Jean Stack

COMMENTARY

What's driving the increase in divestitures?

Reminiscent of the activity in the mid-1990s, the government services market has experienced a flurry of spinoffs and divestitures in 2010 and 2011.

In the last 12 months alone, 20 such transactions involving industry players have been announced, representing 20 percent of all deal activity. Unlike the prior divestiture wave, which was sparked by overleveraged balance sheets resulting from a series of mega-mergers, the industry’s business breakups today are being done for highly strategic, business-driven reasons.

Recent deals reveal three primary drivers: the need to eliminate organizational conflicts of interest (OCI), portfolio shaping, and shareholder value creation (i.e., the sum of the parts is worth more than the whole).

The most recent and significant OCI-driven transaction is the spinoff of L3 Communications’ services business to be called Engility. It will have $2 billion in revenue and $190 million in earnings before interest, taxes, depreciation and amoritization. Engility provides systems engineering and technical assistance, training services and mission support to the Defense Department. L3 expects to complete the spinoff in the first half of 2012.

Another widely discussed and anticipated transaction — representing both the sale of a non-core asset and driven by OCI challenges — is the sale of Cobham’s Analytic Solutions business (formerly Sparta, Inc.). With 1,200 employees, Analytic Solutions provides technical analysis, computer science and engineering solutions to national security agencies, including the Missile Defense Agency and the intelligence community. Cobham acquired Sparta in 2008 for $416 million but recently determined that OCI challenges in the domestic defense market constrict Cobham’s larger growth strategy.

Another major transaction, contemplated for different strategic reasons, is ITT’s breakup into three separate publicly traded entities. ITT was primarily driven to unlock shareholder value, with a declining defense business negatively impacting its stock performance. ITT’s new entities, focused on water, defense, and industrial markets respectively, will be spun out in a tax-free transaction expected to close by year's end. The $5.5-plus billion defense solutions business, to be called Exelis, provides C4ISR products and systems, IT and technical services to military, governments and commercial organizations.

While these deals involve large businesses, most divestitures are small, involving the disposition of minor, noncritical assets. Examples include the sale of Booz Allen Hamilton’s state and local transportation consulting business to CH2MHill, the sale of SAIC’s oil and gas IT business to Wipro, and the sale of QinetiQ’s security business to ManTech.

These transactions, though, are not without their challenges. They often include negative tax implications to the selling company (i.e., gains to C-corporations are taxed as ordinary income); organization of the asset to be sold (i.e. which contracts, employees, and intellectual property are to be included); and development of the stand-alone financial profile of the business to be disposed. Among the benefits, proceeds from business dispositions can be used to enhance value to investors through distributions or stock buybacks. Funds also can be used for acquisitions in areas of strategic importance.

Looking ahead, there are a number of important implications for our market. First, divestitures are likely to continue because the factors driving the transactions to date are still in place. Second, the breakup of businesses has resulted in the creation of a new middle tier of well-capitalized government services companies, very likely to focus on making acquisitions as well as organic growth strategies.

Last, size matters, but specialization may be more important, particularly when it comes to weathering the storm of a decline in federal spending. Companies, both large and small, should regularly reassess their portfolios to assess whether divestitures or spinoffs make good business sense.

About the Author

Jean Stack (Jstack@hl.com) is the director of the aerospace, defense and government group at the investment bank Houlihan Lokey.

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