Author Archives: Michael Potolicchio

About Michael Potolicchio

Michael Potolicchio is a senior analyst with Aronson Capital Partners (ACP), where he specializes in the Aerospace, Defense and Government Services industries. Mr. Potolicchio performs duties pertaining to financial analysis, modeling and business diligence to ACP clients in various service areas including M&A, Capital Raising and Strategic Advisory. Previously, Michael Potolicchio was a senior analyst for a boutique investment bank and private equity fund where he advised and supported a number of clients across multiple industries.

Michael Potolicchio

Valuation Drivers: KEYW’s $235M Acquisition of Sotera Defense Solutions

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The federal market is a prime example of an industry where companies have turned to inorganic strategies to drive growth. This is especially true in the lower middle-market contracting community ($50.0 million – $1.0 billion in revenue) where the need to scale to compete in an evolving industry has become more prevalent. KEYW’s recently announced acquisition of Ares Management, L.P. Portfolio Company, Sotera Defense Solutions (Sotera) serves as an excellent case study for owner-operators who are striving to build value in their business.

The publicly disclosed total cash purchase price of $235 million (~9.8x 2017E adjusted EBITDA, net of expected present value of tax benefits*) represents an attractive valuation driven primarily by a number of value drivers inherent in the business combination, which include:

  • Customer Access to Intelligence Community (IC) Agencies: The acquisition of Sotera adds high-priority, new customer agencies to KEYW’s existing IC portfolio (~$176 million in 2017 revenue), including highly sought-after FBI and DHS customers, and creates additional avenues for growth in the DoD market (e.g., Army Intelligence).
  • New and Complementary Capabilities: KEYW’s acquisition of Sotera augments the strengths of each company to create a leading pure-play products and solutions provider, adding new and complementary capabilities in agile software and solution development, cyber security, data analytics, machine learning, and big data. This well-rounded capability will expand KEYW’s reach across the value chain and unlock cross-selling opportunities with existing customers that would have otherwise contracted with the competition for the same product and/or service.
  • Access to a Large Portfolio of Prime Contracts and IDIQ Vehicles: KEYW will gain immediate access to past performance qualifications, customer relationships, and revenue streams of more than 12 prime IDIQ and GWAC contract vehicles. Moreover, the combined company will offer a complete set of enhanced capabilities to new and existing customers utilizing a more powerful and robust business development function.
  • A Unique, IC-focused Provider of Significant Sale: The transaction will create a pure-play IC-focused services provider with an estimated $535 million of pro forma 2017 revenue and $62 million in adjusted EBITDA (~10.0+% adjusted EBITDA margins). The combined company will have over 2,000 skilled employees with ~80.0% maintaining Top Secret clearances and above. The combined scale of both companies will provide a more competitive cost model to drive additional growth.
  • Cost Synergies: A transaction of this size typically generates significant cost synergies associated with the removal of duplicative indirect functions. This transaction is expected to yield approximately $3.5 million of cost synergies within the fiscal year 2017 and a total of $7 to $10 million in expected synergies over the long term.
  • Enhanced Cash Flow Metrics/Realizable Tax Attributes: The combined company is projected to generate roughly $43 million in pro forma 2017 operating cash flow. Expected net present value tax attributes of $46 million will increase net cash flow through a reduction of cash tax expense.

M&A comes with a number of challenges for companies of all sizes. Therefore, it is important for both buyers and sellers to develop a thorough strategy prior to embarking on an M&A event to mitigate uncertainties that emerge during a deal process. Companies should perform financial (e.g. pro forma P&L forecasting, balance sheet management) and organizational (e.g., operations, systems, employees) due diligence to assess potential challenges relating to:

  • Cultural fit (e.g., employee retention);
  • Financial wherewithal (e.g., transaction financing);
  • Contract mix (e.g. small business set-aside/F&O, prime/sub);
  • Revenue synergies (e.g. realizing identifiable synergies pre- and post-closing); and,
  • Effective integration (e.g. operations, systems, employees).

Implementing a clear and well-defined roadmap and assigning accountability for tracking and executing on your M&A strategy will increase the likelihood of a successful transaction in the future.

For questions and more information, please contact Michael D. Potolicchio at mpotolicchio@aronsoncapitalpartners.com.

