GUEST COLUMN: 2013 Market Perspectives, by Susan Gabay of Bluestone Capital Partners

By: Susan Gabay, co-founder and Managing Director, Bluestone Capital Partners

The Washington Nationals’ selection of an unconventional figure (William Taft) to join the coterie of Presidential mascots is a fitting parallel to the current state of the defense and government services market, which is facing a unique and “head scratching” set of influences.  Unconventional times in the sector will require unconventional solutions for companies seeking to maximize shareholder value within this dynamic market.

Following a decade-long deluge of M&A activity in the sector, 2013 ushered in an uncommonly quiet period in defense and government services M&A with about a dozen M&A deals completed in the first quarter, relative to an annual clip of nearly 100 over the past several years.  While this slowdown coincided with the trigger of Sequestration, suggesting a possible correlation, current market dynamics in the sector point to a much more complex story, as highlighted below:

1. Uncertainty is high and competition is fierce, but the market is still large. Lack of clarity with respect to the size and depth of looming budget cuts and the programs most susceptible to budget pressures, along with a procurement environment that favors “low cost” over “best value,” have made many business owners feel like they are running on a treadmill.  Despite these challenging dynamics, the annual base DOD budget with the Sequester is expected to be nearly $500 billion, which is still 5% higher than the base budget ten years ago.  While anticipated budget tightening will clearly crowd some players out of the market (particularly those players that have relied heavily on OCO funding), there is still a sizable enough market to sustain a healthy universe of participants.  The strong and nimble will undoubtedly survive.
2. Public company valuations in the sector have stabilized. Despite the market noise about the challenging macro dynamics in the sector, public company valuations have traded within a relatively narrow range for the past 4+ years.  In fact, valuations have rebounded more than 20% since the Sequestration trigger in March 2013.  Yes, public companies in the sector are facing a more challenging organic growth environment; however, the market continues to support a valuation “floor” in the 6x EBITDA range for these public companies, consistent with valuation levels during the last downturn.  Dare we say that “stability” is emerging?
3. Corporate leadership, both new and old, is deep in thought. Many of the leading consolidators over the past decade are taking somewhat of a pause as both industry veterans and recently anointed CEOs carefully assess a variety of strategies for positioning their businesses for success during the next cycle.  Many will inevitably “stick to their knitting;” however, an increasing number of industry participants are flirting with expansion into “adjacent” markets while also identifying non-core assets for divestiture.  Even those adopting a “stick to my knitting” strategy recognize that they will need to be more creative than simply chasing “healthcare,” “big data,” or “cyber” and paying high prices for those assets.  Regardless of the ultimate path chosen by industry leaders, M&A is likely to remain a core component of future growth strategies, even if many of the strategic buyers are currently taking a breather to re-set the compass.
4. Capital is cheap and plentiful. Unlike the last cyclical downturn within the defense market, corporate balance sheets are extremely healthy, with more than $30 billion in capital available to leading industry players.  Private equity groups have been increasingly prominent participants in sector M&A activity over the past year and benefit from an attractive credit environment which has remained solid despite big-picture industry headwinds. Both senior and mezzanine lenders have exhibited strong appetites to support deals, effectively creating a valuation “floor” for reasonably well-positioned businesses.  The high yield markets are even entertaining entreaties by highly leveraged market participants to refinance their balance sheets.  These dynamics support robust M&A activity; however, any deterioration in credit quality could pose a threat to a continuation of this frothy credit environment.
5. There is a general supply and demand imbalance in the M&A market. Across all sectors of the economy, investors are lamenting the lack of quality deal flow in the marketplace.  The plentiful supply of cheap capital and general supply and demand imbalance have collectively increased the valuation prospects for businesses across other market sectors, suddenly making assets within the defense and government services market appear relatively “cheap” when compared to opportunities within other sectors.  This is causing more acquirers, particularly private equity buyers, to look hard at the long-term merits of investing in the defense and government services sector. Well-positioned businesses may be able to benefit from this supply and demand imbalance in the near-term.

So what does all of this mean, particularly for the small- and mid-sized companies in the sector?

1. The “Do Nothing” strategy is not an option. Most sector participants recognize that rising tides no longer raise all ships. Now is the time to be creative and opportunistic.  If you desire to be a consolidator in this market, be proactive in reaching out to prospective acquisition candidates, as they seem more receptive than ever to having “quiet” discussions.  A “low cost” procurement environment supports a consolidation strategy focused on building scale, which is exactly the type of consolidation environment we saw earlier in the cycle (albeit for different reasons).  The current credit environment supports the ability of small- and mid-sized contractors to pursue a range of consolidation strategies as well as recapitalization strategies that enable business owners to take some liquidity today, even if they aren’t quite ready to sell their business outright.  Now is the time for business owners to get smart on their options for maximizing shareholder value over the short-term and the long-term.
2. Focus on the “Nuts and Bolts.” Whether you are contemplating selling your business now or in the future, recognize that the market no longer craves or expects high growth from acquisition targets (although if you have it, growth is a plus and can support a higher valuation).  Focus on operational “nuts and bolts” like securing re-competes, preserving your “base” business, and investing in management talent that will be savvy in navigating the vicissitudes of today’s market.  Crafting a credible “story” surrounding the sustainability of the existing business base is critical to securing interest from potential suitors. Contrary to conventional wisdom, there are a variety of liquidity options for many would-be sellers in today’s market. The toughest part is sorting through the market “noise” to better understand both the viability and expected results of a sale process in the current environment to ensure the achievement of desired goals and objectives.

In conclusion, 2013 is likely to be a year of “transition” in defense and government services M&A as market participants digest the dynamics of this unconventional market and decide where to place their chips.  Just as our very own William Taft demonstrated in his professional life (Taft, the only U.S. President to serve as Chief Justice of the Supreme Court, had a productive and satisfying “second career” on the Supreme Court following his Presidency), individuals and businesses frequently need to re-invent themselves to reach the pinnacle of their own ambitions.  Only time will tell how much of this looming “re-invention” will reshape the landscape for defense and government services companies.

As the great Yogi Berra once said, “When you come to a fork in the road…..Take it!”