January 2014 M&A Market Update: Q-4 Earnings Calls

ACP Market Update
February 14, 2014

When we last checked in on our government services indices back in October 2013 following Q3 earnings calls, our contractors were fresh off 16 days of sequestration, the budget debate had been postponed for another few months, and the overarching theme across all calls could be summed up in one word: uncertainty. Though this uncertainty surrounding long-term budget cuts has not completely subsided, the January 2014 bipartisan appropriations bill certainly had many executives breathing a (slight) sigh of relief during Q4 2013 earnings calls, released in late January and early February:

“Sequestration is eliminated for fiscal years 2014 and 2015 and replaced with reduced spending levels. The law also removed the across-the-board spending reduction methodology previously in place under sequestration and restored the ability for government agencies to move funds and discreetly allocate resources to higher priority areas, a critical revision that we have been seeking since the Budget Control Act was established back in 2011.”

 – Lockheed Martin Corporation

“We are pleased that a fiscal year ’14 budget agreement has been signed… providing some near-term sequestration relief. This averts another disruptive government shutdown and provides our customers at least a near-term planning horizon.”

– The Boeing Company

“The end of sequestration does mean our customers can now allocate funds to the critical programs we support. We know that Cyber and C4ISR are going to see increases in 2014 and 2015.”

– KEYW Corporation

Companies not reporting as of date of publication: EGL, ICFI, LDOS, MANT, NCIT, VSEC, XLS

While cautiously optimistic about the federal budget going into 2014 and beyond, several contractors echoed one harsh reality about the current state of federal spending, best summarized by KEYW Chairman and CEO Len Moodispaw: “The money has not yet begun to flow.” Revenue guidance going into 2014 was conservative across the board. Forecasts in today’s environment are being driven very heavily by existing orders and backlog, and very little reliance on or impact from new business revenues.

In other words, relief from the 2014 appropriations bill is not derived from the expectation of significant near-term spending. Rather, the bill has reduced the fear of the potential impact of near-term budget / program cuts; a fear that was omnipresent this time last year, and drove government services valuations to a 10-year low in calendar Q1 2013.

Because the impact of sequestration cuts has not been as drastic as initially expected, and because of the cost-reduction strategies implemented by nearly all of the federal contractors, cash flow in our government services index has remained strong over the past few quarters. Companies have been hoarding capital to prepare for potential disaster scenarios, and balance sheets are strong going into 2014. Because of this, capital deployment for the next 12 months has recently been a hot topic.

Answers have been mostly consistent: the strategy remains to return as much capital as possible to shareholders through share repurchases and dividend payments. For example, Booz Allen Hamilton announced a special $1.00/share cash dividend, and General Dynamics established an accelerated share repurchase plan of 11.4 million shares. However, companies are also watching carefully for selective opportunities to deploy capital via acquisitions.

Our M&A outlook for 2014 has been heavily influenced by this strategy. While deal activity was relatively subdued in 2013, we expect a substantial pickup following the recent increase in spending visibility. More specifically, we believe this pickup will predominantly impact deal volume in the sub-$100 million M&A market. In today’s still-somewhat-uncertain budget environment, $1+ billion transactions will likely be scarce because they represent much riskier propositions than they did during the defense buildup of the mid- to late-2000s. For example, during L-3 Communication’s Q&A session, Chairman, CEO, and President Michael Strianese commented that the chances of a $2 billion deal are “pretty low just based on the availability”. He continued, regarding their $54 million acquisition of Mustang Technology Group:

“I’d like to see the deals a little bit beefier, a couple of $100 million, but probably not $2 billion either. [We’re] on a more risk mitigated approach, where it’s more of an exact fit within one of our business segments that really grows it and brings more synergy and customers to the table.”

Along these same lines, we believe that smaller targets with differentiated technologies, customer relationships, and/or strategic contract vehicles will be highly sought-after targets to help supplement flat organic growth across the buyer universe. Two early examples of this trend in 2014 include MacAulay-Brown, Inc.’s acquisition of Commonwealth Technology, Inc. and Acentia, LLC’s acquisition of Business Computer Applications, Inc, a prime holder of the $5 billion multiple award CDC CIMS contract vehicle.