*Ignoring the tax attributes, the 2017E EV/EBITDA multiple is ~12.2x

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2016 Recap: Focus on Higher Margin Business Segments

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A total of 92 M&A transactions were announced in the defense technology and government services market in 2016, which was slightly below the 107 transactions completed in 2015, but in-line with 2013 and 2014 levels. M&A in 2016 witnessed a “normalization effect” after the flurry of activity that occurred in 2015. Contractors have started to notice the effects the 2013 and 2015 Bipartisan Budget Acts’ sequester relief has had on the overall procurement environment. This relief has allowed the Department of Defense to significantly reduce the amount of anticipated cuts in technology operations and maintenance, translating into strong performance across the defense technology and government services market. As a result, there was active participation across the entire buyer landscape in 2016, driven primarily by (i) private equity sponsors acquiring scalable platform targets and/or “doubling down” with add-on acquisitions that provide complementary capabilities to their existing platform companies, (ii) larger Tier-1 and Mid-Tier’s divesting noncore, low margin assets and focusing more on higher margin business segments aligned with the mission, and (iii) Non-Traditional buyers focusing on targets in high priority end markets in order to strengthen their capabilities, expand market share and add new customers.

The strengthening of the budgetary environment and positive sentiment in the government services public equity markets has enabled private equity firms to remain active in the space. Private equity buyers led 33% of the transactions, including new market participants Chart Capital (acquisition of Fed Data Systems), and Platinum Equity (acquisition of PAE from Lindsay Goldberg). Meanwhile, seasoned investors in the sector, DC Capital and Arlington Capital, both secured new government services platforms earlier in 2016 with the acquisitions of QRC Technologies and EOIR Technologies, respectively. Existing private equity backed platforms drove 21% of the private equity activity, as Arlington Capital continued its buying spree by acquiring ISS and PROTEUS Technologies and merging it with EOIR Technologies to form Polaris Alpha. In addition, Belcan, LLC (acquisition of Intercom Consulting and Federal Systems Corp), Preferred System Solutions (acquisition of Synaptic Solutions, Inc. and Tetra Concepts), Sirius Computer Solutions (acquisition of Force 3, Inc.) and Altamira Technologies Corporation (acquisitions of APG Technologies and Prime Solutions) all strengthened their portfolios with bolt on acquisitions. Lastly, private equity firms continue to utilize the favorable budget environment to exit their existing investments. Examples include the sale of Aquilent (backed by Warwick Capital since 2002) to Booz Allen Hamilton, Camber Corporation (backed by New Mountain Capital since 2008) to Huntington Ingalls Industries, Vistronix (backed by Enlightenment Capital since 2013) to ASRC Federal and PAE (backed by Lindsay Goldberg since 2011) to Platinum Equity.

Mid-Tier and Tier-1 contractors continued to reshape the federal government contracting industry with notable M&A deals in 2016. Leidos’ $5.0 billion acquisition of Lockheed Martin IS&GS earlier in 2016 has catapulted the SAIC mission focused spin-out into the largest mid-tier publicly traded Government Services focused contractor ($10.7 billion in enterprise value as of December 31st, 2016) and allowed them to effectively compete for even larger contracts sought after by Tier-1 defense contractors. In addition, ManTech Corporation acquired the Cyber Network Operations Practice of Oceans Edge in June 2016, to expand upon its vulnerability research, development and analysis capabilities and Edaptive Systems, LLC in December 2016 to strengthen its federal healthcare presence. Booz Allen Hamilton acquired digital and cloud services provider Aquilent for $250 million to strengthen its capabilities and enhance its presence within HHS. Finally, Tier-1 contractors, Boeing and L-3 have made the strategic decision to focus on their autonomous systems and collaborative robotic capabilities with the acquisitions of Liquid Robotics and MacDonald Humfrey, respectively. In addition, L-3 officially changed its name from L-3 Communications to L-3 Technologies in order to capitalize on its strong brand equity, while better reflecting the Company’s evolution into a leading global provider of technology solutions.


As shown in the table, the 2016 buyer mix continued similar trends when compared to 2015, with public strategic buyers representing the largest buyer group (35.0% of all M&A activity). However, this year it was mainly driven by non-traditional buyers making transformative acquisitions to strengthen capabilities in areas of funding priority, gain customer access, and expand their contract portfolios. These buyers in 2016 included KBR (Wyle and Honeywell Technology Solutions, Inc.) Huntington Ingalls Industries (Camber Corporation), Magellan Health, Inc. (Armed Forces Services Corp.) DLH Holdings Corp (Danya International, Inc.) Jacobs Engineering Group, Inc. (The Van Dyke Technology Group) and Ball Aerospace and Technologies (Wavefront Technologies). The non-traditional buyer activity over the past twelve months bodes well for the industry as it signals renewed confidence in the overall growth prospects of the federal market.

