Divestitures gain ground in federal market

Divestitures in the federal contracting space accounted for about 20 percent of all M&A activity last year, continuing a trend that began heating up in 2009.

Experts ascribe the trend to several factors – the federal requirement to eliminate organizational conflicts of interest (OCI), the realignment of core businesses prompted by tight federal budgets and continuing resolutions on Capitol Hill, and in some cases corporate financial distress.

“Last year was really one of the first years when probably more than half the companies experienced organic shrinkage versus organic growth,” said Bob Kipps, managing director at investment bank KippsDeSanto.

“The market is tightening and companies are having to reduce their cost structure and sometimes it is more cost efficient to be on your own,” he said.

Brian Gesuale, senior vice president and government technology analyst at Raymond James, sees another factor driving divestitures.

Although a little less than 14 percent of the federal defense budget in 1990 went to the top five contractors, by 2010, that percentage had increased to 32 percent, he said.

When almost one-third of government defense contracting goes to the top five and another 20 percent goes to small businesses, there are fewer opportunities for mid-size companies and foreign prime contractors, Gesuale explained.

As a result, “companies are trying to become a little more specialized and a little more nimble, if that’s possible, from prime contractors’ standpoint,” he said.

So after years of acquisitions and growth, “you’re essentially starting to see these companies try to position themselves to be able to adapt in a much more challenging budget environment,” Gesuale said.

“In 2011, there were probably 10 or so divestitures that we would characterize as more services-oriented companies and there was more activity, perhaps even twice as much, in the defense electronics and defense technology and manufacturing sectors," said Gregory Van Beuren, managing director and partner at Bluestone Capital Partners.

Cobham Plc.'s sale of Sparta Inc. to Parsons Corp. was picked as the top divestiture of 2011 by Washington Technology's panel of merger and acquisition experts.

But obviously it wasn't the only divestiture. L-3 Communications Holdings Inc.’s OCI-driven spinoff of its defense systems engineering and technical services business into Engility Corp. was a noteworthy transaction.

Others included ITT Corp.’s split into three publicly traded entities, including its multi-billion dollar defense solutions unit as Exelis ITT; SAIC’s sale of its oil and gas IT business to Wipro; and QinetiQ Group's divestiture of its security business to ManTech International.

Contractors want to be squarely in the hot markets -- cybersecurity, intelligence, cloud computing and health care IT, Kipps said. So, they are looking inward and “portfolio pruning” by divesting units that fall outside of those targets, he added.

Kipps said he expects to see further pruning and divestitures by some of the larger integrators that acquired numerous businesses during the past 10 to 20 years.

“I think you will see some more distress [also] as the financial and private equity groups perhaps have trouble with some of the companies they bought and look to divestiture to solve some of that,” he said.

But the level of divestiture “most likely will neither spike nor decline to any great degree,” Kipps added.

Divestitures recently took on a new dimension as continuing resolutions and federal budget delays have prompted shareholders to demand value-enhancing strategies, said Rick Knop, managing member of FedCap Partners LLC, a private equity fund focused on the federal contracting industry.

“The large primes have been and probably will continue to rationalize their portfolios by divesting non-core assets in order to redeploy in areas where the budget should be stable or growing, such as cyber, intell, health and energy,” Knop said.

In addition, OCI issues remain a key factor, he added.

“I understand that L3 and BAE Systems are considering a number of divestitures for OCI reasons. I think in part that’s because some clarity has been brought into OCI by DOD issuing their final DFARS [Defense Federal Acquisition Regulation Supplement],” Knop said.

“But even with the final DFARS, many contracts and programs in different [DOD] agencies have adopted a more stringent, sort of choose-your-approach to organizational conflicts of interest, forcing companies to decide between providing advisory and assistance services to a defense agency or competing for the program or business opportunity,” Knop said.

Another recent development was the tightening of restrictions on classified intelligence contracts, which caused some foreign companies to sell their U.S. subsidiaries, a trend that will continue during the next few years, he added.

United Kingdom-based Cobham selling Sparta is an example. Cobham paid $416 million for Sparta in 2008.

“My understanding in part that was done because Sparta is really an intell company that does very highly classified work. They were either losing some of that work or they were not winning re-competes [and] not winning new business,” Knop explained.

He said he believes the Italian defense company Finmeccanica is contemplating some divestitures for OCI reasons. “Foreign ownership is a negative when it comes to the most highly classified work,” Knop said. “There will continue to be some divestitures for that reason, but I don’t think it’s going to spike."

Van Beuren predicts that the current level of divestiture activity should continue for several years, but acquisitions also will continue.

“You may see that at the exact same time that [contractors] are doubling down on the market. You may see a company like Raytheon or General Dynamics or ManTech make three, four or five acquisitions in the same year they divest a non-core unit,” he said.

Which begs the question: OCI and intelligence restrictions notwithstanding, is divestiture the answer for strengthening the bottom line and shareholder satisfaction? Kipps, for one, is dubious.

Divestitures often are merely “window dressing” and counterintuitive, he said, because acquisitions most often enable a company to be more cost efficient.

“It’s more like doing what [Wall] Street wants you to do,” Kipps said.

“If you’re trying to position your business to where you think the market is going to go as opposed to where it’s been,” Gesuale said. “Natural pruning is pretty healthy for these businesses in my view.”

Divestiture allows each entity to be more agile and have more resources, he added. “So I think you’re going to see a lot of those spun-out businesses being acquired.”