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.

With spending cuts looming in the coming days, the U.S. Defense Department plans to slow payments to prime contractors in order to add roughly $1 billion of cash on-hand.  This amount is worth a few days of needed working capital, though quite minimal compared to the $46 billion in 2013 budget reductions the Pentagon will be met with should sequestration begin on March 1^st.  The DoD typically keeps a week’s worth of working capital on-hand, however it currently only has two to four days of cash available.  Since 2011, the DoD has used Quick Pay in order to get payments to contractors weeks faster.  However, with current cash constraints, the Pentagon plans to inhibit Quick Pay by allowing only qualified small businesses to participate.

United Continental Holdings announced that it is taking the 787 Dreamliner out of its flying plans through June 5^th, except for a single Denver-to-Tokyo route which is expected to start in May.  The decision came following a Japanese investigation of a fuel leak caused by a composite material in the plane’s fuel tanks.  The investigation was launched days before authorities around the globe grounded the aircraft.  United is the only U.S. carrier of the 787, with ownership of six planes.

Big Movers

CIBER, Inc. (Up 15.1%) – Shares are up this week after the company announced that it had delivered a profit and beat analyst expectations in 4Q12.  Revenue rose to $225.3, a 44.5% increase over the same period last year.  Adjusted earnings per share decreased 33.3% to $0.02, however analysts were expecting earnings of $0.03 per share.

Barnes Group Inc. (Up 13.7%) – Shares were up this week after the company announced 4Q12 financial information that was higher than analyst expectations.  Sales in the quarter jumped 16.0% to $327.4, while operating margin increased to 12.1% from 10.2%.

Relevant Transactions

Ball Aerospace & Technologies Corp. acquired certain assets of OGSystems’ TASER Business Unit, a prime awardee on the $1 billion TASER contract, which provides mission analysis, systems and software engineering, integration, and IT services for the National Geospatial-Intelligence Agency.  The acquisition expands Ball’s geographic and customer footprint within its intelligence and information services business.

Computer Sciences Corp. (“CSC”) has entered into an agreement to sell its Enterprise Systems Integration unit to ITOCHU Techno-Solutions Corp. and ITOCHU Corp. for $90 million.  Enterprise Systems Integration is a reseller of enterprise hardware and software, as well as a provider of maintenance services with operations in Malaysia and Singapore.  The unit’s revenue in fiscal 2012 was around $180 million.  The deal is CSC’s fourth divestiture in four months.

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In a memo submitted by the Army to the Secretary of Defense outlining its plans to implement spending cuts under sequestration and a continuing resolution, the service pointed to a number of operational impacts that could occur under both scenarios.  The Army estimated that sequestration would cut $5.3 billion from its Operations & Maintenance account, while a continuing resolution would reduce funding by another $6 billion.  The decrease in funding could affect contracts serviced by about 300 contractors and 1,000 suppliers in 40 states. 

The memo also noted that it could take as long as 150 days to restart contracts that had been shut down.  This could create an issue for FY14 procurement as acquisition managers would be overburdened with FY13 contract re-negotiations.  The defense services’ reports come ahead of the DoD’s testimony to the House and Senate Armed Services Committees, which will include the service heads, Deputy Secretary of Defense Ashton Carter, and DoD Comptroller Robert Hale.

Big Movers

FLIR Systems (Up 12.2%) – shares were up for the week following the company’s release of 2012 earnings and updated 2013 guidance.  The Company announced 2012 EPS of $1.45, compared to $1.38 in 2011.  Revenue, however, decreased 9% from $1.5 billion in 2011 to $1.4 billion in 2012.  FLIR provided guidance for 2013 EPS growth of 8% – 14% to $1.56 – $1.66 for the year.

KeyW Corporation (Down 13.1%) – shares were down for the week following fourth quarter earnings that missed expectations.  Although revenue jumped 48% to $74.2 million, EPS was break even per share.

CPI Aerostructures (Down 16.5%) – shares were down for the week following the Company’s release of preliminary 2012 results and postponement of 2013 guidance.  Despite achieving revenue growth of 21% and EPS growth of 37% over 2011, the Company missed expectations and provided a cautious outlook.  It announced that it believes 2013 revenue and earnings will fall back down to 2011 levels, driven in large part by the threat of sequestration.

Relevant Transactions

Drew Marine acquired Alexander/Ryan, a manufacturer, distributor, and safety certification provider for maritime and offshore safety equipment, for an undisclosed amount.  The acquisition will expand Drew Marine’s product offerings in maritime safety, fitting into its strategy of growth in the offshore industry.

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This past Thursday, Senator Chuck Hagel endured a peppering of questions during his confirmation hearing before the Senate Armed Services Committee (“SASC”).  Republican panel members questioned Hagel’s past judgment on issues such as the nation’s alliance with Israel, Iran’s nuclear program, troop levels after 2014, and the 2007 troop “surge” in Iraq. 

In one of the more stimulating moments of the hearing, Sen. John McCain grilled Hagel on his opposition to the surge and refusal to stand by his previous comments.  McCain: “I would like you to answer whether you were right or wrong, and then you are free to elaborate.” Hagel: “I’m not going to give you a yes or no answer on a lot of things today.”  McCain further questioned Hagel on his opinion of the nation’s involvement in Syria, and whether or not the U.S. should be more engaged.  Hagel refused to take a clear stance on Syria and several other issues; however, he often sided with the judgment of the President.  

