Sheltered from the storm: Government market flourishes despite continuing uncertainties

Market Watch | Financial views of a competitive environment

The government information technology industry is not immune from the larger economy or political changes, but it is more isolated than many industry sectors. What does the mergers and acquisitions environment look like for our sector for the rest of 2008?

Generally, the government contracting industry is once again weathering an economic downturn better than most industry sectors. Just as in 2000-2001 and the early 1990s, our industry is viewed as a safe haven. The government will not go bankrupt; there are long-term contracts that result in visible backlogs; outsourcing is increasing because of the retiring government workforce and technology changes; and margins are improving because of procurement reform.

Yet there is uncertainty in the air due to the upcoming national election and its potential impact on spending priorities, budgetary constraints, contract award delays and general economic conditions that are resulting in buyers being more discerning and careful when evaluating acquisition opportunities. Buyers are focused on highly strategic targets that have barriers to entry and are synergistic. Adding revenue or increasing critical mass is not as significant a driving force as it has been in the past.

Furthermore, that uncertainty is resulting in deals taking longer to close because of more comprehensive and difficult due-diligence and contract negotiations. Buyers and lenders have become more sensitive to potential liabilities and risk.

The general tightness of credit has not had as much of an impact on this industry as it has had on other sectors of the economy. Lenders are still lending at a rate of 4 to 4.5 times earnings before interest, taxes, depreciation and amortization (EBITDA) for the right deals and the right buyers, but they are doing a deeper dive on due diligence. Larger transactions, especially for private equity buyers, are not getting the same leverage they were a year or two ago. Some lenders to the industry that have been seriously affected by the credit crisis have retreated to the sidelines, but other lenders that want to increase market share in the government IT industry replaced them. So despite the macro headwinds that are blowing, the balance of 2008 should result in the announcement of more high-profile deals.

Two international transactions have just been announced at very high multiples. BAE Systems is acquiring Detica Group, a provider of information security services, which does business with both the U.S. and U.K. governments, at 17 times EBITDA and 2.6 times revenues. QinetiQ North America, a wholly owned subsidiary of U.K.-based QinetiQ Group, is acquiring Dominion Technology Resources Inc., a provider of high-end services and products to the U.S. intelligence community, for $123 million in total consideration at closing, which is in excess of 20 times EBITDA.

The invasion by European - mainly United Kingdom - buyers is driven in part by exchange-rate differentials, and it continues to be the big news story of 2008 for government and defense M&A.

Another factor will be buyers seeking to make strategic acquisitions to better position themselves for changing political and budgeting priorities. SRA International Inc.'s recent acquisition of Era Corp., the leading international supplier of next-generation surveillance and flight-tracking solutions, illustrates that trend. In 2007, SRA announced its intention to add leading-edge product capabilities that differentiate its services in new and rapidly growing markets.

The increased spending by the Homeland Security Department and the prospect of future congressional increases in the DHS budget, increased spending on cybersecurity solutions, and more spending on energy, environmental programs and health care initiatives should also stimulate M&A activity for the balance of the year.

In addition, the specter of a federal capital gains tax increase to 25 percent or more - up from 15 percent - in 2009 is stimulating owners to consider taking their companies to market earlier than many had initially planned.

Deals are taking longer to cross the finish line and are encountering more obstacles along the way, but M&A in the U.S. government and defense contracting industry remains active, with a good mix of buyers and sellers.

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