Uncle Sam: A New Favorite Customer For IT and Defense Services Firms

Over the years, companies have serviced the government market but few have regarded federal work as a key part of their business. Limited outsourcing of work, a labyrinthine procurement process, and restrictive specifications for goods purchased turned many firms off from selling to Uncle Sam. But as the government implements technology upgrades and gears up for the war on terrorism – initiatives backed by hefty budgets – more and more companies are eyeing those federal funds and trying to position themselves as able competitors for government contracts. Heightened competition for the government’s dollars will be a major impetus for industry consolidation, say dealmakers who follow the government sector. Government information technology and defense services will be two especially fertile fields for m&a in coming years, says Jerry Grossman, a Managing Director at Houlihan Lokey Howard & Zukin. As a result of increased spending on homeland security and a shift by the Defense Department toward a network-centric warfare model, which requires modernization of computer systems and the development of advanced software applications, he expects to see companies increasingly focus on serving the government. Services provided by commercial firms such as systems integration, software engineering, information security, information sharing, and data recovery as well as defense equipment maintenance and repair, inventory control, and logistics will be key to helping the government achieve its new technology and defense goals. Changes in government spending priorities will continue to entice service firms into the federal arena. Other lures for commercial firms to enter the government market include increased outsourcing by the government, ongoing procurement reform, and the elimination of strict product specifications coupled with increased use of commercially available products. “The federal IT and defense services markets are growing faster than commercial markets and their profit margins are higher than commercial markets. The successful firms with the high valuations are now in the government space. That’s a highly unusual set of circumstances, and it’s hard to say how long it will last. But what it has done is to raise the visibility of the federal markets,” Grossman states. He estimates that the government information technology and defense services markets are growing at about 10% a year, perhaps slightly higher due to the war on terrorism. But as colleague Bob Kipps, a Senior Vice President at Houlihan Lokey, points out, there are significant barriers to entry in the federal market. “To the extent that more companies decide that they want to participate, acquisitions will be the way to get in. It’s very hard to build a federal contracting business. It is increasingly becoming a business based on customer relationships and past performance. For a new player to come in and play a meaningful role, that will likely be done through acquisition.” That’s not to say that companies less experienced in federal business dealings will be unable to sell technology to the government, although products would likely be sold to a large contractor as opposed to directly to the government, Kipps adds. As more firms think about targeting the government as a customer, those that lack the ability to serve the federal market will hunt for partners that can help them win contracts, or will hire people with “domain expertise” – or an understanding of the “mission” – such as former senior military officers or former government officials, Kipps adds. Companies with established government relationships may try to broaden their service offerings, through internal growth and acquisitions, in order to gain more government business. Additionally, companies can also gain access to the market by buying firms that have learned the ins and outs of the government procurement process. Specifically, what buyers will be looking for are companies with state-of-the-art technologies, intellectual property rights, and long-standing relationships with the government, says Grossman. Shifts in spending priorities often lead to acquisitions, notes Kipps. Companies that are not active in the “priority spending” areas will have less demand for their products and services; those that are well positioned in those areas will thrive and increasingly will be eyed as acquisition targets, he notes. The broad defense industry is a sector that lends itself to constant reshuffling of portfolios, Grossman says. He points to the exodus of federal contractors such as General Electric Co. and Ford Aerospace & Communications Corp. in the late 1980s and early 1990s as defense budgets contracted. Many firms put defense-related businesses on the block but eager buyers like Carlyle Group and Lockheed Corp. picked them up. Outsiders are looking in Now, companies that historically hadn’t been players in the federal market want in. Perot Systems Corp., for example, acquired ADI Technology Corp., a government consulting and IT service provider, in July to use as a platform for a government services business it is building. And many companies that a couple of years ago were considered commercial technology or Internet technology companies are now looking for ways to serve the federal government. In defense services, L-3 Communications Holdings Inc. has been an active consolidator in recent months. The aerospace and defense firm acquired Technology, Management & Analysis, a professional services provider to the Defense Department, for approximately $50 million; Wescam Inc., a developer of systems for defense applications, for approximately $118 million; Westwood Corp., a provider of shipboard power distribution, machinery, and automation systems to the Navy, Army, Air Force, and Coast Guard, for $22 million; and ComCept Inc., a leader in network-centric warfare. While established players certainly have an edge in winning federal contracts, new companies are also being encouraged to vie for a share of the work. The government has programs in place to fund technology development by the private sector, notes Kipps. Those programs could help spur the creation and development of new service providers in the federal market. But even with these new opportunities, he adds, it is unlikely that an inexperienced company lacking size or resources will win lucrative federal contracts. Grossman believes there is plenty of room for new entrants in the defense services industry. In his estimation, the total market cap for sector pure plays and fringe players is only about $15 billion to $20 billion. While new, smaller firms coming into the market may lack the size and resources to win contracts on their own or attract strategic buyers, he says, many may hold the promise of steady growth within their specialized markets and thus be attractive to financial buyers. Currently, there are only a handful of private equity companies that have participated in the industry, such as Carlyle Group, J.F. Lehman & Co., and Veritas Capital, which has made the shift from an everyday, middle-market LBO firm to a niche defense investor. On top of that there are a few other equity sponsors that have invested in newly public companies in the sector. “Part of the process of attracting more financial buyers is a need for the private equity groups to become more familiar with the government market so they can buy those platform companies, install a corporate governance structure with knowledgeable board members, and move forward,” says Grossman. There is also significant opportunity for private equity firms to create platforms in the government IT industry, says Kipps. “The opening of IPO market for federal IT companies over the past year has attracted financial buyers, and the ability to buy and build companies and take them public has been a large part in increasing private equity interest in the sector.” In some instances, though, equity sponsors could have a tough time competing against strategic buyers for desirable targets, says Kipps, since the best IT companies command lofty prices. However, there are opportunities for financial buyers in cases where a company’s management team wants to stay with the business and help grow it, not sell out for the highest price.