Further blows came from Republican panel members Sen. Lindsey Graham and Sen. Ted Cruz who questioned Hagel’s statements from an interview in 2006 in which he called pro-Israeli groups the “Jewish lobby” as well as comments he made on Al-Jazeera television network in which he agreed that Israel has committed war crimes in the past.  The SASC requires Hagel submit further information requested by panel members and plans on voting on his nomination as early as February 7^th.

The Senate kept busy on Thursday by passing a bill to extend the U.S. borrowing authority until mid-May.  The Senate approved the bill 64 – 34, and sent it to the White House later in the afternoon for approval.  Congress plans to focus its attention on the threat of sequestration which is set to begin on March 1^st.

Big Movers

Unisys Corporation (Up 22.1%) – Shares are up this week after the company announced 4Q12 earnings per share of $1.67, beating consensus estimates by $0.74.  The company attributed its success to a strong performance in its technology business and increased margins in its services business.

Mercury Systems, Inc. (Down 6.9%) – Shares are down this week after the company announced fiscal year 2Q13 financial results that were below analyst expectations.  Revenues for the quarter were $49.8 million, a decrease of $18.2 million from the same period last year.  The company attributed the slowdown to the potential for sequestration and continued uncertainty within Congress.

Relevant Transactions

Goldner Hawn Johnson & Morrison acquired Universal Turbine Parts, a provider of turboprop aircraft engine products and related services to maintenance, repair, and overhaul facilities, fleet operators, and engine parts dealers.  Terms of the deal were not disclosed.

DC Capital Partners acquired Computer Security Solutions, a provider of technology solutions for the intelligence community (“IC”).  The acquisition expands DC Capital’s portfolio of companies that focus on the IC, including Catapult Technology, Kaseman, and Strategic Intelligence Group.  Terms of the deal were not disclosed.

Dynamic Precision Group acquired Paradigm Precision Holdings, a provider of precision machined aerospace engine components.  The acquisition expands Dynamic Precision Group’s global footprint and supports the company’s strategy to deliver complex engine components to its customer base.  Terms of the deal were not disclosed.

Consolidated Aerospace Manufacturing acquired Aerofit, a provider of high and low pressure fluid fittings and fitting systems for the aerospace industry.  The acquisition expands Consolidated Aerospace’s product offerings as well as its customer base across commercial and military aircraft platforms.  Terms of the deal were not disclosed.

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On Thursday new details emerged about the effects of sequestration or a year-long continuing resolution on the Navy’s operations.  In a message sent by Admiral Jonathan Greenert, chief of naval operations, the Navy’s top officer outlined cost-cutting steps the Navy is already taking and could further take in preparation for spending reductions. 

It noted that under a continuing resolution, the Navy would see a $4.6 billion shortfall in operations and maintenance (OMN) requirements for the remainder of fiscal 2013, while sequestration would double that shortfall.  Specific immediate actions noted by Adm. Greenert include the cancellation of overhauls to about 30 surface ships and a reduction of nearly 10 percent of government shipyard workers through termination of temporary employees and a civilian hiring freeze. 

If sequestration does occur and the Navy does not gain authority to move investment funds into OMN, then more drastic effects would occur, such as stopping all non-deployed operations for training and exercise.  According to the note, this action would ultimately prevent carrier strike groups and amphibious ready groups from deploying as well.  Pursuant to Deputy Secretary of Defense Ashton Carter’s guidance issued on January 10^th regarding such preparations, all of the actions being taken immediately are reversible. However, Adm. Greenert warned that once sustainment training is shut down, it could take the Navy’s ships and squadrons about nine months to conduct the training and maintenance needed to deploy again.

Big Movers

Oshkosk Corporation (Up 21.8%) – shares were up for the week after the company raised its FY 2013 earnings guidance to an EPS range of $2.80 – $3.05, exceeding analyst estimates of $2.63.  The announcement came as the company reported a strong 1^st quarter ended December 31, with earnings of $0.51 per share, compared with $0.43 a year earlier.  Total sales fell 6% in the quarter, driven in large part by a 21% decline in its defense business revenue.  However, the business segment reported operating margins of 7.5%, beating analyst expectations.

Embraer SA (Up 15.4%) – shares were up for the week following the company’s announcement that it has signed an agreement to deliver 47 jets to Airways Holdings Inc.  The agreement includes the option to purchase an additional 47 jets, which would bring the total value of the order to $4 billion.

Relevant Transactions

Kidd & Co., in collaboration with Centerfield Capital Partners, acquired Imaginetics, a manufacturer of precision metal components and assemblies for the aerospace industry.  The transaction will enable the Company to leverage Kidd & Co.’s experience and financial support to expand its product offerings and attract customers in new markets.

Network Designs Inc. has merged with BitSec Global Forensics, a provider of digital forensics, electronic discovery, and data breach investigation services, for an undisclosed amount.  The merger will enable the companies to expand their cybersecurity services to include vulnerability, penetration, and application testing.

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