Mergers and acquisition activity in the federal sector is off to a strong start in 2010. Several market trends witnessed in the first quarter suggest that M&A deals will continue at a brisk pace for the foreseeable future, supported by current industry dynamics. Aronson Capital Partners has observed several key market themes that we expect to catalyze M&A activity over the next 12 to 24 months.

Capabilities and Customer Reprioritization

The FY11 Budget Request, the largest ever, provides a clear picture into President Obama’s spending priorities and domestic and foreign policy agenda. While cyber security and Intelligence Community activities remain top priorities, federal civilian agencies focused on energy, healthcare, homeland security and international assistance received considerable budget increases, positioning them at the forefront of the President’s agenda. Strategic buyers have taken note of this realignment and are reprioritizing their M&A programs accordingly. The article in this issue of The Ticker, “Comments on Public Buyers’ Acquisition Strategy,” provides M&A related commentary from recent earnings calls and an overview of strategic buyers’ M&A areas of focus.

In parallel with the recent budget request, the 2010 Quadrennial Defense Review laid out the DoD’s focus areas. Defense procurement dollars are being redirected from large hardware platforms to non-traditional, irregular warfare including cyber warfare, stability operations, unmanned vehicles, and intelligence, surveillance, and reconnaissance technology.

In responding to this evolving defense investment environment, middle-market services companies are viewed as more agile and flexible than traditional platform-oriented Tier 1 prime contractors. As such, middle-market government services companies focused on priority areas have seen valuations hold up remarkably well in terms of both purchase price and public company valuation multiples. The exhibit below provides an overview of public market Enterprise Value-to-EBITDA (“EV/EBITDA”) valuation trends for government services and Tier 1 prime contractors.

Exhibit: Publicly-traded Enterprise Value / EBITDA Valuation Trends, 1Q08 to 1Q10


Source: Factset

Govt Services Index: APSG, STST, CACI, DRCO, HRS, MANT, NCIT, SRX, ICFI, SXE

Tier 1 Index: GD, HON, ITT, LMT, LLL, NOC, RTN, SAI

Abundant Buyer Universe with Ample Dry Powder

The federal M&A market continues to benefit from a large pool of well-capitalized strategic buyers as the strategic imperatives for consolidation remain very much in place. Large and mid-tier strategic buyers are underleveraged by historical standards and armed with robust cash reserves and ample financing capacity to consummate transactions. Moreover, anemic organic growth expectations are requiring strategic buyers to accelerate their M&A programs to meet Wall Street expectations. A favorable financing environment and the re-emergence of the IPO market, as evidenced by the IPO of Global Defense Technology & Systems (GTEC) in November 2009, ManTech’s $200 million Senior Note Offering in April 2010, and Kratos’ $225 Senior Note Offering in May, are positive signs for M&A activity in the sector.

Financial Buyers

Equipped with substantial dry powder and welcomed by receptive debt markets, financial sponsors are actively pursuing new platform acquisitions and building portfolio companies through bolt-on acquisitions. Existing private equity-backed platforms seeking to build critical mass and achieve operational leverage through acquisition synergies have increased competition in sales processes as these buyers act more like strategic buyers. In addition, the favorable IPO market has reenergized financial sponsors’ pursuit of bolt-on acquisitions to reach IPO size and optimize their liquidity options. The Ticker article “Private Equity Hunkers Down in Government Services Market” highlights the continued resilience of private equity in the federal sector.

Emerging Strategic Players

In addition to the traditional M&A players, emerging strategic buyer groups are becoming more aggressive. In particular, firms at a critical inflection point at the lower end of the middle market with revenues between $75 million and $150 million are implementing aggressive acquisition plans. With strong management teams, healthy balance sheets and a favorable lending environment, these buyers are pursuing acquisitions to diversify their offerings and customer bases, increase their scale and compete for large prime contract opportunities. Doing so establishes critical mass and results in valuation premiums.

Diversified IT, Consulting and Commercial-focused Buyers

Well-capitalized, commercial-focused firms have elevated the federal sector to top billing in their M&A programs in order to take advantage of the industry’s robust fundamentals and hedge against the downturn in their private sector businesses. Diversified IT and accounting firms have revitalized their government businesses through acquisitions; examples include IBM’s acquisition of NISC in March 2010 and Ernst & Young’s acquisition of Capital City Technologies in October 2009. Engineering and construction firms have been particularly acquisitive in the federal sector as they seek to increase their backlog from public funding sources, with examples including Jacobs Engineering’s acquisition of Tybrin in December 2009 and the pending sale of VT Group plc to Babcock Group plc. Perhaps most notable among the commercial-focused firms is the emergence of OEMs and product vendors as active acquirers in the federal sector. These firms are driven by their desire to become full-service, one-stop shops for IT and technology solutions. Recent examples of OEMs acquiring federal-focused and technology-agnostic services companies include Dell’s acquisition of Perot Systems, Avaya’s acquisition of Nortel’s government business and Xerox’s acquisition of ACS.

International Buyers

Lastly, the abundant pool of buyers is by no means limited to domestic firms. Foreign buyers remain in active pursuit of U.S. federal government contractors. Many of these buyers have special security arrangements that enable pursuit of high-value targets involved with the U.S. intelligence and defense communities. Despite several of these firms already establishing footprints in the U.S. market over the last several years, this group of buyers continues to pay premium valuations for access to new, large and growing markets. Most recently, Canada-based CGI announced its acquisition of Stanley for 11.7 times EV/EBITDA.

