MARKET WATCH

Who Are These Guys?

Jerry Grossman

Merger and acquisition activity in the defense and government services markets remains robust, even as many domestic buyers have slowed their pace of buying because of stock price declines or tightening of debt and mezzanine markets.

Filling some of the gap are foreign-based companies, many of which are unfamiliar to domestic industry executives and investors. Look for a continuation and, potentially, an expansion of this cross-border (U.S.-European) merger and acquisition activity.

There are several reasons to expect these deals to continue. First, worldwide aerospace and defense and government services markets exhibit slow, single-digit top-line growth and, in product sectors, overcapacity on the supply side. But to sustain or grow stock market valuations or satisfy private sources of capital, foreign buyers must achieve earnings growth rates in the 10 percent to 20 percent range, thus prompting acquisition initiatives.

Second, the Pentagon's shift from products built to military specifications ? milspecs ? to engineered commercial, off-the-shelf products is driving traditional platform builders to acquire engineering talent with systems integration skills to complement their own expertise in original design and production.

Third, the relatively high market valuations of European-based buyers provide the firepower for these acquirers to close deals at attractive valuations.

In the United States, when discussion of the government information technology, aerospace and defense industries occurs, the tier 1 players are well-known and frequently in the news with transactions, contract wins and joint-venture activities. Names include Lockheed Martin Corp., Northrop Grumman Corp., Raytheon Co., General Dynamics Corp., TRW Inc. and the Boeing Co. on the aerospace and defense side; Computer Sciences Corp., Electronic Data Systems Corp., Science Applications International Corp., American Management Systems Inc., DynCorp, Veridian Inc. and Anteon Corp. on the IT and technical services side.

Looking ahead, some new names will emerge as more active and aggressive foreign-based players initiate or expand their participation in domestic government and defense markets.

The dominant foreign tier 1 player in U.S. markets clearly has been BAE Systems, a U.K. company with operating units and joint-venture activities in every significant (and secondary) defense market in the world. Formed by the combination of British Aerospace and GEC's Marconi Electronic Systems, and augmented by the purchase of Sanders from Lockheed Martin, BAE has been aggressively building its U.S. aerospace and defense and government IT practice through acquisitions. Most industry investors and executives are familiar with BAE.

However, some other foreign companies with their eye on growing their presence in the U.S. defense markets have less familiar names. This group encompasses traditional, old-line aerospace and defense companies principally involved in hardware platforms ? airframes, ships, tanks ? as well as defense electronics, avionics and other high-technology systems.

Such companies are VT (Vosper Thornycroft), EADS, Thales and Cobham Plc. While their principal business lines are outside the IT arena, all of them understand the fundamental application and criticality of the IT component to the success of technology products and systems, as well as the effectiveness of their customer organizations.

Other outsourcing companies have emerged, focused on support services to government customers. The most prominent of these providers is Serco, a high-growth, visible publicly traded company, with a robust market capitalization of more than $2 billion. Several privately held services companies are aiming at U.S. markets, which remain, by far, the largest for government IT, outsourcing, aerospace and defense.

Public market price and performance relationships of European aerospace and defense companies, at an enterprise value/earnings before interest, taxes, depreciation, amortization multiple of 10, are similar to their U.S. counterparts and significantly higher than U.S. government IT and technology companies, predominantly priced at EV/EBITDA multiples of about 7. U.K. government services companies ? Serco, WS Atkins and Capita Group ? are priced very aggressively at present, exhibiting unsustainable EV/EBITDA multiples in the 20 to 30 range.

Absent significant changes in the posture of governments relative to cross-border ownership or major realignments of market pricing and sentiment, we expect continuing foreign-domestic business combinations in the industry. These combinations will increasingly include alliance and joint-venture arrangements which, when well-structured, can eliminate or mitigate some thorny defense-related issues.

For example, regulations and guidelines relative to foreign ownership control and influence, particularly important where security clearances are involved, must be accommodated through specialized corporate governance structures or security agreements. While these issues don't necessarily become deal-breakers, they do require active consideration and resolution.

Most of the cross-border transactions, both M&A and alliances, will involve tier 2 and 3 companies. For all of the reasons discussed, companies and investors assessing either strategic alternatives or shareholder liquidity alternatives need to be familiar with the possibilities internationally.

Jerry Grossman is managing director at Houlihan Lokey & Zukin in McLean, Va.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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