What Buyers Are Looking For – Key Valuation Drivers

By Greg Hogan, Senior Vice President, SC&H Capital & Justin Reaves, Senior Associate, SC&H Capital

Federal Government contractors have long relied on acquisitions to supplement organic growth, diversify capabilities, gain access to specific contracts and agencies, increase market share and achieve earnings estimates.

 

In the not so distant past, rising Federal budgets created an environment that was conducive and forgiving for rapid fire M&A.  However, in today’s more austere federal budgetary environment, acquirers are implementing a more disciplined approach to targeting and executing strategic acquisitions. Buyers are focusing on acquisition targets that possess several key, value-building characteristics.  Acquisition targets that have these characteristics will likely attract higher valuation multiples in acquisition scenarios.

 

1.       Market Position: What does the company do for its customers?

 

Companies solving mission critical problems and providing differentiated services to well-funded agencies receive more attention from buyers.  Differentiation implies higher pricing power and security of future revenue streams.  Customer intimacy and knowledge of key customer issues is also important, as many buyers associate customer intimacy and depth of expertise with long-term stability.  Customer interviews prior to closing are now routine as buyers seek to confirm differentiation from the customer’s point of view.

 

2.       Revenue growth: Is the company growing?

 

In years past, many contractors were growing revenue as the Federal Government spending levels grew.  Today, far fewer companies can show any growth at all.  Buyers are seeking targets with consistent double digit revenue growth, and strong prospects to continue growing at the same pace on long term, funded contracts.

3.       Profitability: Does this company have strong earnings margins?

 

Buyers today are increasingly focused  on gross profit margins (GPM) and EBITDA margins, whereas some buyers in the past focused more on revenue. A strong GPM shows an ability to manage the cost of generating revenue, particularly important in an environment of bill rate pressure from the government.  In addition, strong EBITDA margins show the company’s ability to generate profit and cash flow through the effective management of indirect.

 

4.       Contracts: What is the company’s contract composition?

 

Budget pressures have led to additional diligence around a company’s contracts as buyers seek to understand the composition of future revenue streams.  Buyers seek diversity, visibility, predictability and stability in a company’s contract base.  This can be the result of a target’s positions on key contracts at well-funded agencies or a contract backlog with a high percentage of long term, full and open, prime contracts.  Tracking both existing contracts and pipeline opportunities in a “Contract Waterfall” can be beneficial to owners to support future revenue projections and demonstrate growth potential.

 

The changes in the budget environment have shifted the focus for acquirers and raised the bar for acquisition targets.  Target shareholders that desire to realize maximum value in a liquidity transaction should be aware of the significant change in the M&A landscape and tailor their strategic plan accordingly.

 

For more detailed information concerning the current state of the M&A market for Federal Government contractors, please contact Greg Hogan (ghogan@scandh.com) at (410) 403-1500.

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