Market Watch: Soft public valuations make target-rich acquisition climate

With few exceptions, stock prices and enterprise values of pure-play federal IT companies have declined over the past year, while the cost of interest-bearing debt has risen. Many privately held industry contractors are seeking insight into the trends' impact on merger and acquisition pricing.

Buyers are hoping that recent acquisition pricing levels will subside in the months ahead, industry investors are trying to gain insight into the future for both the federal IT stocks and the underlying companies, and industry executives and investors anticipate slower overall demand-side growth as reflected in federal outlays that drive contractor revenues.

M&A pricing in the government services sector has remained strong, despite lower valuations for many publicly traded federal IT acquirers. There are several reasons for this situation.

Most transactions involve buyers outside the relatively small federal IT group, such as aerospace-defense prime contractors, diversified foreign and domestic IT companies, engineering companies, private equity funds and privately held federal IT companies. The market values of many of these buyers, engineering companies, privately held companies and special purpose acquisition corporations, have not declined.

Additionally, acquisitions remain a critical portfolio-shaping tool to align company capabilities with evolving customer requirements. For those wishing to crack the federal space, buying in is the only practical way to establish a meaningful platform for growth.

Turning to the decline of stock prices in the federal IT sector, it is important to understand it in a broader context. The trajectory of the industry, as well as individual companies, is reflected in pricing multiples, as well as price trends.
Individual company performance trends and pricing multiples vary substantially.

While the aggregate equity value of six federal IT companies has declined about 10 percent in the past year, their aggregate revenues and earnings before interest, taxes, depreciation and amortization have grown by 17 percent and 15 percent respectively. Aggregate net income for the group has shown less growth, about 8 percent year over year.

Unlike revenue and EBITDA, net income is burdened by the interest expense and intangible amortization generated by recent acquisitions. The combination of lower share prices and rising fundamentals is driving significant declines in public pricing multiples.

Over the past 12 to 15 months, the ratios of enterprise value to revenues and EV to EBITDA have fallen by nearly 25 percent. The current EV/EBITDA multiples for public federal IT contractors are roughly 15 percent below the 10-year average and more than 25 percent below their five-year average levels.

A closer look at six companies that were public in 2002 and remain so today, reveals revenue growth in excess of 140 percent during the four-year period. Aggregate enterprise value is about 110 percent greater now than it was in mid-2002.

Partially offsetting this growth is a large increase in total shares outstanding, to nearly 165 million from about 110 million four years ago. This share expansion has mitigated price-per-share growth during the period. Thus we find that the weighted average share price for the group is about 20 percent above the 2002 level.

The M&A market in federal IT remains vibrant. For many in the large population of buyers, acquisitions are a strategic imperative, supported by substantial remaining financial capacity.

With lesser organic growth in prospect, the importance of M&A to the maintenance of revenue growth rates seems likely to sustain the volume of transactions above longer-term norms.

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