by Paul Serotkin

Is it a trend or not? M&A transactions involving federal/defense technology services are down 26% for the first five months through May 2004 compared to the corresponding period in 2003.

Thirty five deals were completed last year v. 26 this year. This despite views from investment banks and others in the industry that the M&A market in the federal tech services sector continues apace and, in their words, sees no sign of letting up.

We ask whether this five month performance heralds a longer-term trend, or is a short-term aberration that will soon reverse itself.

While too early to declare one way or another, why might the M&A market be somewhat slowing?

— Most buyers claim to be strategic. Joe Kampf, CEO of Anteon, speaking at the annual event this May sponsored by attorney Phil Jaeger (pjaeger@beankinney.com), said the company has completed 7 deals in 8 years, all of which were done for primarily strategic, not financial, reasons. Is it possible that, due to the glut of M&A transactions done in the last several years in this sector, it is becoming harder to justify truly strategic deals?

— The slowing federal IT budget. The 2005 IT budget proposed for the federal government is projected to grow at about 1%, well down from the robust annual gains of the last few years. While the 1% increase comes atop an admittedly large $60 billion base, is it possible that corporate and private equity investors are hedging their bets a bit on investing so aggressively in the federal tech space?

— The ROI demands of private equity. Carl D. Thoma, co-founder and partner of Thoma Cressey Equity Partners, Inc., the private equity group, said recently that 50% of the returns derived from PEG portfolio investments will come from operational improvement, a much higher percent than needed historically. Speaking at the Association for Corporate Growth (ACG) annual National Capital Chapter conference in May (see www.acgcapital.org), Thoma said the spread between PEG returns and those realized from capital market investments is thinning, making the justification for investment that much more challenging.

— Slow moving funding. The government’s 2005 fiscal budget may not pass by the time members of Congress leave October 1 to campaign. The result could be a series a continuing resolutions, leading to two week dole-outs of funds — and delays in starting new programs. With the election looming, uncertainty in the budget process could be causing buyers to hold off until the issue is settled.

— The dealmaker dynamo is resting (we think). Employee owned, $6.7 billion SAIC has announced only one deal this year, and not since their pickup of Aquidneck Management Associates in early February. They led the corporate pack in acquisitions by a long shot in 2003. With SAIC apparently either digesting all its companies or making sure its massive reorganization takes root — or working perhaps on a major deal in the works, the effect has been to slow the overall ‘done deals’ scorecard.

— Bracing for BRAC. We are now in the ‘pre-BRAC period,’ when the military is evaluating which bases to close or otherwise realign in 2005. Some buyers are gun-shy in acquiring firms who have too much business at one of these high-risk bases. Once the BRAC list is announced, those hesitant buyers may rush in to complete deals in abeyance.

— Corporate over-governance? The advent of Sarbanes-Oxley regulations in the post-Enron era is making it more difficult for sellers to get through due diligence hoops. One long-time CEO dealmaker told us he has seen more federal IT deals that fell apart after the LOI was signed than he ever has.

Is it trend or blip? We will be monitoring the flow of deals and report back as the year unfolds with further observations.

Paul Serotkin is President of Minuteman Ventures LLC, paulserotkin@minutemanventures.com, 781-750-8065 or 703-894-1270.

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by Kevin P. Mullen

Can the Homeland Security market be a ticket to M&A or capital-raising success? Whether CEO of a company in the federal space or looking to enter it via a Homeland Security solution, attorney Kevin P. Mullen from Piper Rudnick LLP provides useful advice on structuring your strategy.

The realities of September 11th and the conflicts in Iraq, Afghanistan and Israel, have focused the attention of the Bush Administration on Homeland Security, as both a domestic policy and procurement priority. Facilitated by Congressional willingness to enact special legislation and to allocate staggering amounts of appropriated funds to protecting against terrorist attacks, the United States Government has created unprecedented business opportunities for companies developing and selling anti-terrorism products and services. These companies — whether they develop and sell vaccines to combat bioterrorism, sensors to detect biological, chemical, and radiological substances, or physical security services to protect citizens and property — are likely to experience strong growth and increased value in the foreseeable future.

Companies operating in the Homeland Security market, however, face a special business and legal landscape. As a fundamental matter, Uncle Sam is the dominant market customer. Government contractors are subject to a host of legal requirements that do not apply to commercial sales. The Government’s business methods and procurement process present real challenges to companies unfamiliar with this environment. In addition, the sale of anti-terrorism technologies brings unique risks, along with the prospect of substantial revenues. In particular, Homeland Security contractors face potentially overwhelming legal liabilities from third-party lawsuits in the event of a terrorist attack. The litigation aftermath of September 11th confirms the staggering scope of this liability exposure.

