A Bright Spot in a Dismal Economy: Government Contracting By Robert N. Rubin

October 17, 2010

With virtually every sector of the economy experiencing unprecedented financial distress, the predictability of long term contracts, visibility of significant and in many cases increasing federal agency budgets, access to a huge marketplace for a wide variety of products and services through agency and government wide contracting vehicles, low credit risk and prompt collection of receivables, and minimal capital requirements creates a compelling investment case. 

The current multiples for publicly held defense and aerospace companies tend to reinforce this view, as valuations, in general, have suffered a less precipitous decline than the overall market.  In the near term with the passage of the fiscal 2009 budget government contracting is one of a very few domestic industries which is projecting growth over the next year. 

On the horizon, potential budget cutbacks due to the current financial crisis, a possible reduction in the commitment to the war efforts, reassessment of intelligence and homeland security priorities, cancellation or significant reductions in large DoD hardware programs, changes in priorities of a new administration and continuing concerns with restricted contract awards such as Small Business Set Asides are the issues of most concern. 

The credit quality of defense and aerospace companies is compelling and as they abandon other asset categories bankers appear comfortable with existing commitments and continue to focus new business development efforts on this sector. 

 While some of the larger banks experiencing financial distress may be pulling back from new commitments, regional and community banks, as well as other specialized lenders are taking advantage of current market conditions to expand their portfolio of borrowers. Lindsey Rheaume, Senior Vice President at SunTrust, a major lender in the government contracting arena says “We continue to actively seek financing opportunities in the government contracting sector including M&A transactions.  However, Borrowers should understand that pricing and terms, as well as certain structural elements such as possible requirements for other types of credit enhancement have changed to reflect current economic realities.

Since 9-11, the combination of strong buyer demand and the availability of funding at favorable rates and terms have fueled robust M&A activity across a wide spectrum of defense and aerospace companies.  In 2008 M&A activity was dominated by larger transactions including EDS/HP, Booz/Carlyle, DRS/Finmeccancica and SI International/Serco.  The last two transactions are noteworthy as indicators of heightened demand from foreign buyers driven by the decline in the value of the dollar experienced earlier in 2008.  With the resurgence of the dollar and economic challenges facing Europe in particular, this trend most probably will not continue.

In contrast, M&A activity involving small and mid-sized companies (Revenues below $100 million) has been sluggish due in large part to recent changes in Small Business Set Aside regulations.  With the uncertainty brought about by these changes surrounding an acquirers ability to continue operating under a contract, most larger acquirers are exhibiting great caution in pursuing transactions where a significant amount of restricted contracts are present.

More than ever buyers are exhibiting a laser like focus on specific acquisition criteria and appear more reluctant to pursue opportunities not closely aligned with these characteristics.  Companies uniquely positioned in intelligence, homeland security, cyber security and other mission critical areas within the Department of Defense continue to attract strong interest from buyers and premium valuations.

The demand for companies possessing either the size to be an effective platform for further expansion, coveted contracting authority and/or unique expertise remains very strong and still command premium valuations.  Valuations for smaller companies (revenues under $50 million) in general have declined more than the levels experienced by publicly held companies. For companies with large amounts of restricted contracts or providing commodity type services the decline in valuation is even more pronounced.  Deal structure for small and mid-sized companies is also undergoing significant change as sellers are being asked to take back larger amounts of transaction consideration in the form of buyer notes and/or longer earn outs.

In the face of a challenging economy M&A transactions involving defense and aerospace firms will continue to get done. Though more difficult to obtain and costly, debt and equity funding is still available from a variety of sources.  Given the relatively attractive valuation multiples for publicly held companies it is possible that stock could become an important currency in M&A transactions involving larger targets. In addition, buyer demand remains strong with a large pool of strategic, financial, Private Equity and SPAC buyer’s still actively seeking platform and add-on targets. 

Long term industry fundamentals point to continued consolidation as strategic buyers attempt to expand their customer, contract and resource base to compete for increasingly larger, more complicated and a declining number of larger procurements.  In addition, publicly held companies will need to continue executing aggressive acquisition programs to meet investor growth and profitability expectations.

 

Smaller strategic acquirers are expected to be aggressive participants in the M&A market as they seek opportunities to accumulate the critical mass necessary to compete and win larger and prime contracting opportunities to enhance their long term value.  With a different risk profile than publicly held companies, these companies are more likely acquirers of targets with restricted contracts.  Private Equity firms and SPAC’s have been active acquirers of targets in the government contracting arena, particularly in the intelligence and homeland security arenas.
Although new fund raising efforts will be difficult, these firms have committed a substantial amount of capital for investment in the defense and aerospace sector.  These firms have an additional and very strong incentive to continue making acquisitions as funds not invested over a specific time period must be returned to investors. 

Bottom line, in contrast to virtually every other sector of the economy, government contracting is one area which will continue to experience significant M&A activity.

Robert N. Rubin has more than 25 years of M&A and corporate finance experience in Fortune100 and entrepreneurial environments and specializes in transactions in IT services, software development and commercial IT and other outsourced business services in the government contracting and commercial markets.

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