Pandemic Highlights Critical Need for Government IT Modernization
Government executives had already been struggling with the challenges of modernization when the pandemic exposed deep fault lines between mission requirements and outdated infrastructure. A new urgency now creates a generational opportunity for innovation at scale, across the entirety of government.
Mission critical needs and new programmatic demands at the local, state, and federal levels during the COVID-19 pandemic strained government information technology (IT) software and systems, underscoring the latent need to modernize infrastructure—a colossal task that will spur sustained activity in the already thriving Government IT Services industry. From 2021 to 2022, worldwide Government IT spending is projected to increase 6.5% to $557.3 billion to support accelerated modernization needs, according to an August Gartner report.1 The lion’s share of this spending is projected to go towards IT Services ($203.9 billion, an 8% increase from 2021) and Software ($151.9 billion, a 12% increase).
As the single largest consumer of IT software and services in the world, the U.S. Government has placed renewed emphasis on modernization by replacing legacy systems, migrating to the cloud, protecting vital networks from cyber-attacks, and utilizing artificial intelligence (AI) to optimize outcomes while enhancing efficiency. These fast currents of investment comprise a dynamic growth environment for disruptive technology firms. Indeed, the government’s reliance on the Commercial sector to deliver innovative IT solutions yields a unique generational set of opportunities for emerging companies in the middle market to capture fast-growing contracts and generate significant levels of recurring revenue, in so doing becoming sought after acquisition targets for leading government prime contractors.
Case in Point: $400 Billion in Improper and Fraudulent Unemployment Insurance Claims Attributed to Outdated Technology
In one of the most dramatic examples of the mismatch between legacy IT infrastructure and mission requirements, unemployment fraud amid the pandemic exploded into public view. Major flaws in state workforce agency (SWA) systems resulted in billions of dollars in lost and stolen benefits. It is estimated that of the $837 billion in claims paid out by the federal government, as much as half ($400 billion) was paid improperly or stolen by foreign crime syndicates, according to Axios.2
The Coronavirus Aid, Relief, and Economic Security (CARES) Act greatly expanded Unemployment Insurance (UI) programs by offering an extra $600 dollars a week to individuals who lost their job while also increasing the maximum number of weeks that individuals could receive UI payments with extended federal benefits administered through the SWAs. The UI programs have historically experienced some of the highest improper payment rates among all federal benefits programs, and the infusion of federal funds and flurry of claims during the pandemic made the program an easy target for organized crime. Social security numbers belonging to deceased individuals, prison inmates, and those registered in multiple states are only the most egregious measures employed. The widespread fraud has resulted in UI benefit complaints accounting for 87% of Office of Inspector General’s (OIG) investigative cases, compared to just 12% before the pandemic, according to the Department of Labor (DOL).3
Antiquated technology systems have been recognized as a key reason for the fraud, and in August the DOL announced a new Office on Unemployment Modernization to reform the existing systems. The department will begin with $2 billion in funds from the American Rescue Plan to start addressing the most critical areas of UI reform.
“The pandemic underscored the need for modernization of the 53 different systems that administer unemployment insurance benefits in the United States, and it exposed significant vulnerabilities in state technology to criminals looking for an opportunity,” U.S. Secretary of Labor Marty Walsh said in the announcement.4
A key approach will include partnering with identity verification providers to reduce fraud going forward including identify proofing services offered by ID.me, LexisNexis, Thomson Reuters' (NYSE:TRI) Pondera Solutions (acquired in March 2020 for $125 million), Alphabet’s (Nasdaq:GOOG.L) Google Cloud, TransUnion (NYSE:TRU), and V3Gate. Addressing the long-term challenges at the state level will also include building new, modular IT systems that provide agility and scalability in the case of another surge in the system. Notably, active Capstone investment banking clients are now engaged in the critical work of delivering next generation software that automates fundamental SWA business processes, answering the call for technology to deliver accountability and transparency where it is so long overdue.