Whether considering a M&A transaction targeting a Homeland Security company or showcasing a company as an attractive investment opportunity, you should examine the following legal factors which directly impact corporate value in this unique marketplace:

— The Government’s Spending Priorities. The Department of Homeland Security (DHS), in cooperation with other agencies such as the Department of Defense (DOD) and the Department of Health and Human Services (HHS), has identified the country’s funding and procurement priorities for Homeland Security. The extent to which a company’s technology corresponds with major spending initiatives can determine ultimate business success in Government contracting.

— The Government’s Procurement Cycle. Unlike the commercial world, the wheels of Government procurement typically grind slowly. As a general rule, Government agencies must make purchase decisions based on full and open competition. Competitive solicitations inevitably extend the timeline for award of a Government contract. As a result, sales to Government customers can be a frustrating process for uninitiated companies. Patience is a necessary virtue, and sufficient corporate resources are required for long-term survival. Moreover, an agency must formally justify any sole-source procurement, as an exception to full and open competition. When examining an M&A target, you should be skeptical of any company claims of exceptional treatment from a prospective Government customer.

— The Company’s Current Contracts. While a company’s backlog is always an important factor for valuation, Government contracts raise special issues affecting the expectation of revenue and risk. For example, the Government pays close attention to contract performance, and often demands precise satisfaction of specifications and standards under threat of default termination. Also, Government agencies generally are allowed to terminate a contract at will, pursuant to the standard “Termination for Convenience” clause. The “Changes” clause permits the Government to unilaterally amend contract specifications and delivery terms in return for fair compensation to the contractor. Most importantly, an agency’s ability to fund a contract is subject to the appropriation process controlled by Congress. Examination of current contracts should include a diligent analysis of the risks associated with potential terminations, cost overruns, and funding vulnerabilities, in order to provide a complete picture of the contractor’s likely future revenue.

— The Company’s Intellectual Property. Intellectual property (IP) rights are the corporate jewels for high-tech companies, and anti-terrorism technology is no different. Government contracting, however, applies special rules to the allocation of IP rights, including inventions, patents, technical data, and software. Any company selling products or services to the Government should understand this peculiar IP terrain, and protect itself from unwittingly transferring its critical IP to Federal customers. Similarly, any M&A due diligence should include a detailed review of Government contracts to identify IP transfer that might impact corporate value.

— The Company’s Compliance Systems. Statutes and regulations impose a variety of compliance obligations on Government contractors. There are ethical obligations, socio-economic requirements (such as Equal Employment Opportunity and Affirmative Action), subcontracting requirements, and cost accounting rules governing the recovery of contract costs, just to name a few. A top-quality compliance program is an excellent corporate investment and an important asset, when evaluating the risk of legal exposure and sanctions for violating Government contracting rules.

— The Company’s Mitigation of Liability Risk. Homeland Security contracting is rife with exposure to immense legal liabilities, given the possibility of terrorist acts on American soil. As a practical matter, commercial insurance usually excludes this dangerous contingency, exposing a company to terminal lawsuits. Although the “Government Contractor Defense” provides protection for contractors performing according to Government specifications, such circumstances typically don’t apply to companies that develop and manufacture technologies without Government direction. While certain Government agencies are authorized to indemnify contractors against “unusually hazardous risks,” the Bush Administration has been reluctant to utilize this authority except in extreme circumstances.

To address this liability crisis, Congress enacted the SAFETY Act in November 2002. This new statute provides liability protection for sellers of anti-terrorism technologies, who are otherwise unable to obtain sufficient commercial insurance, by restricting third-party lawsuits and capping damages at the level of the seller’s insurance coverage. Notably, this legal protection extends to the buyer of the anti-terrorism technology, whether a Government agency or commercial customer. DHS administers the SAFETY Act application process, and grants approval to technologies judged to be effective, reliable and safe in protecting against terrorism. SAFETY Act eligibility offers a valuable competitive advantage to companies selling Homeland Security products and services. When analyzing corporate value, don’t underestimate the importance of mitigating liability for anti-terrorism technologies.

Valuation of Homeland Security companies involves legal and business issues with which many executives and their due diligence teams are unfamiliar. In this regard, your business team should include lawyers and consultants who can provide strategic advice backed by real Government contracts expertise and experience. A true appreciation for the Homeland Security market from a legal perspective will place you in a better position to capitalize on business and investment opportunities related to the protection of the United States.

Kevin P. Mullen is a Partner in the Washington, D.C. office of Piper Rudnick LLP, where he is a member of the Government Contracts and Homeland Security practice groups. You may contact Mr. Mullen at 202-861-6414 or kevin.mullen@piperrudnick.com.

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While this list only provides a high level summary of the information you will need to provide to a potential buyer, it will help you get organized and enable the buyer to begin the due diligence as soon as the Letter of Intent is signed. It will also assist in a smoother, faster and more efficient due diligence.

Peter Dwyer is co-founder of EdgeStone Consulting, specializing in acquisition consulting and due diligence support to firms in the federal marketplace. For additional information, contact Peter Dwyer at pdwyer@edgestone.net, or review more detailed information at www.edgestone.net.

