M&A activities slowed by pickier buyers

 Executives at Narus Inc. were about to launch a fundraising exercise earlier this year to augment the venture capital that had financed the cybersecurity software provider when a longtime client and sometime partner made them an offer they couldn’t refuse.

“How would you like a strategic investor?” Greg Oslan, president and CEO of Narus, recalled Boeing Co. officials asking him.

“When you’re the size of Boeing,” Oslan said, “that usually means ‘How fast can we buy you?’ ”

Boeing unveiled its plan to acquire the Sunnyvale, Calif., company in July and wrapped up the deal in early August. But Boeing did not stop there.

Days later, the defense contracting giant completed its $775 million acquisition of Argon ST Inc., a developer of command, control, communications, computers, intelligence, surveillance, and reconnaissance systems, known as C4ISR. Argon is based in Fairfax, Va.

Although financial terms were not announced, the Boeing/Narus deal was among several transactions that heated up the mergers and acquisitions market during the torrid summer days of 2010.

Industry analysts are forecasting strong M&A activity in the federal sector through the end of the year and probably into 2011 — albeit with fewer deals done and at a slower pace than in the recent past.

“I think it’s going to be a very active time frame,” said John Hagan, co-head of defense and government services at BB&T Capital Markets Windsor Group.

The government contracting industry has been consolidating for a long time, said Larry Davis, partner and founder of Aronson Capital Partners.

“The forces and pressures that are driving consolidation aren’t subsiding,” he said.

But those pressures on the federal budget, largely a result of the huge deficit, are forcing contractors to moderate their spending, and that probably will result in fewer M&A deals overall in 2010 than last year, Davis said.

“The big difference now is capital is not as readily accessible as it was, and the companies that have capital can be a lot more discerning about the opportunities they pursue,” he added.

In his Washington Technology column this month, John Allen, co-head of the defense and government services group at BB&T Capital Markets Windsor Group, reports a 50 percent decline in the M&A activity of five of the largest government contractors, from 40 acquisitions between 2006 and 2008 to only 20 from 2008 to this year.

“We’re in a kind of shift from a seller’s to a buyer’s market, where there are a lot of opportunities out there,” Davis said. “It’s just taking a lot longer to get deals done.”

Recent notable deals include CGI Fairfax Corp. acquiring Stanley Inc. through a common stock purchase deal valued at $1.07 billion; Hewlett Packard Corp.’s purchase of Fortify Software Inc., a privately held software security assurance company for an undisclosed amount; and Cerberus Capital Management’s acquisition of DynCorp International Inc. in July for approximately $1.5 billion, incorporating the government contractor as a wholly owned subsidiary.

Earlier, Xerox Corp. purchased Affiliated Computer Services Inc. in February for about $6 billion. And in late November 2009, Dell Inc. paid $3.9 billion to acquire Perot Systems Inc.

“Dell has made 2010 the year of the storage acquisition,” according to TBR, a market research and industry advisory firm.

“The company has aggressively pursued storage acquisitions to build a strong portfolio of unified storage and tools to help improve the utilization of data storage,” a recent TBR commentary said.

Dell has expanded its storage hardware and software portfolio through the acquisitions of clustered filer vendor Exanet in February and data storage systems provider Ocarina Networks in July, the TBR commentary said.

The comany also is in a bidding war with HP, which topped Dell's $1.2 billion offer to acquire enterprise storage vendor 3PAR. Dell responded with an even higher bid on Aug. 26.

Hagan said he would not be surprised to see a few more billion-dollar deals in 2010, especially because of industry concern that Congress will allow the Bush administration’s tax cuts to expire at the end of the year as scheduled.

Letting those tax cuts expire, Hagan added, would add another 5 percent to the current 15 percent capital gains tax on the sale of a business.

“Certainly that pushed a lot of people into the [M&A] market,” Davis said, adding that he has seen a lot of companies eager to conclude a deal now during the more favorable tax period because “the tax situation will get worse.”

Although he is not aware of any major deals in the pipeline, Davis said, “I wouldn’t be surprised if one did occur. Within six to 12 months, you’ll see one or more is my guess.”

However, whether or not the tax cuts expire, Hagan said, “We’re entering a tougher period of time and a more austere defense environment,” which probably will lead to further consolidation in the contracting field.

“As the pie shrinks or doesn’t grow as fast, companies are going to use acquisitions to supplement their organic growth,” Davis said. “I think maybe you’ll see a lot more discipline in the market and buyers focusing on areas that they believe will be resilient in this new administration.”

With that in mind, firms are looking at the government sector, including the defense agencies, as a more stable long-term environment in which to do business.

“It may not have the same highs and, of course, not the same lows as the commercial marketplace,” Davis said. “But it’s a steadier performer, a far more predictable performer.”

Foreign-owned companies also are aware of the attractions of the government sector. They are swelling the ranks of prospective buyers because they have capital and are in a position to make acquisitions, Davis said.

And those that have passed all U.S. requirements and have an established presence in this country, such as BAE Systems, QinetiQ North America and CGI Group, could have a leg up on their competitors, he added.

The government marketplace “may be starting to flatten out,” Davis said, “but is still huge and of significant influence in the marketplace,” especially for certain services that are in great demand by the government and for which they have been budgeted.

“The larger players are all working hard to amass significant capabilities in the cyber area so they can reap a significant share of those budgets,” Davis said.

Large companies such as Boeing and Northrop Grumman Corp. “would like to go out and buy a cybersecurity business with several thousand people, but not many exist," he said. "So you’re seeing a lot of consolidation in the cyber area with midsize companies because that’s what is available, that’s where the expertise is.”

Hagan said the only way for companies to grow in such an austere environment is to increase market share usually through strategic growth. And a growing company in an expanding market is the ideal situation for a company seeking to be acquired.

“Those who are unable to grow or foresee times when it may be more difficult to grow may choose to exit — if they can get a price that’s attractive today,” Hagan said.

Boeing’s acquisition of Narus was a strategic move to increase market share quickly, Oslan said.

“Clearly, Boeing could have chosen to develop this technology on their own; they have very smart technologists and lots of money,” he said. “What they couldn’t easily do is solve the problem of time. So this [acquisition] gave them the ability to get to market immediately.”

Asked whether the larger deals are impetus for other similar acquisitions, Hagan said, “Absolutely, that’s the nature of Wall Street. Whenever one deal happens with one [company], there’s all kinds of activity around others.”

HP’s purchase of Fortify was a strategic acquisition for the company to prevent competitors, such as IBM and Oracle, from acquiring HP’s key partner for application life cycle security services, according to TBR.

Another example Davis cited, although on a smaller scale, was IBM’s purchase in January of National Interest Security Company LLC, a management consulting firm that advises local, state and federal government agencies.

“To see a large organization like IBM enter that marketplace again could mean that they are looking for a larger acquisition again further down the line,” he said.

Davis said Stanley was a good acquisition target as are other midsize public companies, including ICF International, ManTech International and SRA International.

“All those companies represent attractive targets for these large Tier 1 federal contractors, the big guys,” he said.

But in a warning coda, he added that contractors that specialize in services the government is targeting for insourcing could lose their appeal and won’t be as attractive as they once might have been.