 

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2017 Outlook: The Trump Effect

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2017 M&A Outlook

As we enter Fiscal Year 2017, expect to see similar trends emerge with public strategic buyers (Tier-1, Mid-Tier, Non-traditional) continuing to focus on their core capabilities, expanding their market share and/or adding new customers. We expect private equity to continue to invest capital in the federal sector after two years of strong participation, fueled primarily by better visibility in the budget and continued emphasis of future federal funding priorities brought on by the new Trump Administration. President Trump’s initiatives to strengthen cybersecurity and increase infrastructure investment and defense spending could fuel more acquisitions and add new acquisitive participants into the mix. In addition, Trump’s desire to repeal the sequester spending caps that come back into effect for GFY 2018 – 2021 could add up to an addition $107 billion to the overall budget. If Senator McCain’s recently published, “Restoring American Power” recommendation gains traction, expect a more significant uptick in M&A. His report calls for an increase in defense spending to $700 billion (including OCO) and future growth of 4.0%.

Trump Administration’s Effect on Government Contractors

There has been significant headline attention in 2016 as it relates to President Donald Trump’s pledge to fully eliminate the defense sequester and submit a new budget to rebuild the U.S. military, strengthen national security and improve critical infrastructure. President Trump believes it starts with a better defense strategy focused on the U.S. military. More specifically, by modernizing the joint force and regaining capacity of the armed forces that has been “depleted” as a result of budget constraints and force drawdowns. In addition, Trump is focused on making cybersecurity a major priority for the public and private sector. It begins with efficiently prioritizing funding and investing sufficiently in cyber weapon systems that are necessary to conduct military operations and the development of critical training and the necessary tools to equip an expanding 6,200+ person cyber force. Finally, despite Trump’s view on increasing spend on critical infrastructure receiving mixed reviews, successful execution could lead to thousands of additional jobs and strengthen overall employment numbers.

In addition, Senator John McCain released a 28-page white paper echoing President Trump’s priorities, recommending a $700 billion base defense budget in fiscal year 2018, which would represent a $54 billion increase over the budget proposal put forth by President Barack Obama. If adopted, the result will not be cheap, or easy: a complete repeal of the Budget Control Act, a $700 billion base defense budget in fiscal year 2018 and an overhaul of the U.S. military ($430 billion above current defense plans over the next five years).

Trump Administration’s initiatives are summarized in the below table:

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The Trump Administration’s budget reform plan will surely alter how agencies are organized and measured, as well as how budgets are prioritized. Over the past several years, the federal government has become accustomed to a structured procurement methodology (e.g. LPTA). However, with new priorities potentially reshaping the future of the federal contracting market, Trump plans to bring private sector “best practices” to bear on federal management, including practices designed to hold contractors to higher performance standards. This could mean a stronger emphasis on combating fraud, waste and abuse by implementing performance based contracting, where under-performing, redundant or disfavored programs could be closed or replaced with new programs aligned with administration priorities. Plans to strengthen contractor performance management could result in eliminating automatic renewal of option periods, withholding payments for poor performance and/or using performance based contracting. In addition, there may be a reemergence of more commercial-like buying practices and a greater use of GSA schedules or other efficient contract vehicles (e.g. T&M, FFP) to facilitate the procurement of goods and services. Trump’s budget reform also calls for a hiring freeze of civilian “non-essential” federal personnel. To put this into perspective, in 2013 roughly 900K employees, or 43.0% of the federal workforce was subject to furloughs. A decision to go through with this action would result in a potential 100K reduction annually in the federal workforce, ultimately driving agencies to increase the use of government contractors to perform work.

With all of this potential change brought on by Trump’s Administration comes uncertainty for government contractors, especially those furthest away from the mission (e.g. acquisition support, SETA). However, management teams with heavy concentration in these areas can utilize their free cash flow from current contracts and invest in mission-enabling capabilities more insulated from budgetary pressures, ultimately positioning them for future sustained growth.

 

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Q3 Market Update – Positive Trends Continue in the Federal Market

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There continues to be positive momentum across the defense and government services market for publicly traded (e.g. Tier-1, Mid-Tier, Non-Traditional) and smaller, privately-held government contractors. Uncertainty around federal spending seems to be in the “rear-view mirror” and companies are witnessing clearer funding visibility on current and future programs. Furthermore, over the past 12 – 18 months public contractors have re-positioned portfolios to focus on core, higher margin business segments that provide greater returns to shareholders. As a result, Tier-1 and Mid-Tier public companies have surpassed earnings expectations and continue to deploy cash through dividends and stock repurchase programs. These trends have translated into strong stock performance, as Tier-1 and Mid-Tier contractors have outpaced the S&P 500 index by 12.6% and 24.8% through Q3 2016 and continue to trade at valuation levels not seen since 2008. In addition, there has been noteworthy M&A as Non-Traditional buyers continue to make headlines with add-on acquisitions to enhance capabilities, expand market share and add new customers.