In another earlier example of government technology faltering under the stress test of the pandemic, The Centers for Disease Control and Prevention (CDC) acknowledged the shortcoming of its antiquated contact tracing notification system. Riddled with duplicate records, incorrect information, and exceeding its capacity, the system failed to accurately monitor at-risk individuals. In response, the CDC turned to the private sector for a solution that could be scaled nationally and contracted the MITRE Corporation for $16.5 million to use its data-analytics driven surveillance tool Sara Alert™, according to a June 2020 CDC contract.5 Public health officials can now enroll individuals into Sara Alert™, where the individual self-reports via web, text, or phone call, thus providing real-time, accurate updates to health departments. As governments asses critical IT vulnerabilities and prepare for future crises, they will continue to turn to companies in the private sector to provide innovation.
Strategic and Private Equity Buyers Fuel Government IT Services M&A
Deal activity soared in 2021 with a ready set of both strategic and private equity (PE) acquirers fueling mergers and acquisitions (M&A). Through August 24th, 76 transactions have been announced or closed compared to just 37 during the same period in 2020. While Capstone reported a 16.4% decline in overall middle market activity in 2020, the recession-resilient Government IT Services industry reached a record-high of 80 transactions. The torrid pace of consolidation in 2021 is expected to continue beyond this year as buyers seek to strengthen their product portfolio and gain new technologies, customers, and geographies through inorganic growth.
Strategic companies continue to utilize M&A to build their portfolio of products and services, accounting for 51% of announced or closed transactions year-to-date compared to 64% of deals in 2020. While private companies drove a notable 28% of the YTD strategic deal flow, public companies (23%) completed marquee transactions that are shaping the industry.
- Parsons Corporation (NYSE:PSN) Strengthens Electronic Warfare Presence with Two Acquisitions - In August, Parson announced its $9 million acquisition of Echo Ridge, a developer and provider of systems for positioning/navigation/timing (PNT), electronic warfare (EW), and high-fidelity modeling and simulation radio frequency systems. The announcement followed Parson’s July acquisition of BlackHorse Solutions, which also enhanced its EW and information dominance capabilities. The deal was valued at $203 million, or 11.5x BlackHorse's adjusted 2022 EBITDA.
- Huntington Ingalls Industries (NYSE:HII) Completes $1.65 billion Acquisition of Technology-Solutions Provider – In August, Huntington completed its acquisition of Alion Science and Technology in an all-cash transaction of $1.65 billion or 12.2x adjusted 2022 EBITDA. Alion provides advanced engineering and research & development services to the Defense market with a focus on areas including intelligence, security, and reconnaissance (ISR) and cyber and data analytics. “Alion is a perfect complement to our existing capabilities in the technology-driven defense and federal solutions space. The services and products they provide are directly in line with the strategic focus that we have articulated for Technical Solutions," Andy Green, HII Executive Vice President & President of HII’s Technical Solutions Division, said in a press release.6
- Science Application International (NYSE:SAIC) Strengthens Healthcare IT, Artificial Intelligence Solutions – In June, SAIC announced a definitive agreement to acquire federal health technology solutions provider Halfaker & Associates in an all-cash transaction of $250 million. “This acquisition reinforces SAIC’s commitment to supporting the government healthcare mission, including our strong support for the health and wellbeing of veterans. It further accelerates SAIC’s profitable growth, brings key diverse talent, and offers access to strategic customers and contract vehicles within health IT for the DOD and federal government,” SAIC CEO Nazzic Keene stated in a press release.7 Prior to Halfaker, SAIC completed a $55 million dollar acquisition of Koverse in May, structured as $28 million in cash and up to $27 million over the next four years in earnout payments. The software company provides a data management platform that utilizes AI and machine learning to allow agencies to organize complex and sensitive data that requires various clearance levels.
Financial buyers eager deploy capital have become increasingly acquisitive in the space, attracted to the industry's growth and reliable recurring revenue streams. Private equity buyers drove 49% of YTD deal activity, compared to 38% in all of 2020. Firms seeking to strengthen their existing portfolios through bolt-on acquisitions accounted for 33% of volume while firms completing platform acquisitions drove 16%.
