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.
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.
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 scale – NCI, 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.
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.