Tier-1 Government Contractor Update

Tier-1 contractors reported revenue in-line with expectations during Q3 2016, strong earnings per share (EPS) growth of 13.0% on a quarterly basis year-over-year (“YoY”), and increased revenue guidance for Q4 2016. A majority of the Tier-1 companies expect organic growth rates of between 3.0 – 5.0% in 2017. Lockheed Martin, Raytheon and Boeing reported EPS that significantly beat analyst expectations, driven primarily by successful M&A efforts (e.g. Lockheed’s IS&GS divestiture, Raytheon’s ForcePoint acquisition), solid pipeline execution and continued investment in new technologies that align with customer priorities. In addition, L-3 successfully merged three business units together to better size its operations and become more responsive to customer demands, and was successful in winning new contracts and recompetes and expanding scope of work on existing programs. L-3 reiterated its interest in building upon its resume of recent successful acquisitions (e.g. Harrison, Aerosims, Micreo) and will look for complementary business that broaden offerings, expands market share and bring in new customers.

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We continue to evaluate companies that build upon and leverage L3’s capabilities in high potential areas, and of course, returning capital to shareholders through dividend and share repurchase programs. – L-3

We continue to use smaller targeted M&A to build technology and market gap to augment both defense and commercial cyber capabilities. – Raytheon

We have taken significant actions over the past year to reshape our portfolio and strengthen our core defense business and I am confident this positions us well to grow and deliver long-term value to our stock holders. – Lockheed Martin

Mid-Tier Government Contractor Update

Mid-Tier contractors were relatively optimistic of their recent quarterly performance. This past quarter represented YoY organic revenue growth in the low-single digits, despite growth being relatively flat on an annual basis. EPS growth was in the mid-single digits, justifying senior leaderships’ continued focus on streamlining operations, improving productivity and optimizing their respective portfolios. CACI, Engility and Leidos are beginning to reap the benefits of their successful acquisitions of L-3 NSS, TASC/DRC and Lockheed Martin IS&GS, reporting EPS that exceeded analyst expectations for the quarter. ManTech and CACI both emphasized their respective capabilities and past performance will allow them to effectively compete for larger contracts against bigger competitors. Finally, NCI and ICF, both smaller, more nimble mid-tier contractors, reiterated their desire to acquire companies with differentiated capabilities that will position them for larger more strategic contracts in the future.

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We are bullish on a merger/acquisition market in 2017 and believe that once the election cycle is complete several strong companies will become actionable – we plan to be active buyers in 2017 – ManTech

We want to buy access to places where we think we could cross-sell or where we think we can expand, frankly, expand the number of markets that we support by getting into completely new areas of growth, such as the acquisition of NSS. – CACI

The basic truth is that practically every peer in our space is on the hunt for acquisitions resulting in limited viable candidates. However, we’ll continue to seek potential targets that provide capabilities, new customers and additional scaleNCI, Inc.

Non-Traditional Buyers Remain Hungry in the Federal Market

Acquisitions of government contractors with differentiated capabilities and strong customer relationships by Non-Traditional buyers continues to be a major 2016 theme in the federal market. As referenced in ACP’s Q1 2016 Market Update, activity within this group remains robust as companies who have historically shied away from M&A efforts in the federal market, are now witnessing more favorable federal budget dynamics and clearer visibility on long-term programs. In November 2016, Huntington Ingalls Industries, which has been relatively quiet since its spin-off from Northrop Grumman Corporation in 2011, acquired Camber Corporation to significantly broaden its existing capabilities and customer base. In addition, KBR’s previously acquired government services platform Wyle will serve as a beachhead for its recently closed acquisition of Honeywell Technology Solutions. Accenture has made yet another bet on the federal cybersecurity market, acquiring Defense Point Security to strengthen its cybersecurity expertise. DigitalGlobe’s acquisition of The Radiant Group from Aston Capital, LLC, is its first acquisition since 2014 and will help expand its customer base into the Intelligence and Special Operations Command markets while broadening its capabilities across the entire geospatial intelligence value chain. Finally, Cognosante’s acquisition of Business Information Technology Solutions (BITS) in late October, provides them with a federal platform with access to the T4NG contract and expands the Company’s capabilities to serve a wider spectrum of public health care.

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Through Q3 2016, the federal market has shown positive momentum. The performance of Tier-1 and Mid-Tier companies has trickled down to the lower and middle-market creating a higher degree of confidence and certainty in the market. This has fueled renewed M&A interest from Non-Traditional buyers in FY 2016 and is expected to continue through the remainder of the year and into FY 2017.

