Government still hot for M&A

During the last calendar quarter, publicly traded government services companies have taken a beating from investors.

Pricing in the federal services space is down 19 percent, compared with a 5 percent decline for defense prime contractors and a 1 percent increase in the broader public markets. Valuation multiples — enterprise value to earnings before interest, taxes, depreciation and amortization for government services companies — are at their lowest levels in the past decade, well below 10-year averages of 11.5x EBITDA and 2004-05 highs of 15x EBITDA. On average, public companies are trading at 6.5x trailing 12-month EBITDA, down about 25 percent from the end of 2009.

That slide has occurred despite reasonably strong company performance, with aggregate revenue growth of 5 percent during the past year and consistent margins.

So what has changed in the industry to trigger such a dramatic pricing movement so quickly? Companies and investors are cautious about growth prospects for the industry because of federal insourcing efforts, Defense Secretary Robert Gates’ defense budget initiatives and prospective contractor cuts, persistent rhetoric related to the federal deficit, and a scale back of efforts in Iraq and Afghanistan. The downward momentum in pricing for the government services industry suggests that the prevalence of such issues has spawned the question: How low is the floor for the industry? As a result, expected organic growth for companies resides in the 4 percent to 6 percent range, a precipitous drop from average historical levels of 8 percent to 10 percent.

Increasingly, the industry’s publicly traded players are looking to mergers and acquisitions to backfill overall growth expectations that they are not meeting organically. Although that is nothing new to our market, the nature of M&A has changed. Buying for size is no longer the key criteria given the greater risk of organizational conflicts of interest and dearth of large, independent targets with high strategic value because of the aggressive consolidation of the past decade. Companies are looking to reposition themselves in areas of perceived budgetary priority by acquiring new capabilities, contract vehicles and customer relationships.

Deal activity is up more than 30 percent year over year, and 2010 is shaping up to be the one of the strongest years ever for industry consolidation, rivaling the nearly 100 federal services deals announced in 2007. Corporate divestitures — such as moves by Computer Sciences Corp., Lockheed Martin Corp., ITT Corp. and Northrop Grumman Corp. — public company transactions and tax-motivated private company sellers have contributed to the hastened pace of activity.

From a pricing perspective, M&A transactions are trading at a premium compared to public market pricing. The median deal multiple is about 8.5x EBITDA, albeit with significant variability at the high and low end of the range, which is 33 percent more than median public company pricing. Corporate M&A teams will need to justify acquisition pricing, which will often occur at healthy premiums compared to where their own stock is trading.

The relative pricing dynamic between public and M&A markets has several implications. Although corporate divestitures have increased in the past year because of organizational conflicts of interest, divestitures are even more likely to continue in earnest as corporate sellers see the opportunity to achieve premium pricing from the sale of noncore assets. Second, companies that have been considering going public may defer IPO plans until the next window of pricing enthusiasm opens or alternatively consider a sale alternative. In addition, we’d expect to see more public companies being targeted for acquisition by larger prime contractors and private equity sponsors emboldened by relatively inexpensive public pricing.

Given the confluence of those factors — budgetary and regulatory realities, the capital market environment, and seller tax considerations — we foresee continued strong transaction activity for the balance of 2010 and well into 2011.