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FGR offers analysis of a recent M&A transaction involving government technology services contractors. The analysis is written by Stuart McCutchan, president and CEO of InfoBase Publishers, Inc. © and editor of the Defense Mergers & Acquisitions, a premier source for information on defense/aerospace M&A. Opinions expressed below are those of InfoBase. All rights reserved. For more on InfoBase Publishers’ services, contact Bill Burton (410-820-6821, wkburton@infobasepub.com) or click infobasepub.com.

Harris Corp. to Acquire Orkand

Harris Corp. (NYSE: HRS) signed a definitive agreement to acquire Orkand Corp., a privately held provider of technical services and information technology for U.S. Government agencies.

Orkand is headquartered in Falls Church, Virginia, and has operations in 22 U.S. states. The company provides information technology services under contracts with the U.S. Departments of State, Labor, Interior, Health and Human Services, Energy, and the U.S. Postal Service, among others.

Harris chairman, president, and CEO Howard L. Lance stated: “The acquisition of Orkand Corp. expands our mission-critical services business and adds important new customers to our Government Communications Systems division. They have a strong and well-established prime contractor position with these customers. As part of the Harris Technical Services business, Orkand will provide us with increased scale and new contract bid opportunities, expanding our position as a leading communications systems and services provider to the U.S. Government.”

TERMS

On June 7, 2004 Harris announced that it has signed a definitive agreement to acquire Orkand for approximately $66 million in cash, subject to post-closing adjustments.

The transaction, which is subject to customary regulatory approvals, is expected to close prior to Harris’ 2004 fiscal year end on July 2, 2004. The acquisition is expected to be immediately accretive to earnings in fiscal year 2005 at approximately $0.05 per diluted share.

The company also provided increased earnings guidance for FY05.

Orkand is headquartered in Falls Church, Virginia, and has more than 1,000 employees operating in 22 U.S. states.

Orkand revenue for the 12 months ended in March 2004 was $80 million.

ANALYSIS

Orkand’s is a story of high-expectations, founder-driven growth … and ultimately of being in the wrong place at the wrong time.

Founded in 1970, the company grew smartly. Revenues were $20 million by 1988, and had more than tripled, to $72 million, by 1997. In 1998 they stood at $80 million, 85 percent of which came from civil agencies, and a year later, founder, president, and CEO Donald Orkand said that he expected to boost revenues to $200 million by 2002 through organic growth and stepping up efforts at the Dept. of Defense. There were reasons to think it might happen: the company has being strategically responsive to the changing marketplace: GSA Schedule revenues were up 30 percent, and the targeting of DoD was prescient.

But the company did not hit the $200 million target; in fact, it failed to grow at all. The major change in Orkand since 1998 has been in its headcount: it now needs only 1,100 people, as opposed to the 1,300 it employed in ’98, to achieve the same $80 million in revenues.

What went wrong? We’d begin with Donald Orkand’s aversion to acquisitions. In 1999 he told Washington Technology that “None of our growth has come through acquisitions. As more companies get bought and sold, our stability is becoming a tremendous differentiator.”

But all that buying and selling had a purpose. The government customer was shifting towards larger contracts, and companies were using M&A activity to be able to present themselves to that customer as “one-stop shopping” bazaars. That left the sub-$100 million segment of the marketplace increasingly dominated by 8(a)s. In this environment, the only seats available to a company like Orkand are at the back of the bus.

In one sense, Harris is a logical home for Orkand. Like Orkand, Harris has shown no great enthusiasm for acquisitions (at $80 million a year, Orkand is more than twice the size of the biggest-ever acquisition added to Harris’ government sector, $38 million a year Exigent International, acquired three years ago).

We have no size data for Harris Technical Services Corp. (HTSC) (Alexandria, VA), to which Orkand will be added. But we’d expect that this acquisition is a bid to position the company a little bit better to compete against larger peers. Beyond that, the addition of Orkand, whose customer base is dominated by civil agencies, helps balance HTSC, whose customers are largely DoD. If you’ve made a decision to play in this marketplace, deals like this one are part of the price of admission (as Orkand learned to its sorrow). But we look forward to deals in which Harris adds to its higher-tech, higher-margin communications assets.

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We recently completed two assignments, one to support due diligence for a public company in the wireless space looking to acquire a government house with RFID expertise. The other was a valuation report for a $40 million Virginia federal contractor seeking a M&A market value as a comparison to their ESOP valuation … Paul Serotkin will speak October 15 on federal M&A before the annual government contracting conference of the Maryland Association of CPAs. For more on the group, see www.macpa.org … Serotkin will also speak at the 6th Annual Defense & Aerospace Investor & Corporate Development Conference in San Diego this Sept. 19-21. See www.srinstitute.com for more.

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