Organizational Conflict of Interest (“OCI”) Sensitivity

Increased sensitivity to OCIs and shifting OCI policy mandates are creating a bifurcated M&A market for buyers and sellers. The government’s increasingly restrictive OCI posture, initiated by recent legislative measures (e.g., Weapons System Acquisition Reform Act) and further promulgated by agency-specific actions, has set a precedent that will continue to drive divergence as new guidance is clarified and new policy is enacted. In many cases, certain agencies are adopting strict avoidance policies requiring contractors to choose whether they will participate on the technical assistance and advisory or the development side of a procurement. As a result, buyers, particularly larger platform-focused primes, are vetting potential conflicts early in the M&A process and any hint of Systems Engineering and Technical Assistance (“SETA”) overlap with existing programs or lucrative new procurements is causing these deep-pocketed suitors to excuse themselves from sale processes. Consequently, sellers with a substantial mix of SETA or OCI-laden work may find themselves attracting a narrower group of interested buyers.

Large companies are actively auditing their existing contracts, lines of business and market strategies to identify potential conflicts with large acquisition programs. This dynamic will most certainly lead to an increase in corporate divestitures and M&A activity. General Dynamics – AIS’ recent divestiture of its NRO SETA unit to KEYW Corp., Northrop Grumman’s divestiture of TASC to General Atlantic and KKR, and Lockheed Martin’s recently stated intention to sell its Enterprise Integration Group are prime examples of deals driven by the new OCI-restrictive environment.

As Tier 1 primes withdraw from areas that pose conflicts, the SETA market is ripe for consolidation by mid-tier government services contractors and private equity firms. With no publicly-traded, pure play SETA firms, we expect to see increased interest in this segment of the market by private equity firms seeking to execute an aggressive roll-up strategy or scale quickly and test the IPO market in the next 12 to 24 months. Existing SETA-focused PE platforms include Booz Allen (Carlyle Group), SCITOR (Leonard Green & Partners), Schafer (Metalmark) and MCR (Harrison Street), among others.

Portfolio Shaping: Increased Divestitures and Portfolio Realignment

In addition to policy-driven portfolio shaping, industry players continue to evaluate their portfolios and business strategies in order to refine their current and future positioning. This reassessment has led many corporations, both federal-focused firms and more diversified groups with a government-focused unit, to divest non-core assets. Sales of divisions and assets by corporations accounted for a significant portion of deal activity in 2009 and the trend continued in the first quarter of 2010. GD AIS’ sale of its spacecraft development and manufacturing business to Orbital Sciences Corporation in April 2010 and Unisys’ sale of its Health Information Management Business to Molina Healthcare in May 2010 are two examples of companies divesting non-core business units to realign their portfolios. More recently, Lockheed Martin announced an intention to divest much of its Pacific Architects & Engineers group. We expect this type of activity to continue in the months ahead.

Tax Policy Impacting Exit Planning and Market Timing for Selling Shareholders

The impending sunset of former President Bush’s capital gains tax cuts in 2011 and the incremental Medicare tax on unearned income contained in the Health Care Reform Bill are causing many shareholders to seriously evaluate their exit plans. The Obama Administration plans to let the Bush tax cuts expire as scheduled, increasing the capital gains tax rate effective January 1, 2011 from 15 percent to 20 percent for high-income taxpayers. In addition, the recently enacted Health Care Reform Bill has instituted a Medicare tax on the unearned income of high-income taxpayers; for the first time ever, a 3.8 percent Medicare tax will apply to the investment income of high earners, going into effect on January 1, 2013,. When considering the decision and timing of an M&A transaction, tax rates are important factors, and should be considered along with the health of the business and the capital markets as a whole. The significant tax rate changes affecting high-income taxpayers are summarized in the following table.

Exhibit: Significant Tax Rate Changes

* The current Capital Gains and Ordinary Income tax rates will expire on December 31, 2010, reverting to the pre-Bush tax rates.
¥ The Medicare tax is 3.8% of the lesser of the taxpayer’s net investment income or modified AGI in excess of the threshold amounts. Income from dispositions of certain active partnerships and S corporations, distributions from qualified plans, and any item taken into account in determining self-employment income would be exempt from the Medicare tax.

Increased Due Diligence Threshold

While we remain sanguine about the M&A environment moving forward, the federal government'sdeteriorating fiscal posture and evolving policies (e.g., in-sourcing, OCIs, etc.) have led to a general caution pervading the market. Consequently, the due diligence threshold has been raised for all types of M&A transactions. This underscores the need for an advisor with an active approach to all stages of the process, from initial planning and marketing to negotiating the letter of intent, through due diligence and negotiation of a final agreement. A track record of execution and “hands-on” involvement is essential to navigating increasingly rigorous due diligence.

Fundamentals point to an optimistic outlook

While challenges persist in both the federal sector and the wider economy, we are optimistic about the M&A outlook in 2010, particularly in the middle-market. The underlying market fundamentals that have fueled federal contracting M&A activity over the past decade are still very much in effect. Similarly, the strategic turbulence created by a change in administration, priorities and policies has altered corporate strategies and the competitive framework of the industry and created significant opportunities for seasoned executives and investors.

The federal sector continues to attract a variety of strategic, financial and foreign buyers. In addition, while there remains a host of active buyers with the capacity to pursue and close attractive transactions, there are also many deals vying for this mindshare, and achieving premium valuations requires a well-orchestrated sale process now more than ever. We are happy to share our insights on building shareholder value and welcome the opportunity to meet and discuss the current market outlook.