Market Watch: M&A good times march straight into 2004

Jerry Grossman

Many factors driving consolidation over the past two years are still in place as we begin 2004. Mergers and acquisitions in government services and defense product sectors in 2003 were unprecedented at 147 transactions. That's 14 percent more than in 2002, which saw a then-record 129 transactions. By comparison, from 1999 to 2001, the average was 95 deals.

The heightened pace has been accompanied by stronger valuations, particularly for sellers delivering critical products and services in priority defense and intelligence markets.

In the defense segment, pricing -- as represented by enterprise value paid divided by the selling company's revenue -- averaged just more than 1 times revenue in 2002 and 2003. During 1999-2001, the sellers received about 0.8 times revenue.

In the government services segment, during 2003, sellers received valuations averaging nearly 0.9 times revenue, about 20 percent above the typical deal during 1999-2001. Prices paid for good companies in priority markets served to skew average 2003 prices upward.

Among the strategic buyers, most of the large aerospace and defense primes are active, particularly in the federal IT and government services segments. General Dynamics Corp.'s purchase of Veridian Corp. and Lockheed Martin Corp.'s purchase of Titan Corp. are the largest, most visible examples.

These purchases confirm the strong growth outlook in the defense services sector, particularly for companies with key technologies. The convergence of certain technology products and services squares with procurement trends in C4ISR, network-centric warfare and other transformational defense markets.

Seven of the pure-play federal IT companies -- Anteon International Corp., CACI International Inc., Dynamics Research Corp., ManTech International Inc., MTC Technologies Inc., SI International Inc. and SRA International Inc. -- continue to augment organic growth with targeted acquisitions, principally in defense and intelligence. Stock market valuations of these companies rose about 50 percent during 2003, as measured by their aggregate enterprise values at year-end 2002 and 2003.

This significant increase reflects a nearly equal increase during 2003 in the aggregate earnings before interest, tax depreciation and amortization for these companies. The 50 percent rise in EBITDA on a 27 percent increase in revenue was possible through growth in their aggregate EBITDA margin from 8.6 percent to 10.1 percent, or approximately 17 percent.

During 2003, equity sponsors and other private capital sources escalated their involvement in defense and government services sectors through both platform and add-on investments.

For example, Arlington Capital added to its first government IT acquisition, ITS Services Inc., through the purchase of Science & Engineering Services Inc., a fast-growth company with revenue in the $100 million range. Littlejohn, a large private equity group, entered the government services arena with their recent acquisition of Wyle Laboratories, a company providing sophisticated testing, life sciences and other technical services to commercial and government markets. Many other private funding sources have invested or are seeking opportunities in defense companies.

Debt provided by banks and other sources, public and private, remains very inexpensive relative to historic interest levels. High-yield spreads, the incremental cost of non-investment grade subordinated debt relative to treasury bonds, are at their lowest level since 1999, at approximately 2.5 percent. The ratio of total interest-bearing debt levels to a borrower's cash flow has grown from 3.8 times in 2002 to 4.5 times in the fourth quarter of 2003, providing more inexpensive capital to support acquisitions.

These factors, combined with government procurement policies and actions that usually favor very large primes and small businesses, are likely to support strength in M&A activity. Deals will be predominantly sales of middle-market companies. *

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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