Aligning portfolios with spending priorities
- By Jerry Grossman
- Mar 27, 2009
As investors and executives in the federal sector confront heightened uncertainty in the economic environment, effective corporate development strategies, including mergers and acquisitions, will remain important. However, the size, shape, valuation and structure of the majority of M&A transactions have changed from the patterns that prevailed from 2002 to 2007.
For the past two years, the M&A environment has reflected a bipolar pattern. Good companies, with sustainable business content, distinguished capabilities, and priority customers and contracts have attracted many suitors and achieved attractive, cash-at-close valuations. Others, lacking those attributes, have faced modest buyer interest, much lower valuations and structured proposals with deferred/contingent components. Current economic and financial market conditions suggest that structured transactions will remain a significant component of deals well into 2010.
During the past year, the public market price/performance ratios of government services companies also have reflected a bipolar pattern, with the strongest companies trading at earnings before interest, tax depreciation and amortization (EBITDA) to enterprise value (EV) multiples more than twice the level of their peers. At the median, these companies are trading at multiples similar to their 2000 levels, well below the 2002-2006 period.
These lower valuation ratios generally will not impede strong valuations for the best strategic acquisitions. However, the pricing in the majority of transactions will reflect these lower public pricing multiples, with the investor expectation that acquisitions will be accretive immediately or over the short term.
Government technology providers – including companies providing services, software and systems – are faced with growing uncertainty about the trajectory and content of their businesses. The Obama administration, supported by Democrats in Congress, is announcing rescues, new initiatives and massive budget plans every week. Although significant changes in priorities are becoming more apparent, there are insufficient details to trace many of these announced federal commitments to specific agencies and programs. Consequently, it remains difficult to identify material impacts on individual contractors. Sorting out the effects of these initiatives, both short and long term, will take some time.
In a broader context, failing financial institutions, a deepening global recession and devastated capital markets simultaneously have increased the cost of capital while reducing its availability. Management teams are rethinking their strategies in this turbulent environment, one which produces new challenges along with clear opportunities. Notwithstanding the relative strength of the government services sector, companies will need to make adjustments to remain successful.
This is a good time for them to reshape and realign their business portfolios in recognition of the direction and magnitude of federal spending that is unfolding. It’s apparent that companies with solid offerings in health care information technology, cybersecurity, energy and the environment will be beneficiaries while many Defense Department platforms and programs will suffer cutbacks, deferrals or cancellations. For companies with capabilities that don’t match up well with government priorities, organic revenue growth will be difficult over the near term. Repositioning the business, refining the infrastructure and establishing footholds in priority markets can provide the foundation needed for the resumption of growth down the road.
In addition, federal contractors are well aware that stimulus spending will not materialize overnight. The government acquisition workforce, already challenged by the scope and complexity of spending programs, will be struggling to manage even larger budgets in targeted spending areas.
I expect the volume of M&A transactions to moderate slightly during the next year. More midtier public company deals would not be a surprise. Company cash flows, liquidity and balance sheet borrowing capacity remain strong.
Some reshaping of company portfolios seems necessary for many companies, resulting in smaller revenue growth, but a stronger foundation in growth markets. Small to midsize private companies seeking acquisitions in a challenging senior and sub-debt market will require creative transaction structures.
Arguably, a more cost-conscious federal customer might lead to more opportunities for midtier companies with solid offerings in the priority sectors.
Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.