 

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Q1 2016 Market Update

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The Evolving Buyer Landscape in the Government Services Market

The relative budget stability and clarity has driven a renewed interest in government services acquisition targets by commercially focused information technology, consulting, and engineering buyers. Meanwhile, private equity firms have recently demonstrated confidence in this market by making new federal platform investments and bolt-on acquisitions for their commercially focused existing platforms. These buyers were previously on the sidelines for the past few years given the federal sector’s growth challenges and uncertainty.

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Prior to the sequestration and government shutdown period of 2012 – 2014, some of the most reputable commercially focused strategic buyers completed acquisitions of federally focused targets to gain access to a large, addressable federal market with moderate, single-digit growth prospects. Examples included IBM’s acquisition of National Interest Security Company (January 2010), AECOM’s acquisition of McNeil Technologies (August 2010), and URS Corp’s acquisition of Apptis (June 2011). Notable private equity activity during this timeframe included KKR & General Atlantic’s acquisition of TASC from Northrop Grumman, Ares Management’s buyout of Global Defense & Technology (April 2011) and Providence Equity’s buyout of SRA International (July 2011). However, similar activity stalled from 2012 – mid 2015 and has only recently reemerged.

Renewed M&A Interest: Non-Traditional Strategic Acquirers

While the traditional buyers of federal government services targets (e.g., CACI, ManTech, Boeing) will still drive the majority of the public buyer activity, a new wave of strategic buyers has emerged over the past 12 months. Accenture has been relatively quiet in the federal sector in recent years. However, in early 2015, the Company acquired Agilex to enhance its agile delivery for the federal market, and in mid-2015, Accenture closed its acquisition of FusionX to round out its security capability. In early 2016, Ball Aerospace and Technology Corp. acquired Wavefront Technologies to strengthen its federal market position in systems and network engineering, software development and analytical services for cyber/mission-focused programs. INDUS Corporation, a federal IT solutions firm focused on data analytics, geospatial analysis, and secure infrastructure and software applications was acquired by Tetra Tech in March 2016 to expand spatial and water information management capabilities for key clients such as the U.S. EPA. In mid-April 2016, Jacobs announced its acquisition of the 180-person cybersecurity firm Van Dyke Technology Group to bolster their critical infrastructure protection capabilities. Finally, NTT Data has announced its $3.0 billion acquisition of Dell Services (formerly Perot Systems). The combination will create an all-encompassing portfolio of IT and digital business solutions to the public sector, and significantly increase NTT Data’s presence in North America.

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Private-Equity Group (“PEG”) Participation

Historically there have been a handful of PEGs that have an unwavering commitment to investing in the federal contracting space and made investments throughout the more challenging market conditions of 2012 – 2014. More recently however, a new wave of PEGs have signaled an interest in this space and established new platforms or made tuck-in acquisitions of federal targets. Clearlake Capital, Marlin Equity and Kelso & Company all made targeted acquisitions in the past twelve months. Clearlake Capital and its commercial counterpart Tolt Solutions announced its acquisition of Pomeroy IT in order to expand its capabilities and cross-sell its solutions to federal clients. Marlin Equity acquired Fidelis Cybersecurity from General Dynamics in 2015 to capitalize on the advanced threat defense market, which is expected to near $1.0 Billion in 2016. Fidelis immediately made a follow-on acquisition of Resolution 1 to build upon its automated incident response cybersecurity capabilities and create a fully integrated, end-to-end provider of advanced threat defense solutions. In late 2015, Kelso & Company invested in the $1.7 billion, commercially-focused Sirius Computer Solutions, and in less than six months acquired Force 3, Inc., a leading cyber security and networking solutions provider to the federal market. The acquisition provides Sirius with access to both key IDIQ/GWACs and cleared engineering talent, and allows the company to further capitalize on the government’s continued adoption of next generation technologies. Lastly, Millstein and Company, made its first federal investment in DLT solutions in mid-2015, and Platinum Solutions closed its acquisition of PAE in March 2016.

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While sponsors new to the federal space showed confidence in the market, The Carlyle Group’s acquisition of Novetta Solutions in Q4 2015 might have displayed the strongest signal. Carlyle is one of longest standing Aerospace & Defense investors, and had not made a Government Services acquisition since its investment in Booz Allen Hamilton in 2008. This transaction, coupled with Veritas Capital’s buyout of Alion Science & Technology indicate that even the most sophisticated sector investors are once again deploying capital to the federal contracting community. Going forward, we expect this trend to continue as the federal market is once again viewed as a more stable target market with positive growth prospects.

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