Aerospace/Defense & Government Services 2019 M&A Survey

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KippsDesanto & Co is pleased to share its second annual survey of mergers and acquisitions (M&A) activity and sentiment in the Aerospace/Defense, Technology and Government Service sectors. In this study, we asked key dealmakers from relevant sectors to share their predictions about M&A deal activity and valuations over the next year.

We also asked them to share their insights on strategic drivers of M&A activity and the impact of recent events, including the 2018 United States midterm elections.

In this survey, we find dealmakers remain quite positive about 2019, with most expecting moderate economic growth and predicting M&A activity will increase somewhat or remain about the same as 2018. These are quite positive findings, given last year’s robust activity levels.

Click here to download the M&A Survey Report

Government Services Earnings Release

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Over the past few weeks, several Government Service companies released quarterly earnings.  Common themes included declining revenue offset by flat or stronger margins, the need to establish two budget scenarios for FY2014 and FY2015 due to ongoing pricing pressures and continued uncertainty around the impact of sequestration, and mention of the monetary effects of the government shutdown during October.

For the third quarter, CACI reported a year-over-year revenue decline of 7.2%, driven primarily by an expected drawdown in Southwest Asia activities and budget-related reductions.  The company reiterated full-year guidance of $3.5 – 3.7 billion, excluding the acquisition of Six 3 Systems, but including estimated losses from the government shutdown of $10 million in revenue and $4 million in operating income.  Finally, CACI anticipates that roughly 84% of FY2014 revenue will derive from existing business, of which, 80% is funded.

Booz Allen Hamilton reported record margins that helped drive EPS ~26% above consensus estimates.  Fiscal year second quarter revenue was flat at $1.38 billion compared to the same period in the prior year; however, adjusted net income increased to $70.1 million from $55.7 million in the prior year period.  Adjusted EBITDA increased 24.2% to $153.8 million, and adjusted diluted EPS increased by $0.08 to $0.47 per share.  The company announced a $1 special dividend, its third in the past 18 months, as well as a regular dividend of $0.10.  Booz anticipates that the impact of the government shutdown will be roughly a $30 million reduction to third quarter revenue.  Related to the Federal debt ceiling, the company borrowed $250 million due to concerns of significant disruptions to the banking sector if the U.S. defaulted on its debt obligations, a decision that potentially reflected the company’s lack of confidence in the U.S.’s ability to come to a budgetary agreement.

ManTech announced weaker revenue and margins, resulting in third quarter EPS missing consensus estimates by almost 15%.  Management attributed reduced full year guidance to the government shutdown, a continued slowdown in contract awards, and the overturn of a previously awarded $180 million S3 contract (the 2-year $180 million award supporting OCO requirements in Afghanistan was re-awarded to the incumbent after their successful protest).  The company estimates that the shutdown caused a loss of $15 million in revenue and $2.5 million of operating income.  ManTech’s management reaffirmed that M&A is still the “primary use” of cash, noting the debt ceiling debate in Congress caused the company to be reluctant to aggressively acquire.  Furthermore, CEO George Pedersen noted the company’s appetite for acquisitions could be “quite large.”

Overall, shares of government services companies have rebounded from historic lows about twelve months ago.  Despite positive returns and mixed earnings, government service provides are expected to continue facing margin pressures, forcing them to find even more cost cutting initiatives.  Furthermore, some service providers such as ICF are hedging stymied Federal sector growth by targeting commercial and international markets.  For instance, the company noted that international government revenue increased ~34% over the same quarter last year.

2012 Government Services M&A in Review

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2012 marked another strong year of M&A activity in the government services space, with more than 100 announced transactions, and increase from 90 in 2011 and five year average of 93.  Despite strong market headwinds driven by budget pressures, procurement challenges, and the obsession with LPTA, deal activity remained high.  Taken at face value, the number of announcements evidenced the continuation of M&A as a preferred use of capital, and more so as a tool to enhance competitiveness and growth prospects by augmenting contracts, capabilities, or customer footprint. 

2012 volume was also encouraged by the anticipated 2013 tax hikes; however, we’d attribute only a slight increase relative to prior years from this.  Notably, there continues to be heavy activity in the “hot” funding areas as 33% of all announcements in 2012 involved targets in the Intel/SOF, Cyber, or Health IT space.  From a capabilities perspective, application development, cloud, virtualization, big data, and cost cutting solutions were also in high demand.

