Market Watch: Conditions favor continued M&A activity in federal sector

Jerry Grossman

Frequently, industry executives, investors and journalists ask us about the outlook for mergers and acquisitions in the aerospace and defense and government IT sectors. The question is often if the current pace of such deals can continue.

The robust M&A rate -- on track for about 130 deals this year -- is not likely to go on. However, industry transaction volumes consistent with the past five years, or nearly 100 deals per year, are sustainable.

There are three fundamental reasons for the recent M&A activity:

  • Acquisitions have become a fundamental tool of growth in the defense and government IT sectors.

  • Many characteristics of government-oriented businesses help to facilitate M&A activities.

  • The industry cost of capital and capital availability provide the financial foundation for deals.

Naturally, pricing in each deal will vary based upon public market valuations, cost of capital, the equilibrium of buyer and seller -- and supply and demand -- coupled with deal-specific factors.

While acquisitions feature well-documented risks relative to successful integration and financial performance, there have been, nonetheless, more than 500 announced deals since January 1998. Transactions have occurred in all industry segments, involving both publicly traded and privately held acquirers.

The mix of acquisitions was about 60 percent government services and about 40 percent product manufacturers and integrators.

Since 1998, buyers of services companies that disclosed the terms of their deals have acquired nearly $35 billion in revenue. About two-thirds of all completed deals disclosed revenue.

This reflects average target-company revenue of $175 million in about 200 transactions. Large buyers, with sales above $1 billion, acquired 60 percent of the revenue, while completing slightly less than 30 percent of the deals. These large buyers purchased on average $380 million in revenue per deal.

The smaller buyers, under $1 billion in sales, completed more than 150 deals, picking up around $90 million in revenue per transaction. Most likely, the 150 to 200 deals without disclosure involved smaller companies and predominantly privately owned businesses on both sides of the transaction.

Many characteristics of government markets and service providers produce an operating environment and company structure conducive to business combinations. The federal procurement system, cost accounting standards, DCAA and the FAR, along with custom and practice result in broad-based similarities in the administrative, financial, structural and cultural elements of industry companies, large and small.

These common attributes create a portability of employees and customers that is more fluid than in many other industry sectors. In addition, active industry buyers have developed more thoughtful, comprehensive business integration processes, increasing the chances of a successful ownership, employee and customer transition.

Public company market valuations for government services companies are at or near all-time highs. These valuations are premised, in part, on the assumption that these companies will systematically augment their growth with acquisitions.

Several pure-play federal IT companies have completed secondary offerings, strengthening balance sheets and adding to acquisition capacity spawned by last year's initial public offerings. Industry buyers with more than $1 billion in revenue have more than $15 billion in additional debt capacity, about $10 billion of which could be accessed from inexpensive senior debt sources. Cash balances for this group are more than $6 billion.

In addition, the migration of federal business to time-and-materials contracts and away from cost-reimbursable vehicles has improved operating margins and allowed acquirers to augment post-deal profits by retaining cost synergies from transactions.

These factors suggest that M&A activity will remain high, although the specific transaction volume and valuation levels will fluctuate.

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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