The U.S. Defense Department budget experienced a $2+ trillion surge from 1998 to 2010 and was the primary driver behind the growth and sky rocketing valuations of “defense IT” contractors over the same period. Government contractor M&A activity and valuations peaked in 2007 and have since stalled pending government budget cuts and evolving spending priorities. Despite the slowdown, recent indications are that M&A activity in the sector is roaring back – here’s why:
The U.S. Defense Department budget experienced a $2+ trillion surge from 1998 to 2010 and was the primary driver behind the growth and sky rocketing valuations of “defense IT” contractors over the same period. Government contractor M&A activity and valuations peaked in 2007 and have since stalled pending government budget cuts and evolving spending priorities. Despite the slowdown, recent indications are that M&A activity in the sector is roaring back – here’s why:
Facing stagnant growth in their core industry, recessionary pressures, and shareholder demands for higher revenue and earnings, defense IT contractors are increasingly exploring non-traditional avenues for growth. Unlike defense spending which faces the specter of spending cuts for the next several years, U.S. federal government healthcare spending has its own projections set now at $985 billion this year, with growth only accelerating. These combined factors have led leading industry players such as CACI, CSC, and General Dynamics to see healthcare as a major opportunity for growth and a strategic imperative going forward. Financial sponsors are becoming acquisitive too – consider the following deals:
- NCI acquired AdvanceMed for $62 million
- Vangent acquired Buccaneer Computer Systems for $70 million
- Smartronix acquired HIE firm Cogon Systems for an undisclosed amount
- SRA International acquired by Providence Equity for $1.9 billion
- Global Defense Technology and Systems acquired by Ares Management for $315 million
- General Atlantic Partners and KKR purchased TASC from Northrop Grumman for $1.65 billion
- Veritas Capital purchased the Enterprise Integration Group from Lockheed Martin for $815 million
We believe that as comfort with the changing dynamics of the federal budget and healthcare reform grows in the new post-recession environment, strategic defense and IT contractor interest fueled by cash war chests and shareholder demands will drive premium market valuations. Reuters recently announced that Veritas Capital government HCIT portfolio company Vangent has entered a process with valuation expectations north of $1 billion and significant early interest from private equity and strategic buyers.
At the same time, cross-aisle matchmaking between commercial and government healthcare players (CSC’s acquisition of iSoft Group for $188m; Harris’ acquisition of Carefx for $155m; and UnitedHealth Group’s acquisition of federal medical evaluation provider Logistics Health Inc) is being supported beyond the increasing federal involvement in healthcare. UnitedHealth Group has taken an early leadership role with respect to diversifying beyond TRICARE and we expect other payer groups to follow. Some of the macro forces we see driving growing commercial-government convergence are:
- Fewer single department or one-of-a-kind government systems and solutions
- Technology upgrades are prevalent for cost-cutting purposes and streamlined workflows
- Growing mindset around collaboration between governmental agencies
- Diversification between stable government revenue and higher-margin commercial revenue
Despite the heydays of the defense spending boom being over, the government IT/services M&A market is showing it can still generate billion dollar deal flow. With existing industry players doubling down on their investments, new entrants (including financial sponsors) will continue to pursue and capitalize on undervalued assets. Let us know what you think.
Marc Baudry
Marc Baudry is an analyst at TripleTree covering the healthcare industry specializing in government healthcare services, population health management and informatics. Follow Marc on Twitter or email him at mbaudry@triple-tree.com.
