Automatic cuts called `Catastrophic’ for contractor dealmaking

December 4, 2011

Across-the-board budget cuts triggered by the failure of Congress’s deficit-reduction supercommittee might discourage acquisitions of companies that depend on federal contracts.

The cuts, on top of previous measures, would reduce the Defense Department budget by about $1 trillion over 10 years. That might diminish the value of potential acquisition targets working on big-ticket Pentagon programs, said John Hagan, head of the defense and government services group at BB&T Capital Markets in Reston. Those involved in intelligence, cybersecurity or health care might be insulated from cuts and hold their value, he said.

The automatic reductions will be “catastrophic’’ for buyouts of contractors, because the cuts will lower company valuations and hurt the ability to finance deals, said Jean Stack, a McLean-based managing director for Houlihan Lokey, an investment bank in Los Angeles. Lower values won’t necessarily make companies more attractive as acquisition targets because of uncertainty over future revenue, she said.

“Nobody is protected anymore,’’ Stack said. “There will be the need just to digest what this can possibly mean for the industry and who could possibly be saved from this.’’

$1.2 trillion in cuts

Legislation that created the supercommittee mandates automatic cuts, or sequestration, of at least $1.2 trillion over 10 years, split evenly between defense and discretionary civilian spending, beginning in 2013.

“We were hoping the supercommittee would be able to develop a framework acceptable to all sides,’’ Stan Soloway, president of the Professional Services Council, a trade association of government contractors based in Arlington County, said in an e-mailed statement. “Now we face another period of protracted debate.’’

Within hours of the Nov. 21 announcement that the panel had failed to achieve its goal, some lawmakers said they were looking for ways to lessen the effects of cuts, especially on military spending. The Pentagon already is cutting about $450 billion from its budget over the next 10 years as a result of the law that created the supercommittee. President Obama vowed to veto any attempt to undo the sequestration.

Prime contractors might become more aggressive buyers “once the dust settles and target small properties that fill voids in the portfolio,’’ said Michael Lewis, director of equity research for Lazard Capital Markets, based in New York.

“If you’re a CEO, you’re not going to buy a company with a few contracts until you know those contracts are secure,’’ he said.

Dealmaking already down

Mergers and acquisitions in the government contracting market totaled 152 through the first nine months this year, compared with 177 in the same period of 2010, a record year for federal market deals, according to KippsDeSanto & Co., an investment bank in McLean. The company didn’t report average deal values.

Most of the deals this year were in defense and aerospace. The most active sectors outside that industry were cybersecurity, health information technology, and intelligence, according to KippsDeSanto.

General Dynamics has been the most active buyer in the U.S. defense and aerospace sector this year, with at least five announced acquisitions, Bloomberg data show. In the past year, the Falls Church contractor has targeted companies selling information technology services, ship maintenance services and military vehicles.

The federal government contracts for more than $500 billion a year. Lockheed Martin had the most civilian government contracts in the fiscal year that ended Sept. 30, at $6.19 billion; drug distributor McKesson was second, at $3.92 billion, according to data compiled by Bloomberg Government.

Full-year figures for defense contracting aren’t available for 2011. In the previous fiscal year, Lockheed was No. 1, with $29.6 billion in contracts. Boeing was second, with $18.1 billion.

— Bloomberg Government

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