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National Security Demand Buoys Consolidation Activity in Government IT Services Sector

Government information technology (IT) service providers have been reaping the benefits of the government's ongoing transition to cloud computing, particularly at the federal level. In the first half of 2023, the U.S. government allocated $1.7 billion in IT services contracts, marking a 6.3% increase year-over-year compared to the previous year's $1.6 billion, according to USASPENDING. Federal IT contract awards have been directed towards maintaining existing capabilities and establishing infrastructure for new IT systems. The U.S. intelligence community has been leading the charge in embracing cloud computing, advanced data analytics, and modernization efforts.
Although major intelligence community IT contracts tend to be awarded to large public companies, middle-market players with innovative capabilities have seized opportunities to meet the demand for specialized services and disruptive software systems. For instance, System High, a provider of IT protection solutions and a portfolio company of Enlightenment Capital, secured a $50 million contract in July 2023 to handle the controlled destruction and disposal of classified IT systems for an undisclosed member of the U.S. intelligence community, as reported on System High's website. These instances illustrate that while the broader U.S. government continues its IT modernization efforts, the intelligence community is anticipated to drive investment in national security IT through contracts and strategic collaborations with nimble and innovative contractors, thereby fostering a vibrant merger and acquisition (M&A) landscape for middle-market players. ESF Equity, LP has maintained its activity in the Government IT Services sector, with ongoing deals encompassing software development, E-procurement, identity management, and IT modernization.

IT Investment in Defense and Intelligence Agencies Benefits Public Company Player

Public companies in the sector are reaping the rewards of U.S. government investments in IT modernization for defense and intelligence agencies. Recent earnings calls have highlighted the normalization of contract award activity as a positive indicator of sustained profitability. For instance, Leidos (NYSE:LDOS) CEO Roger Krone noted in the company’s Q1 2023 earnings call that award activity is returning to normal levels, signaling a favorable environment for Leidos with its track record of thriving in competitive markets. Leidos exceeded its gross awards plan for Q1 2023 and secured a net of $3 billion in awards, pushing its total contract backlog to $35.1 billion by the end of the quarter, a 17% year-over-year increase. Additionally, Leidos secured a $375 million prime contract in July to provide intelligence and IT project management services to the Office of the Director of National Intelligence (ODNI), as per a press release.
Strategic priorities outlined in the Department of Defense’s (DOD) national security posture have also influenced operational plans for leading public companies in the sector. The DOD has identified the People’s Republic of China (PRC) as a significant challenge and has redirected substantial national security resources to the Indo-Pacific region. Booz Allen Hamilton (NYSE:BAH) has responded by expanding its presence in the Indo-Pacific region to support U.S. intelligence missions. Initiatives undertaken by Booz Allen Hamilton include growing its office and team in Hawaii to over 300 professionals and positioning an additional 200 professionals across the entire region, as detailed in the company’s fiscal year Q4 2023 earnings call.
Earnings of public companies have been bolstered by a focused national security strategy and the acquisition of new high-value DOD contracts. For instance, CACI International (NYSE:CACI) was awarded a $5.7 billion blanket purchase agreement contract from the U.S. Air Force for Enterprise Information Technology-as-a-Service (EITSaaS) in June, representing the largest contract award for the company to-date. CACI reported a 10% quarter-over-quarter revenue increase in fiscal Q3, citing $1.1 billion in Q3 contract awards as the next major revenue driver. This translated to an 8% year-over-year increase in contract value, bringing CACI’s current backlog value to $25.3 billion. Such substantial contract wins continue to have a lasting impact on earnings for public companies in the sector.

Government IT Sector M&A Normalizes to Pre-COVID Levels, Valuations Remain Robust

M&A activity within the Government IT Services sector has shown signs of moderation, with 54 transactions announced or completed year-to-date (YTD) in 2023. This represents a decrease from the 84 transactions recorded in YTD 2022, indicating a slowdown following the heightened activity observed in 2021 and 2022. However, it's worth noting that YTD 2023 deal volume has surpassed the levels seen in YTD 2020 (42 transactions) and remained consistent with YTD 2019 (56 transactions). Moreover, against the backdrop of elevated inflation and a more expensive debt environment, there has been an increased demand for companies with strong margin profiles and unique capabilities, leading to premium valuations for well-positioned firms.
An illustrative example of this trend is the acquisition of Sealing Technologies, a cybersecurity and technology company based in Maryland, by Parsons (NYSE:PSN) in August. The deal, valued at $200 million, allows Parsons to expand its customer base within the National Security sector while enhancing its digital infrastructure protection and secure data management capabilities. Notably, the transaction underscores the willingness of strategic buyers to offer competitive valuations for companies with critical intellectual property and a track record of revenue growth exceeding 10%, as highlighted in a press release. Despite the temporary slowdown in acquisition activity across the sector and the broader M&A market, companies with long-term contracts, strong margin profiles, and unique capabilities are anticipated to continue attracting buyer interest and commanding premium valuations.

Elevated Cybersecurity Demand Drives Consolidation Among Providers Serving the Intelligence End Market

The demand for services within the Department of Defense (DOD) and the U.S. intelligence community has translated into increased activity within the M&A market in 2023, particularly with targets serving the Intelligence end market. Year-to-date (YTD) 2023 has seen Intelligence segment targets accounting for 20.4% of all transactions, compared to 9.5% in the same period in 2022. One notable example is the acquisition of Secure Innovations by Enlightenment Capital-backed iNovex in June 2023, the details of which were undisclosed. This transaction exemplifies the strong motivations driving activity within this segment, fueled by heightened demand for cybersecurity services from both the intelligence community and the broader national security sector.
According to Jason Rigoli, Chairman of the Board at iNovex, "Cyber dominance is the new 'arms race,' and the national security community is actively seeking novel approaches and innovative solutions from emerging prime contractors." Secure Innovations' expertise in cybersecurity solutions and its established track record in serving the intelligence community are expected to complement iNovex's software development capabilities, further solidifying iNovex's position as a leading middle-market company with prime contract awards exceeding $2 billion.

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