During the current economic downturn and consequent hangover, the U.S and global economic environment has undergone a unique and extraordinary transformation.  While the financial crisis has certainly affected the broader M&A markets, the impact has been uneven sector by sector.  The current period of sustained turbulence and shifting political winds continues to propel consolidation in the federal sector due to the relative strength of the government sector to other markets.

Federal Sector: Relative Strength and Fundamental Buoyancy

Historically, the federal sector has outperformed the S&P 500 during periods of prolonged economic downturn, offering a “safe harbor” from market dislocations that depress economic growth. The top four aerospace & defense contractors have outperformed the S&P 500 by an average of 42% during the past five US economic recessions.  

Exhibit A: Historic Recessionary Period Performance               

Tier 1 Index: GD, NOC, RTN, LMT
Abs – Absolute performance
Rel – Relative performance (relative to S&P 500)

Investors remain committed to this industry amidst recessions for a number of reasons, including: i) the stable, mature and defensive nature of the sector, ii) robust operating fundamentals, and iii) reliability of the government customer and predictability of cash flow.  While the sector has come under pressure due to a variety of industry-specific factors in the past 12 months, public company performance and M&A market activity has remained relatively buoyant. Federal-focused, publicly-traded companies have significantly outperformed the major indices and their commercial-focused counterparts during the current economic downturn, as shown in Exhibit B and C below.

Exhibit B: Public Equity Index Returns. (Indexed to 100)

 

Source: FactSet Research Systems

Exhibit C: Public Valuation Multiples. (EV/EBITDA)

Source: FactSet Research Systems

Tier 1 Index: GD, HON, LLL, LMT, NOC, RTN
Government Services Index: CACI, DCP, DRCO, ICFI, MANT, NCIT, SAI, SRX, SXE
Commercial IT Index: CAN, ACS, CSC, PER, TEAM, UIS

Although the S&P 500 has lost 26.7% of its value since September 1, 2008, an index of large-cap Tier 1 government contractors has lost 31.4% and the index of publicly traded government services firms has gained 9.6%. Compared to an index of diversified IT services firm with significant private sector market share, the government services index has outperformed its commercial-focused counterparts by 19.5% and the S&P 500 by 36.3%.  The economic slowdown, amplified by numerous government bailouts, looming budget cuts  and a mounting federal deficit has called into question the federal sector’s growth and margin expansion prospects, which increased volatility and negatively affected the sector’s public equity performance and valuations in the latter half of 2008 and the first quarter of 2009. Specifically, the fate of large scale defense weapons platforms and looming acquisition reform are risks that have lingered over the tier 1 index for quite some time.  Despite these concerns, the sector still boasts robust fundamentals that many sectors envy and have served to support the sector’s inherent resiliency.  President Obama’s FY2010 budget request and agenda details, coupled with the positive spending impact of the unprecedented stimulus package have provided significant visibility on the sector’s prospects and served to bolster investor confidence.

Federal M&A Market Trends

We are very optimistic about the M&A outlook for the federal sector, particularly in the middle-market. History shows that increased economic and industry turbulence have been key drivers of M&A activity in the federal sector. Even throughout the current economic downturn, the federal services M&A market, while down from record historical levels, has been a leader in U.S. M&A activity. Despite a slight decrease in volume, deals continue to get done at attractive prices and terms, see Exhibit D.

Exhibit D: Federal Government Services Quarterly M&A Deal Activity

Source: Company press releases

The stabilizing credit markets, recent rebound of broader equity market indexes and clearer visibility on the Obama administration’s agenda and top priorities are promising signs for the M&A deal environment. Based on the transactions that have been completed or announced so far this year, Aronson Capital Partners has identified several key trends that we expect to continue over the next 12 to 24 months.

• Premium valuations for well-positioned firms with distinctive attributes
  This theme persists despite the recent downward pressure on publicly-traded valuation multiples. Tier 1 firms have seen valuations drop precipitously since the beginning of 2008; however, these same firms have increased their focus on M&A to hedge against aforementioned concerns and have willingly paid premiums to consummate deals that are not immediately accretive to penetrate and/or build scale in priority markets. So long as targets have coveted, proprietary capabilities in high priority, sought-after markets, they will continue to attract the interest of a number of well-capitalized suitors during their competitive sale processes. Winning bidders consistently have proven capable of paying significant premiums, willingly doing dilutive deals to snap up distinctive properties. Areas of significant interest to buyers of all sizes as demonstrated by YTD deal activity and advertised interest include: cybersecurity, intelligence, healthcare IT, logistics, energy and environmental.
  
  
  
• Focus on low to mid-market deals
  Federal sector deal activity in the low to middle market has held up extraordinarily well when compared to other markets. Buyers of all types continue to pursue smaller deals at a rapid pace. Larger buyers that once had size thresholds of at least $100 million have since dropped those parameters in an effort to further refine and shape their portfolios. Niche companies with specific technologies and capabilities, significant past performance and unique expertise have proven themselves more adept in tackling challenges in emerging priority markets than their larger public counterparts. Furthermore, cost-conscious public companies have reduced IR&D initiatives and have been cautious to invest in development projects in order to protect their profit margins. Through an effective M&A program, buyers are able to fill these critical technology, capability and expertise gaps with small balance sheet measures (i.e. cash and debt) rather than through their income statement, which adds further pressure to earnings. By acquiring niche firms, buyers are able to bolster their past performance record, better positioning themselves for large-scale, emerging opportunities in “fast currents” of government spending. Companies that have been hesitant to pursue these acquisition candidates could find themselves on the sidelines as large opportunities are awarded in new priority areas to first movers in the M&A market. Examples of recent portfolio-shaping deals completed by larger buyers include Boeing’s acquisition of RavenWing and eXMeritus; Raytheon’s purchases of SI Government Solutions and Telemus Solutions; SAIC’s recent acquisition of Atlan, Inc.; and ManTech International’s deal for DDK Technology Inc.
  
