The positive momentum driving M&A activity picked up last year and the expectations of acquisition experts Bob Kipps and Marc Marlin are that it will continue in 2018 and maybe beyond.
In thinking through where the government contractor merger-and-acquisition market has been, where it is, and where it’s going, “momentum” is the perfect catch-all phrase.
Following a 2011-2012 market bottom in terms of growth, deals and optimism, 2017 showcased the launch point in the industry "J-curve," and we don’t anticipate the excitement to slow down in 2018.
Industry dynamics create a highly active and complex M&A environment shaped by macro-market trends, public pricing and capital markets activity, and overall deal appetite. The industry continues to benefit from the broader market tailwinds and optimism for government and defense post-election.
The public markets continue to soar, with the Dow (approximately 26,000 today) and S&P 500 reaching all-time highs.
Couple this with continued low interest rates and the recently passed pro-business tax regime, and what is otherwise already a positive sentiment around government and defense contracting, the momentum is now super-charged.
In this sector, an increased awareness around national and homeland security, refocus on military readiness and capital investment is “Trumping” the drama associated with the polarizing administration, budget uncertainty and a continued challenged procurement environment.
Furthermore, ongoing IT modernization presents a blueprint for near-to-moderate term growth above and beyond the low single digit macro market growth trend. Prioritization of defensive and offensive cyber, cloud, artificial intelligence, and differentiated mission support for the intelligence community round out the capability specifics of many organic and inorganic growth strategies in 2018. Not to mention the expectation of blockchain; coming to a website, conference and corporate roundtable near you in 2018!
Amongst this favorable market backdrop, the momentum public company C-suites have experienced over the past few years is further influencing organic and inorganic strategies into the new year. Public company multiples are in some cases at 50 percent premiums to their ten-year averages, and for most firms trading in the double-digit EBITDA multiples.
These valuations present an implied earnings growth meaningfully higher than industry averages, encouraging M&A to add additional capabilities to sell to existing customers or add new customers for existing capabilities.
In either case, the market momentum of stock prices and expectations discourages further meaningful stock repurchases or the status quo. As a result, nearly all firms are in some way thinking about M&A as either a buyer or seller.
M&A activity in 2017 was very active, with over 100 announced government services transactions (in addition, more than 200 transactions were announced in the aerospace and defense products market), an increase of over 15 percent from 2016.
We anticipate this momentum to continue, with 2018 deal announcements to meet or exceed 2017. As for the composition of deal activity, next generation IT and intelligence community/homeland security assets are likely to command much of the attention.
The general consensus around the longer-term attractiveness in these areas and dearth of actionable mid-market targets – broadly defined as $50 million to $500 million in revenue – will likely result in fierce competition for those businesses and valuation multiples that meet or exceed those being enjoyed by the public companies.
We’d also expect to see a continued focus by the larger and typically more aggressive acquirers for assets having valuations or revenue north of $100 million. We have seen a steady increase in the proportion of these larger transactions (about 20 percent of deal activity), and especially as it relates to the generally more aggressive public acquirers.
There has been an ongoing trend of consolidation and as the public companies continue to get bigger, so does their appetite for larger deals that move the needle for them. In a market in which we see the publics paying a few turns higher on valuation than private buyers – private equity backed or independently owned - size and focus matter.
2018 should also see at least one new addition to the public company clubhouse with the DXC/Vencore/KeyPoint combination set to close in the first quarter. This deal adds another $4 billion public company to the mix. As portfolio shaping discussions continue, and should public pricing remain strong, we wouldn’t rule out another Reverse-Morris-Trust, vanilla divestiture or mega merger in 2018 to further change the industry landscape.
While the larger public companies are anticipated to remain active, they represent a small segment of the transaction marketplace given their relatively narrow M&A aperture and selectiveness around targets. The vast majority of activity should continue in the private markets amongst private equity (new platforms and tuck-ins), private to private transactions, minority equity investments, and contract sales.
Scale continues to be a competitive advantage both in terms of revenue diversification, pricing power and as a facilitator of transition from small business to larger. Combinations such as TeraThink / Dominion Consulting, while complex, may become more common than in years past. Governance and relative valuation more than deal interest seems to be the greatest challenge to consolidation amongst the lower middle-market.
Contract sales have also been of great interest. As the government continues to award longer duration contracts with an increased number of awardees, vehicle placement remains important as ever, and a motivator for those on the sidelines to aggressively pursue lines of business with crown jewel vehicles. Alliant 2, OASIS, CIOSP-3, ENCORE III and RS3 could remain the top of shopping lists for 2018. Award activity under these vehicles in the form of new starts could also change the fortunes and value proposition of awardees as they show in many cases a second consecutive year of organic growth, a key ingredient to M&A attractiveness and valuation.
Recognizing no lack of M&A players, the driver for M&A market momentum in 2018 comes down to valuation. Valuation trends can be a tad misleading because while median M&A multiples have remained in the 8 times trailing twelve-month EBITDA range over the past few years, the spread around the median has widened, with valuations increasingly being deal-specific. We anticipate this phenomenon to continue in 2018. Firms with scale (greater than $100 million), focus (especially in one of the hotter aforementioned customer or capability areas) and prime AND full-and-open contract portfolios should continue to receive considerable interest and valuations north of 10x in many cases.
Notwithstanding all the market momentum, set-asides continues to be the most significant value detractor in the GovCon market. Prime, full-and-open contract portfolios will remain critical to attract top dollars in M&A transactions. Supply should also come available as private equity firms look to sell vintage assets and take advantage of current strong multiples and a dearth of targets.
TAX CUT IMPACT
The recent tax law changes further fuel this M&A momentum from both sides. Buyers (most of which are C-corporations) should see greater after-tax cash flow from their base business and also increases in the after-tax cash flow of the businesses they acquire.
For potential sellers, many of which are organized as S-corporations or LLCs (“pass-through entities”) for tax purposes, the after-tax cash flow from the status quo (i.e., continuing to hold their businesses) was not as meaningfully enhanced.
However, their M&A values should be higher -- perhaps 15-20 percent for C-Corps and 10 percent for pass-through entities as a result of the tax changes -- enhancing the relative attractiveness of selling vs the status quo.
As such, we see 2018 as another strong year for GovCon M&A (perhaps trending upwards to challenge 2012’s record activity levels). Deal activity should be dominated by buyers seeking new growth opportunities and scale. Defense, intelligence and next-generation IT are likely to attract the most interest, as firms possessing these in-demand market footprints and/or capabilities and favorable contract profiles attract outlier valuations.
Fingers crossed, the momentum continues into our 2019 market outlook.
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