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How GovCon Firms Stack Up in the Three-tier Markets

2012 is shaping up to be another year of transition for most GovCon firms.

Unlike the first decade of this century, when rising budgets enhanced the financial profile of companies industry-wide, the past couple of years have focused  attention (and budgets) toward fewer areas. Health IT (especially VA and HHS), data analytics, mobility, cloud computing/cost efficiency, cybersecurity, intelligence, unmanned systems/C4ISR, and special forces have dominated the landscape.

The fortunate GovCon players with critical elements in those areas as well as strong customer intimacy, critical solutions/capability sets and prime contract vehicles continue to exhibit significant business momentum even as firms lacking such attributes turn up their marketing engines to claim experience in such areas.

Behind the marketing smoke and mirrors, a select few firms are optimally positioned to navigate the challenges of the next three to five years.

Tightening budgets, skittish customers and troublesome procurement activity—protests, continuing resolutions, cancellations—are causing a broader dispersion of financial performance in the industry. Further, the increased clout of government acquisition professionals vs. end-user customers in procurement decisions has elevated the usage and reliance on “low price, technically acceptable” (LPTA) vs. “best value” for procurement decisions. This emphasis effectively commoditizes the solutions procured.

And most, if not all, public GovCon firms have already told Wall Street analysts to expect little to no organic revenue growth in 2012—that is, expect all growth to be from mergers and acquisitions. Tightened budgets and increased emphasis on cost have created an interesting fork in the road for GovCon firms. And they’ve adopted different strategies to determine their directions.

Choosing Their Paths

The first strategy—which has been fairly broadly adopted, as evidenced by the layoff headlines over the past year—involves cutting overhead and general administrative costs in an effort to be cost competitive (and remain profitable).

The second strategy involves almost the reverse: increased spending and investment (including M&A) in technologies and other differentiated capabilities. Fewer firms are trying this. It is premised on two factors: i) LPTA being a shorter-term experiment (like in-sourcing) that will pass, and ii) being able to provide lower-cost, disruptive (typically non-labor-based) solutions through the use of innovative technologies and approaches.

What does all of this mean for valuations and the M&A market? Statistics showing little change in overall M&A deal volume or median deal values are masking major changes underfoot.

For one, the aforementioned market challenges along with the threat of higher tax rates has caused more owners to consider their strategic options than in years past.  The increased supply of potential sellers combined with current buyer strategies, significantly influenced by the above market dynamics, has created a different and very discriminating three-tier M&A market.

Three-tier Market

The first tier involves GovCon targets that have chosen the higher risk strategy and invested in sustainable, differentiated tools and solutions (often IP-based). They have developed and retained a seasoned management team and pursued unrestricted prime contracts and vehicles. They remain focused on mission-critical customer problems in the abovementioned hot areas like health IT, mobility, ISR, and cyber.

These firms (such as HPTi, TexelTek, SPT, and Argon) are still experiencing a seller’s market, with 80 percent or more of investors and large, public strategic buyers pursuing them. This market frothiness and frenzied buyer demand has driven median prices for the top quartile of sellers to 12 to 14 times their trailing EBITDA.

The second tier includes other high-quality organizations that may not be quite as focused, likely do not have the same financial profile or sustainable differentiation and/or may have higher contractual risks, whether from subcontractor roles or preference-program prime contract exposure.   M&A options for these players exist but at substantially different valuations—often 5 to 7 times trailing EBITDA—than in the past or that exist for the top tier.

Private equity groups are active suitors and buyers of companies in the industry’s second tier, given the reduced valuation requirements. In 2011, more than 30 percent of deals involved private equity groups either buying a new platform (such as Sotera or SRA) or adding onto existing platforms (witness this year’s merger of Lake Capital’s NetStar1 with WBB Consulting and Frontenac’s Salient Solutions purchase of ATS Corporation).

Most public GovCon firms are in this second tier, like it or not. And public GovCon firms have seen their valuation multiples drop substantially over the past four years (see table).

GovCon Sector Median EBITDA
Multiple – 12/11
Median EBITDA Multiple – 12/07 % Change
Aerospace/Defense 5.5x 10.3x -43%
Government Services 6.0x 10.6x -47%

Because of metrics like these, larger, public firms—almost to a T—are not interested in buying more of the second tier. It’s true that larger firms have been reducing costs via layoffs and early retirements.  They have been using M&A simultaneously. But these actions are almost entirely focused on chasing the top-tier targets—in essence, marrying up. They’re also considering the divestiture of units or business components that don’t fit the top-tier profile, also in an effort to improve market competitiveness and post-deal organic growth profile. L-3’s announced spin-off of Engility as it continues to pursue top-tier acquisitions is a great example of the industry’s pruning and reshaping activity.

And the third tier? Today’s finicky market is less robust for these, the remaining 50 percent or more of industry firms that do not fit into the abovementioned two tiers. This larger group is most hard-hit by today’s contract and budget dynamics and face hard decisions in their efforts to stabilize and survive.  Many are focused on partnering with industry veterans who can share wisdom and in some cases purchase equity or take on board or other senior executive roles.

Bob Kipps

Bob Kipps , a contributing writer to GovConExec, serves as managing director at KippsDeSanto & Co., an investment banking fi rm that advises leading aerospace/ defense, technology, and government services companies on mergers and acquisitions, capital placements, and other strategies.