Although forecasting the federal market has become more complicated and more uncertain, the relative stability of both large and small contractors and their growth potential makes for sound investment.
Industry executives and investors are reassessing their acquisition strategies in the face of severe economic distress and are walking away from potential deals involving companies with contract-transition barriers and undistinguished capabilities.
Forecasting business and market performance is much harder these days. Federal information technology executives and investors seeking to set strategies and expectations have many more considerations than usual.
Recent turmoil in debt and equity markets highlights the contrast between federally oriented businesses and companies serving private-sector customers. It reminds us of the attractive, fundamental characteristics of the government services industry: stability, visibility, predictable cash flows and modest capital requirements.
The slowing of federal budget growth increases the competitive challenge for government contractors, especially for the companies that no longer qualify as small businesses. In this tough environment, a company's distinguishing characteristics become even more important.
Recent Small Business Administration actions aimed at substantial increases in contract awards to small businesses are colliding with market realities and, in manyinstances, are counterproductive to the government getting its work done efficiently and cost effectively.
SBA implemented a rule that became effective June 30, 2007, and requires companies that have been acquired to recertify their small-company status within 30 days of the deal closing. This rule has significantly altered transaction structures and valuations in the government services mergers and acquisitions market.
Since 2004, the price-to-performance multiples of publiclytraded government technology services companies havetrended downward, while the valuations of mergers andacquisitions have held their ground. Is this rational,sustainable and likely to continue through this year and the next?
Most prospective buyers in the government services markets are seeking pure-play, federal-oriented targets. These acquirers are either already focused on thefederal segment and want to expand there or they are seeking to enter the federal arena. This approach essentially involves sticking to the market you know.
The government services mergers and acquisition market has been consistently active since 2001. But today it's more of a bipolar M&A market driven by the small-business recertification requirements that took effect July 1.
Slowing growth in government spending has intensified contractors' search for othergrowth areas, particularly those with high priority, within the budgets at all levels of government.
We can expect to see larger merger-and-acquisition transactions in the federal market during the next year or two. The aggregate dollar volume of deals is likely to increase while the number of transactions may decline.
Many industry analysts and investors have expressed concern about the outlook for federal services companies. They seem to believe that the industry's best years are in the rearview mirror.
Merger and acquisition activity in the federal IT and government services markets has been strong for five years, coinciding with federal spending increases exceeding longer-term norms.
Arguably, the Small Business Administration's final rule, announced Nov. 15, regarding small-business size recertification under long-term federal contracts has few beneficiaries in the long term, except, perhaps, unsuccessful small businesses.