Public IT Companies Remain On Most Wanted Lists
By Jerry Grossman
The government technology and services market is under attack by a merger and acquisition bug that is somewhat virus-like in the scope and speed
of its ability to infect large numbers of industry players. Recent deals reflect the compelling rationale for both business building through acquisition and for continued rationalization of the industry to bring the market supply of government technology services companies into better balance with market demand.
This rationale has prompted acquisitions of mid-sized public government technology service, or GTS, companies by larger public companies. Specifically, three recent deals symbolize the trends: 1) Computer Sciences Corp.'s acquisition of Nichols Research Corp.; 2) Titan Corp.'s purchase of Advanced Communications Systems Inc.; and 3) AT&T Corp.'s acquisition of GRC International Inc.
The Nichols-Computer Sciences transaction, announced in September 1999, was consummated at pricing multiples that were consistent with deals closed during the 1997-1999 period. Specifically, the total value of market capitalization, including interest-bearing debt and equity paid in the Nichols acquisition, was 84 percent of the latest 12 months revenue, 9.5 times earning before interest, taxes, depreciation and amortization (EBITDA), 13.6 times EBIT, and 20 times earnings.
The Advanced Communications Systems and
GRC acquisitions, announced in December 1999 and February 2000, respectively, were consummated at pricing multiples that were, on average, about 20 percent higher than the predominant levels in the industry, including the Nichols transaction. When analyzing these transactions, however, it is important to carefully incorporate the full impact of recent acquisitions completed by the target company upon the prices paid.
In the case of GRC, for example, its 1999 purchase of Management Consulting and Research Inc. was not fully reflected in GRC's reported performance as of the acquisition date, giving the appearance that acquisition multiples were higher than those actually negotiated. These higher price/performance relationships reflect the growing scarcity of public mid-sized GTS contractors, coupled with positive trends in government procurement, relative to larger-sized entities.
Another factor influencing the investment appeal of government IT contractors is their technology and intellectual property assets. There is clearly a renewal of interest within the GTS community in migrating technology-based intellectual property toward commercial market application. Booming market valuations of e-commerce, Internet, communications and other high-technology companies have rekindled interest in technology transfer. Many companies are moving these assets and efforts into subsidiaries to create more independent business entities. These "spun-out businesses" can then be separately financed, developed and possibly taken public ? naturally, at astronomical prices.
Nichols Research, Advanced Communications Systems and, to a lesser extent, GRC had in large measure built their businesses through acquisition.
The boards of the selling companies, management teams and shareholders are confirming three things:
1) the allure of attractive acquisition pricing; 2) the difficulty of achieving 15 to 20 percent compounded annual growth through organic business development (the typical expectation for public GTS); and 3) the highly competitive market for scarce technical talent.
In addition, recent deals involving buyers with modest federal market participation underline the appeal of the government IT market to commercial IT players. At least for the near term, these factors are likely to continue robust acquisition activity. Although the cost of capital, particularly debt capital, has risen in the range of 100 basis points (1 percent), the availability of capital to finance transactions continues to be robust. The exception is the high-yield market, which is relatively unreceptive to new financing at present.
The primary economic, industry and technology factors that drive industry performance remain in place.
Over the near to intermediate term, the supply of technical talent is unlikely to match demand in the U.S. economy. This problem is more acute in the federal sector due to the predominant business mode: a cost-based procurement system. Accordingly, part of the "remedy" is the deployment of technology on a leveraged basis ? a solution orientation. This technology-based approach requires active deployment of software tools, broadband communications and e-commerce capability and, in many instances, effective process re-engineering.
The more successful federal IT companies are actively applying these tools to assist their government customers. The result is usually a combination of more exciting and challenging work, lower costs and higher outputs in customer environments, and more profits and higher values for contractors.
Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va.