Each March, leading defense/aerospace and federal IT investors and corporate development executives meet in Reston, Virginia, to take stock of what’s changed – and what hasn’t – in the competitive landscape of the rapidly evolving defense & aerospace industry.
Industry leaders at the Strategic Research Institute’s 5th Annual Defense & Aerospace Investor & Corporate Development Conference observed that 2005 appears to be on track to meet or exceed the M&A activity in 2004. Eighteen transactions were already announced in the government services sector in January, compared to 8 announced deals in January 2004. The escalated trend was reinforced the first morning of the conference by the announcement the previous day of the $3.9 + billion acquisition of United Defense Industries, Inc. by BAE Systems North America.
Publicly traded defense and government services companies are continuing to hold valuations at the top end of their historical pricing range. A report presented by Mercer Management Consulting showed that last year, Wall Street’s defense sector mean valuation multiple was just short of 13x EBITDA. This compares to the 20-year mean multiple of 7x. Growth is a key factor in maintaining these current elevated levels of pricing; therefore, these public companies should continue to drive acquisitions. Valuation experts from around the country all reported that M&A pricing for privately held companies on average has remained consistently high since last year and most expect it to continue in 2005 even if public company valuations trend off the historic level. Excluding the niche service providers and large businesses, the median transaction multiple reported in the market has consistently been 7x to 9x trailing 12 months EBITDA for the acquisition of privately held companies.
As was the case in October, M&A activity in the defense market continues to be pushed by industry consolidation. First tier contractors continue to acquire second tier companies in an effort to expand service offerings and improve overall growth rates, while second tier players search for third tier acquisitions in order to expand their client base and /or service offerings. Increasingly challenged by the contract consolidation, third tier contractors pursue acquisitions in an effort to respond an remain competitive.
What’s moving the marketplace?
- Continued growth in Department of Defense spending, supporting conflicts in Iraq, Afghanistan, and elsewhere; DoD “transformation” efforts; and the shift in the DoD budget of a greater percentage to operations & maintenance due to the aging of military equipment.
- Department of Homeland Security spending kicking in due to the ongoing war on terrorism and a move from proactive to reactive spending.
- Aging federal workforce and long-term cost of retired health benefits influencing the federal government to outsource many services.
- Military and federal government’s increased spending on IT to increase productivity as they shift to E-Gov and implement technology upgrades.
What’s holding the market back?
- Budget shifting to support the war effort causing movement away from procurement to operations & maintenance.
- U.S. Navy tightening the budget belt.
- the federal government’s slow response to accelerating security clearances, restricting the ability of contractors to grow.
- Re prioritizations given the start of the “W” II administration, coupled with the uncertainty of the direction of military spending with the QDR (Report of the Quadrennial Defense Review) due out in May.
M&A – What are they looking for?
- Access to new clients and programs
- Access to new capabilities (R&D)
- IT Services (outsourcing) versus Systems Engineering
- Re-compete risk on major products, projects, or programs
- Prime work as a percentage of revenue
- Historical dependence on special bidding status (8A, etc.)
- Passthroughs as a percent of revenue
- Post-deal financial leverage
- Accretive to earnings
Indications are that the M&A trends that closed out 2004 at an all-time high will continue through 2005 at the same place. Due to the many defense and aerospace contractors in Florida, the state will continue to experience the effects of the consolidation trend. Because of PCE’s expertise in this sector, we will continue to be active in mergers, acquisitions, and divestiture deals in the defense industry.