KUHN CAPITAL Saturday, February 24, 2018
Dispatches from the front

Doing Deals in Homeland Defense IT

Nine-Eleven set off a scramble for IT security products and services, a push that was further accelerated by the creation of the massive new federal government agency, Tom Ridge's Department of Homeland Security (DHS). And then the IT security industry in general has further benefited from the rising drumbeat of publicity surrounding metasticizing incidents of spam and identity theft.

The stakes are huge. DHS has already earmarked a $38 billion spend for domestic purposes next year and Fortune Magazine estimates another $150 billion in expenditures that year by private industry. These numbers don't include military expenditures, also in the billions. The action has attracted venture capitalists (security being one of the few areas that VC's are active in today), and rapid growth and consolidation at least as experienced by established players like Northrop Gruman, Lockheed Martin and General Dynamics.

But what about the middle market: how is the business segmented and where are capital transactions occurring? In sum, our research indicates that small to mid-sized would-be sellers must approach a sell campaign with thoroughness and caution to avoid disappointment.

Security IT Segments
While Homeland Defense IT products and services (HDIT) come in many flavors, we've listed some of the larger ones below. Of course, categories can overlap:
• Weapons Detection and Monitoring (e.g., devices that identify explosives, biologicals/environmental agents)
• Person Identification (e.g., technologies that use biometric and authentication certificates to confirm identity)
• Object Identification (e.g., RFID, drug detection tehcnologies)
• Secure Communication (e.g., encryption, laser cables, etc.)
• Security Services (e.g., guard and law enforcement services and systems, employee screening)
• Surveillance (e.g., systems that track correspondence, movement, etc.: datamining, audio/video data manipulation, email/phone content analysis)
• Training/Simulation

Click here for examples of smaller public companies serving these markets.

Deals Done and Undone
According to Mergerstat, in the last five years, about 500 M&A deals -- or about 100 per year on average -- were consummated among government IT and defense-related companies. Things have clearly been speeding up: 2002's share of these deals totaled 140. On the other hand, over 200 sellers were competing for the 140 deals that actually closed that year, an increase in sellers of about 100% over the five-year average. All this implies that while activity has been increasing, sellers' value expectations have been rising even faster.

The data further support the argument that this gap in expectations is greatest in the case of smaller sellers paired with smaller buyers, buyers who can't trade liquid and well-priced stock. In addition, HDIT's rapid-growth environment makes many buyers concerned about spending cash reserves otherwise necessary to sustain their own strategies.

Equity to the Rescue?
While sellers in the recent past may have had some difficulty convincing buyers of their value, a trend of rising buyer equity value may increasingly close the difference. For example, in the 12 months between May 2001 and May 2002, public small to mid-cap HDIT players saw their stock appreciate by up to 50%. Interestingly, as a group those smaller public companies that closed M&A transactions during this time appreciated up to 120%.

As these beneficiaries of rising market enthusiasm come to regard their stock as a cheap source of acquisition financing, sellers -- especially those willing to entertain a merger or at least a substantial portion of the purchase price as stock -- will obviously benefit as well.

Take Aways
We suggest sellers approach this buyer market with unusual care. The range of valuations appears to vary widely depending on how well the seller has prepared the company for a transaction, and in selecting appropriate buyer candidates.

Specifically, the seller rewarded by the best price will have invested effort in understanding how to align the company to the strategic interests of prospective buyers in advance, and will have established strong internal control systems, an appropriate capital structure, and an executive team experienced in managing growth. We'd be happy to discuss with you these key preparatory moves as they may relate to your circumstances. The good news is that, more than is the case with most other IT sectors, some advanced thinking can return substantial transaction rewards.

Ryan Kuhn

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