Market Watch: M&A pace picks up for government IT players

Jerry Grossman

Merger and acquisition activity in the government IT sector has increased significantly in the first nine months of 2002. Measured by the 79 transactions in this industry sector in the 12 months ended Sept. 30, this recent pace is a 44 percent increase over the 55 M&A deals announced in 2001. This pace is nearly equal to the 78 transactions announced in 2000, and about 20 percent above the average annual rate of 64 deals during 1998 to 2000.

A large proportion of these transactions, on a dollar value basis, involved public company buyers. Nearly 20 percent of these acquisitions were executed by five active acquirers: CACI International Inc., Titan Corp., Affiliated Computer Services Inc., L-3 Communications Corp. and Northrop Grumman Corp. These companies continue to pursue acquisitions in line with their strategic plans.

Recent initial public offerings by Mantech International Inc., Anteon International Inc., Veridian Corp., SRA International Inc. and MTC Technologies have provided significant incremental purchasing power in the sector.

Private equity shops and mezzanine capital investors, many of which have not invested in the industry historically, are taking a hard look at opportunities to either provide capital to government IT companies in support of their acquisition activity or use their capital to buy control positions in well-managed companies. In the aggregate, these sources of capital have more than $2 billion of purchasing power available for cash transactions without returning to the equity markets, or accessing the subdebt, mezzanine or high yield markets.

The eleven "pure play" government IT companies trading in the public markets have aggregate market capitalization of about $6 billion. Taken together, these companies have negligible interest-bearing debt outstanding, indicating that the $2 billion of acquisition power referenced above could be sourced using senior debt.

With senior debt costs at or near historical lows, this environment is ripe for public buyers to complete transactions at compelling pricing multiples while achieving substantial earnings per share accretion for the acquirers' shareholders.

For example, an acquisition priced at 70 percent of revenue can be prudently financed with debt, on a basis well within the lenders' parameters, while being comfortably accretive to the buyer's shareholders.

With senior debt interest rates at only 50 percent to 70 percent of longer term norms, the accretion test is much easier to meet today, for creditworthy buyers, at acquisition pricing at, or above, historical levels.

Many private government IT companies have elected S-corporation tax status, eliminating income tax at the corporate level. Under this tax status, shareholders pay the income tax on the corporation's profits. This provides the potential for sellers to elect a 338(h)10 election, delivering tax savings to buyers and, potentially, higher prices to these sellers. Any net benefit from this tax approach will add to the earnings accretion calculated above. Any cost savings resulting from the integration of the businesses can further enhance earnings accretion.

Equity market receptivity to government IT companies may result in additional industry IPOs and secondary offerings, producing additional acquisition capital to fuel transaction activity. Private capital sources are only beginning to gain adequate understanding of the investment opportunities in this sector.

I'd expect some additional private companies to pursue an acquisition strategy, backed by private equity sponsors adding to the buying capacity of the public companies.

M&A activity -- both acquisitions to enhance growth and divestitures to shape business portfolios in line with strategy adjustments -- is a logical element of industry business planning. The capital markets environment provides excellent support for continued M&A activity at a pace above longer-term historical norms. *

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

About the Author

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

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