2014 M&A Recap:
With 81 M&A deals announced in the Government Services market, transaction activity in 2014 increased by 25% compared to 2013 and was in-line with 2012 levels. Improved revenue visibility and better understanding of the new environment was a key factor to this volume increase. For public strategic buyers, higher company valuation, increased dry powder, and an attractive credit market contributed to the pickup in transaction volume. Similarly, well capitalized private and private equity-backed contractors deployed cash on their balance sheet and accessed the credit market to participate in the M&A market. Private equity sponsors remained active as they looked to invest a sizable amount of un-deployed private equity and traditional bank capital. Access to lower middle market leverage multiples combined with low interest rates contributed to the increase in M&A transactions.
In addition to M&A transactions, a continuing trend in Government Services market was the major divestitures and spin-offs of business segments. Rationale behind most of these transactions was to focus on core markets and capabilities, portfolio reshaping and to unlock value. Notable transactions of 2014 included QinetiQ’s sale of its North American business and Exelis’ spin-off of its Mission Systems
Recent M&A Activity Sees Emergence in Spin-Offs and Divestitures
Federal contractors continue to adapt to the well-documented budget constraints. Competition for government contracts has increased, leading to bidding wars with more aggressive offers and slimmer margins. An increase in competition can typically spark M&A activity as companies vie for contracts and resort to acquisitions to expand their capabilities and win business. Through Q3 of 2014, public companies have been involved in roughly 50% of the deals, sparking a reemergence of mega mergers and consolidation amongst large industry players. While some companies have consolidated through acquisitions, like Cobham’s $1.5 billion purchase of Aeroflex, and AECOM’s $6.0 billion acquisition of URS Corporation, other major contractors have been spinning off, or divesting, divisions to increase focus on specific business segments more aligned with companies’ overall strategic initiatives. B/E Aerospace announced on June 10, 2014, its spin-off into two separate publicly-traded companies, focusing on manufacturing and services. On September 27, 2014, Exelis announced the successful spin-off of its mission systems division, now known as Vectrus (NYSE:VEC), from its C4ISR and IT-focused businesses.
There are certain factors that can motivate companies to focus on restructuring. From an operational perspective, the flexibility to pursue new business opportunities and the ability to implement new cost structures and control capital
The recent speculation that Textron is considering a spinoff of some of its business units, including Cessna Aircraft, is revealing of a growing trend in which diversified conglomerates face pressure from activist investors to dispose of certain defense-related business units. Rumors of a possible sale of the Cessna business unit have been fueled by the reported interest of activist investor Ralph Whitworth’s Relational Investors. According to Reuters, Relational Investors examined Textron as a potential target for a change in strategy a month ago; however, the activist firm has since stated that Textron was never a serious prospect.
Activist investors, like Relational Investors, have determined the slower growth federal contracting verticals of large conglomerates to be a drain on company valuations. To unlock shareholder value, investors are pushing for breakups or spinoffs of segments with a stagnant or declining growth outlook. These changes come as the wars in Afghanistan and Iraq wind down and major cuts are being made to the U.S. government’s defense budget. With the growing deficit and increasing budgetary strain, the trend of spinning off low-growth businesses from diversified conglomerates is likely to continue into 2012, with or without investor pressure.
Relational Investors has been known to pressure diversified conglomerates to split up in recent years. In October 2011, ITT Corporation spun off Exelis Inc., its Defense and Information solutions business, and Xylem Inc., its Water Technology and Services business, resulting in three distinct publicly traded companies. Relational cofounder Ralph Whitworth told Reuters that the hedge fund urged the company to sell its defense unit to a private equity firm and spin off its basic industrials business after accruing a 3.93% stake in the company and nominating three directors to the company’s board. ITT instead announced its two planned spinoffs, possibly in order to avert a proxy contest with Relational Investors, although ITT’s Chairman and CEO, Steve Loranger, maintains that the decision to break up the company was made with no investor pressure.
Relational also played a role in the pending spinoff of certain government services operations of L-3 Communications, which is expected to be completed in the first half of 2012. The firm became the largest shareholder in L-3 in June 2011 after acquiring an almost 6% stake in the company, when it began pushing for the conglomerate to spin off its low-margin and slow-growth businesses.