Business decisions like many others are a balance of risk and reward. As financial types like us often say, uncertainty equals risk and risk is neither good for deals nor valuations.
In today’s GovCon market and the broader overall economy there is plenty of uncertainty and risk to go around. Decades of government spending beyond its means—more specifically in excess of its tax revenue— has left the U.S. government, as well as most state and local governments, for that matter, and the governments of most of the developed world in a bind, with the music threatening to stop and no easy solutions.
While this dilemma has been brewing for quite some time for the U.S. government, and is no surprise to GovCon firms who have been dealing with program deferrals and cancellations, protests, insourcing and cost-dominated/irrational procurement strategies, an unprecedented roller coaster is approaching at the end of this year. Year-end presidential and congressional elections and decisions on sequestration (taxes, budgets), as well as potentially altered foreign policy direction may have a major impact on the near- and long-term financial performance, cost structures, and strategies of most GovCon players.
Budget tightening and uncertainties have already hit many firms’ financial performance. As shown below, public Government Services and Defense Electronics’ stocks have declined this year due to pressure on margins, reduced visibility and (in most cases) revenue contraction, excluding growth via M&A. The public Defense Primes’ stocks—which have been under pressure for years—have generally been flat.
Market Sector YTD Stock Performance
Government Services <6.7%>
Defense Electronics <5.6>
Defense Primes 3.1%
S&P 500 6.7%
Source: Capital IQ
Status: M&A Market
The dynamics mentioned above have also materially affected the M&A market.
First of all, buyers—especially corporate or “strategic” buyers—have become hyper-selective and laser-focused on the few market areas where they believe government budgets have growth potential or are most secure—the “hot lane” areas of Cybersecurity, Health IT, Intelligence, Unmanned Systems, Special Forces, Mobile Security, Cloud Computing and Big Data.
Second, there are currently more business owners trying to sell than buyer demand can support. Third, contract delays and other market dynamics have caused business performance mayhem to private firms similar to the challenges experienced by their larger brethren. Missing financial projections is equally tumultuous for firms trying to sell as it is for public companies that “miss their numbers,” or materially alter their guidance to the street. For sellers, missing their financial projections diminishes their credibility and is likely the number one reason deals lose momentum and/or fail to reach closure.
As such, even with increased owner interest in selling (or divesting), the number of deals that got closed during the first half of 2012 was actually slightly down from the first half of 2010 and 2011 with decline this year coming from reduced activity of private equity, versus their activity in 2011.
While strategic buyer interest continues to be—as it has been over the last couple years—focused on the hot lane areas, private equity has also become more active in those areas. The latter trend in many cases reflects private equity’s strategy of “shaping” and/or building further critical mass in their portfolio companies (like Sotera and Acentia) to enhance their eventual exit strategy, which is likely a sale to the larger strategic buyers—who typically pay the highest price.
Notwithstanding all the uncertainty right around the corner, M&A activity continues and could even accelerate a bit over the second half of 2012. For the buyer community, M&A is a long-term decision. While their criteria have tightened given today’s uncertainties, the need for larger firms to evolve (i.e., increase their proportion in the hot lane areas) will continue to keep M&A, the tool of choice for instant evolution, a priority for them. Similarly, private equity funds—like the strategic buyer universe—remain flush with capital, and financing remains abundant and cheap.
On the supply/seller side, the tougher operating environment and threat of higher taxes are catalysts for them to explore their exits, likely making the supply/demand ratio more out of balance over the near term and creating more of a buyer’s market (except for in the hot lane sectors).
Around the Corner
While the light at the end of the tunnel may not be halogen-like any longer, all is not negative. The GovCon market is vast and like it or not, our world is likely getting less, not more, secure. The Government’s current infatuation with Low Cost will pass (like Insourcing has waned) and decision making will become more rational and timely.
So, in the meantime, industry leaders need to continue to think medium to long-term. Buck the low cost, “commoditization” trend the government customer is desiring. Differentiation, ingenuity, depth and focus are key now and continue to be going forward. With that in mind, areas to emphasize (vs curtail) to maintain/build value include:
- Pursue and win full and open contracts and vehicles as a prime.
- Stay focused on areas of core competency vs. becoming spread too thin.
- Invest in processes, procedures, and infrastructure.
- Build a robust business development and recruiting function, to win the big opportunities and attract the best talent (more of that is available than ever).
- Strengthen your senior management team.
Don’t play to survive, play to win! When we reach the other side of the tunnel, irrespective of how faint the light may have appeared, firms that have stayed focused and continued to invest in themselves will be the few that are strong and poised to thrive. GCE
Bob Kipps, a contributing writer to GovConExec, serves as managing director at KippsDeSanto & Co., an investment banking firm that advises leading aerospace/defense, technology, and government services companies on mergers and acquisitions, capital placements, and other strategies. KippsDeSanto & Co. is not affiliated with any other company mentioned herein.