  
• Increased divestitures and distressed deals
  Spurred by increasingly stringent regulations, renewed emphasis on transparency and accountability, and uncertainty in the capital markets, well-managed federal contractors are seriously reviewing their portfolios in order to optimize their current and future positioning. Large firms are looking to refine their portfolios, focusing on core business areas and sectors with long-term growth prospects.
  
  As an example, business lines and contracts fraught with OCI issues have come under intense scrutiny from industry regulators and corporate “portfolio managers.” These firms have been actively assessing their strategic options with these “out-of-favor” lines of business. Three primary factors are driving increased scrutiny of OCIs: i) heightened sensitivity to OCIs (a post-deal symptom of the General Dynamics/Anteon transaction); ii) expanding view of potential conflicts and risk-averse agencies enacting specific regulations requiring contractors to “choose their major” – SETA/A&AS vs. platforms; and iii) recently enacted legislation (Weapons System Acquisition Reform Act of 2009 – May 22, 2009) directing agencies to issue regulations prohibiting OCIs. The combination of these factors will most certainly lead to an increase in corporate divestitures and a consequent increase in acquisition activity as buyers look to deploy sales proceeds from divestitures to reposition their businesses in priority markets complementary to their existing offerings.
  
  Despite what we see as the federal sector’s encouraging prospects, it would not be a true economic downturn without a handful of bankruptcy filings and distressed deals. The first half of 2009 saw the demise of BearingPoint, and the subsequent auction and intense competition for its assets. In March, ICF International was able to pick off healthcare consulting firm Macro International from its ailing, publicly traded corporate parent, InfoGroup. In May, Informa plc announced its intentions to sell its U.S. based Robbins-Gioia division as a part of plans to cut debt and shore up its balance sheet. In the past several months, many other deals, some as small as a few contracts, have been constituted for similar reasons. Going forward, we continue to see a large inventory of companies that are at the critical “sink-or-swim” point, so we expect the distressed deal trend to continue through the end of 2009. As a result, well-capitalized survivors will continue to have significant opportunities to snap up highly prized distressed properties that would not otherwise be available.
  
  
• Expanding buyer universe with burgeoning M&A interest
  While the federal M&A market will continue to benefit from the traditional pool of well-capitalized strategic buyers and old hat financial buyers, sellers are being met with aggressive interest from a handful of new buyer groups.
  
  In the face of rampant industry consolidation over the past few years, the federal market is currently faced with a dearth of true mid-tier players, firms in the $100-$500M range. Firms in the lower part of this range and just below are initiating aggressive acquisition plans to fill this vacuum. With strong management teams, healthy balance sheets and a stabilizing lending environment, these buyers are primarily driven by the need to diversify their offerings and customer bases to establish scale in order to compete for increasingly large prime contract opportunities. These buyers see an opportunity to move up the value chain, establish critical mass, and benefit from the associated valuation premiums which follow. Recent examples include SENTEL Corporation’s acquisition of 24/7 Solutions, Inc., Trace System’s purchase of SynExi, and the aggressive acquisition program implemented by MacAulay Brown, Inc.
  
  The federal sector remains fertile ground for private equity investment, and the highly fragmented nature of the market fits well with the private equity “buy-and-build” model. A new crowd of private equity groups without a track record in the federal market have made strong inroads during the first half of 2009. These buyers are equipped with significant dry powder and a greater willingness to contribute sizable equity investments to get deals done. Driven by a combination of factors, including a dearth of safe, leveragable investment options in other markets and the relative successes of the industry’s oldest financial buyers (e.g. Carlyle Group, Veritas Capital, CM Equity), these groups, and a large contingent of their peers clamoring to join them, are creating still more exit options for federal sector companies. Private equity groups with new platforms include Harrison Street Capital (MCR Federal), Court Square Capital Partners (Wyle Holdings), and Snow Phipps Group (ITSolutions.)
  
  Lastly, we are witnessing renewed interest in the federal sector from well-capitalized commercial-focused firms, particularly in the IT, accounting, and engineering and construction sectors. These firms are looking to hedge against the downturn in their private sector businesses while taking advantage of the government sector’s multi-year backlogs, steady earnings streams, and expanding budgets. Parsons’ acquisition of McMunn Associates in February 2009 illustrates how non-traditional acquirers in the government services space are looking to build and expand their presence within growth markets. In addition, Deloitte’s acquisition of the public sector assets of BearingPoint may serve as an indication that the Big 4 are serious about regenerating their government consulting businesses. As evidenced by the relative underperformance of commercial public equities compared to federal-focused public equities, commercial-focused companies realize the inherent resiliency of the sector during challenging times and we continue to receive serious inquiries from a wide range of these companies seeking acquisitions to enter or bolster their presence in the government market.

Fundamentals still point to an encouraging outlook for the sector.

History shows that defense and government technology and services sector consolidation is more than just a short-lived phenomenon. The underlying market fundamentals that have fueled M&A activity in the past are still very much in effect. Similarly, the strategic turbulence that has resulted from certain market dislocations and industry changes has also shifted the landscape and created significant opportunities for seasoned investors and industry participants to take advantage of. This combination of strong business fundamentals and increased strategic turbulence creates an atmosphere conducive to robust levels of M&A activity and indicates a continuation of attractive market conditions for all industry participants.