What the number of deal announcements doesn’t signal is the strength of the deal activity and valuations.  Generally, valuations were disparate across the deal universe, with actual multiples very deal-by-deal specific.  High single and double digit multiples opportunities remained for the top decile, pure play businesses focused on the aforementioned hot lanes.  That said, there were also valuations in the mid-single digits that would be considered very successful outcomes.  The deal number comparison also fails to address close rates, for which there is less definite data.  Anecdotally, KippsDeSanto estimates the number of unsuccessful sellers was also higher than previous years.

Simply, the buyers are more discriminating than ever.  The hold and harvest model may be more financially attractive for select owners.  However, the deal market overall remains active and dynamic, but more than ever it’s important to seek sound advice and take the market temperature from those with deal experience when contemplating a transaction given the current environment.

Government Services Firms Seeking Ways to Drive Value

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Despite downward budgetary pressures and a contracted spending environment, services firms continue to seek new ways to return value to shareholders.  Services firms are employing a range of techniques to accomplish this from the traditional growth drivers including M&A, to less common tactics like the distribution of dividends.   

Earlier this month Booz Allen announced a $1B special dividend, citing the attractiveness of current debt markets and effective use of the balance sheet.  Exploring our government services comp set, Booz, SAIC, and ManTech all boast dividend yields in excess of 2%.  Traditionally, dividends are reserved for lower growth companies whose business had matured to a level in which returning cash to shareholders trumped reinvestment (e.g., capex, M&A). 

That said, we don’t interpret the dividend trend of these three government services firms as an indictment on growth opportunities in the federal space.  These firms, consistent with their non-dividend paying peers, are also opportunistically pursuing acquisitions and taking advantage of ongoing low interest rates and available credit (often at the same time).  The low capital expenditure and net working capital requirements of the services business model affords significant cash generation even in this down market.  SAIC (maxIT Healthcare), CACI (Delta Solutions and Technologies), ManTech (HBGary; Evolvent), ICF (GHK Holdings), and Kratos (Ingersoll Rand Security Technologies) have all announced or closed deals thus far in 2012.  Granted, the maxIT, and GHK deals were more commercially focused and evidence a diversification strategy. 

The key however, is that with looming sequestration, upcoming elections, and an ever tenuous budget environment, the industry bell weathers are not hoarding cash like during the 2008 downturn, but continue to proactively seek ways to reposition and drive value.  Bottom line, the credit and M&A markets remain open and active for government services firms, and we anticipate that to continue for the remainder of 2012.

Does Being Public Still Make Sense for Government Services Firms?

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The WashingtonBusinessJournal recently quoted SAIC CFO Mark Sopp stating “valuation has gone against us since we’ve gone public (SAIC is down approximately 26% post-offering)… [and] we have not raised capital through the equity markets and we don’t plan to do so…So it’s hard to point at net positives of going public, other than the infrastructure improvement and discipline and cadence we created…”

There have been 16 IPOs by government services companies since 2000, raising combined proceeds of approximately $4 billion.  Six of these initial offerings occurred in 2002 commensurate with the commencement of the war on terror and national security focus, and five occurred in 2006 alongside  heightened defense spending expectations.

Of the 16, only seven remain public (the others have been acquired), and of those seven only ICF and ManTech have posted positive stock returns since IPO.  The average stock price for the remaining five companies (Booz Allen, SAIC, NCI, KEYW, QinetiQ) has declined more than 20% since IPO with NCI down nearly 50%.  Companies have been deprived of one of the ideal benefits of a public offering – access to capital through additional offerings or currency for acquisitions to fuel growth.  ICF was the last contractor to issue a follow-on offering, and that was in 2009.  Additionally, none of the aforementioned firms besides KEYW have made an acquisition utilizing stock to finance a material portion of the purchase price.

The absence of these inherent go-public benefits begs the obvious question: is there any benefit for a government service provider to be a public company?  Moreover, will we see more companies such as SRA International choose to go private in the near to medium term in what is anticipated to be a challenging market environment.