Deja Vu All Over Again By Jon B. Kutler
The titans of industry consolidate at a rapid pace. Age-old definitions of critical mass are recalculated monthly as larger and larger competitors are created. Pentagon observers will quickly recognize this scenario as the merger and acquisition wars of the past five years, which recast the aerospace and defense industry into three dominant companies: Lockheed Martin Corp., Boeing Co. and Raytheon Co. While packing less impact than the headline-grabbing deals by these big three, recent transactions such as the sale of McLean, Va.-based BDM International Inc. to TRW Inc. of Cleveland and the sheer numbers of companies located in the area, have placed Beltway residents at ground zero for the next round of the consolidation wars in the federal services and information technology market.
As with the consolidation of the hardware companies, the main drivers behind the services consolidation is simple - cost reduction and value creation. Federal customers, faced with the challenge of doing more with less, have bundled contract vehicles to reduce their contractor base in a drive for efficiency.
Small contractors are increasingly finding themselves outgunned in capabilities as they compete for broader contracts. Having been dominated by a cost-plus vehicles base, the services sector is late in focusing on the aggressive pursuit of cost control that has become the mantra of its commercial counterparts. Reducing rates by spreading fixed overhead costs over a larger contract pool may negatively impact near-term profitability, but it is a key to long-term survival.
This activity has not been unnoticed by Wall Street. Institutional investors who were slow to acknowledge the value created by the early defense hardware mergers are quickly becoming aware of the benefits of consolidation among service providers. The same investors that shunned BDM in its first attempt at a public offering and then thought its 1995 initial offering price of $9.25 per share (on a pre-split basis) was overvalued were certainly awakened by a TRW acquisition at $29.50 per share.
There are aspects, however, of the federal services consolidation that will differ from the recent hardware model. These primarily revolve around the size and background of acquirers. While both consolidations have started with dances among the giants, smaller services companies have expressed more interest in participating early in the cycle than their hardware counterparts.
The driving force behind consolidation at this level is even more impressive when the degree of difficulty is considered. Unlike their hardware counterparts, which were primarily owned by dispassionate public shareholders, a significant level of emotional issues must be overcome when merging private companies whose ownership is often concentrated in a handful of founders and managers. This is a task often aided by an investment banker known to both parties.
The universe of potential merger partners is also larger. While special-purpose military hardware like missiles have no obvious commercial counterpart, commercial information technology companies have exhibited increasing interest in participating in the federal services consolidation process.
Companies like Affiliated Computer Services, Dallas, through its recent acquisition of Computer Data Systems Inc., Rockville, Md., have exhibited exceptional foresight in focusing commercial interest and capabilities on the federal sector.
With the benefit of a road map for what will happen in the next few years, readers must decide how to position their companies for the upcoming consolidation. The overriding lesson from previous periods of consolidation is to be proactive about your fate.
Companies need to decide early whether they are a buyer or a seller. Those that decided to sit on the sidelines or thought that they could not be impacted by the forces of consolidation effectively became sellers, but without the benefit of more choice in a partner or the opportunity to position their firms to maximize value.
While the last few years of consolidation among aerospace and defense hardware providers are fresh in our minds, a review of the prior cycle is also a helpful precedent.
In the mid-1980s, the hardware sector went through a similarly active period of consolidation. The underlying driver at that time was adding capabilities and capacity to respond to Reagan-era defense buildup. The federal services sector mirrored that activity with acquisition multiples peaking at approximately 1.4 times revenue versus the eye-popping valuations approaching one times revenue of several recent transactions.
Unlike the hardware consolidation, which slowed primarily due to the end of the Cold War, the federal services sector entered nearly a decade with minimal liquidity for investors due primarily to a perception problem and a lack of focus on the cyclical nature of capital markets.
Industry observers are aware that like a decade ago, record-setting prices paid for federal service companies have been achieved through the use of a structured auction process. What is less well-known, however, is that in most auctions in this mid-1980s period, all but one of the potential acquirers submitted bids that were relatively close. It was one outlying bidder, paying in cases up to 30 percent more than the others, which ultimately won its prize.
When these record-setting bidders departed the scene after satisfying their acquisition appetite, the market quickly retreated to the substantially lower levels that were supported by the vast majority of the buyers. To those of us running these auction processes, this result seemed like the logical conclusion to exhausting a supply of premium buyers. To the market, however, it had a disastrous effect. Sellers who expected higher prices were no longer prepared to sell at the new market price. The remaining buyers, however, never were willing to pay those premium prices and therefore found their overtures rebuffed.
I expect the consolidation of the federal services sector to be quite robust through the end of the decade. The experiences of the last several cycles should be reviewed rather than relearned, however, as companies seek guidance for how to take advantage of the opportunities it offers. In the words of the immortal catcher Yogi Berra, "It feels like deja vu all over again."
Jon B. Kutler is president of Quarterdeck Investment Partners Inc., an investment banking firm serving the information technology industry with offices in Washington and Los Angeles.
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