many are actively seeking to reduce the overall cost structures in their defense businesses. For example, Boeing Co.’s defense profit was down 19 percent this quarter. The company signaled lower margin expectations for the entire year, citing pricing pressure from the government. In response, Boeing indicated that layoffs are likely. Similarly, in the wake of tightening defense budgets, Lockheed Martin Corp. recently announced a mandate to improve cost efficiencies and streamline its organization.

In addition to focusing on cost efficiencies, government contractors are actively reshaping their portfolios. They continue to seek acquisitions that will deliver new capabilities in the fastest-growing segments of the government market. The intelligence, surveillance and reconnaissance market continues to be among the most sought-after segments. Boeing acquired Digital Receiver Technology Inc. in December 2008 and recently closed the acquisition of Argon ST Inc., solidifying its position as a leading provider of ISR solutions.

Companies are also divesting noncore assets and/or those that are creating organizational conflicts of interest. For example, Lockheed Martin recently announced its intent to divest its Enterprise Integration Group and its Pacific Architects and Engineers business units.

Such acquisitions and divestitures, coupled with an industry that possesses outstanding cash levels and debt capacity, translate into an active market for mergers and acquisitions as contractors position themselves for the future.

Whether today’s valuation multiples represent a bottom will be heavily dependent on the forthcoming fiscal 2012 defense budget outlook.