- Peraton Corporation Completes Watershed Acquisition of Perspecta – Peraton, acquired by Veritas Capital in 2017 from what is now L3Harris Technologies (NYSE:LHX), notably completed its acquisition of IT solutions provider Perspecta (previously NYSE:PSRP). The deal closed in Q2 for $7.1 billion at 11.6x EV/EBITDA and 1.6x EV/Revenue. The transaction followed Peraton’s acquisition of Northrop Grumman’s Federal IT and Mission Support Services Business for $3.4 billion. Peraton has now positioned itself as a dominant IT solutions provider in the Defense market. “Recent world events have underscored the fact that our national security has never been so interconnected,” Stu Shea, Peraton Chariman, President, & CEO stated in a press release.8 “It is dependent on our ability to effectively deter our adversaries, deliver robust citizen services, protect our financial system and rapidly respond to unconventional threats to our very way of life. Peraton operates at this critical nexus, supporting a wide range of government missions of consequence where failure could result in lost lives, disrupted systems, or violations of the public’s trust and confidence.”
- BlueHalo Builds Data Science and Analytics Solutions with First Acquisitions – Arlington Capital-backed BlueHalo completed its first acquisition in July, purchasing space-qualified systems provider Design and Development Services Corporation (terms not disclosed). Shortly following the closing of its first deal, the company announced that it had entered a definitive agreement to acquire Intelligent Automation in August (terms undisclosed). Intelligent Automation provides technology to customers across the Department of Defense and commercial markets in areas including AI, machine learning, 5G, cybersecurity, and data analytics.
- Arlington Capital Announces Two Platform Acquisitions – In addition to add-on acquisitions, Arlington has been active in completing platform investments in the Government IT Services industry. In August, the firm acquired MCR, a provider of software development and engineering to address critical national security, space, and cyber solutions (undisclosed). Also in August, Arlington agreed to acquire the Electron Devices Business ($185 million) and Narda Microware-West Division (undisclosed) from L3Harris Technologies (NYSE:LHX). Upon close, the divisions will become a standalone platform known as Stellant Systems and will enhance Arlington’s presence in the Defense Electronics market.
Diversified IT Services, Software, and Cyber Most Frequently Targeted Segments
With all-encompassing challenges to IT modernization, it is no surprise that Diversified IT Services companies were the most frequently acquired in the industry to-date accounting for 50% of deals. Cyber and Software companies claimed the next largest shares at 14% respectively. Capstone expects demand for software companies to remain high as organizations shed antiquated systems. Within Cyber, the elevated usage of digital communication during the pandemic dramatically expanded the attack surface while the increasing sophistication of cybercrime exposed the need for AI-powered technology to quickly detect and respond to threats. These trends will continue to fuel M&A activity in the increasingly digitized government sector. You can read more about the trends driving M&A in this space in our August Cybersecurity article.
Public Government IT Services Companies Show Sector Strength
Multiples among publicly traded comparable companies have remained relatively stable year-over-year, trading between 9.7x - 15.4x last twelve months (LTM) EBITDA as of October 2021 compared to 10.0x-14.9x LTM EBITDA as of October 2020. Stocks in this group are also trading collectively at 86% of their 52-weeks highs with average LTM 2021 EBITDA margins of 10.1%. Showcasing the industry’s resilience, many leading companies have reported an increase in revenues supported by healthy and growing contract backlogs in 2021. Headwinds that players continue to monitor include chip shortages, which could impair their ability to provide technology products, and the competitive labor environment, which could make staffing contracts increasingly challenging.
In August, CACI International (NYSE:CACI) reported a 4.6% revenue increase for the recently closed quarter and a record backlog of $24.2 billion, up 12% year-over-year (YOY) in fiscal year (FY) 2021.9 Notably, this included a $12.6 billion multiple-award defense agency contract to modernize the infrastructure, systems, and applications of the Defense Intelligence Agency (DIA) and National Geospatial-Intelligence Agency (NGA), according to a company press release.10 ManTech (Nasdaq:MANT) also reported a 3% revenue increase in Q2, with its backlog up 10% to reach $10.2 billion.11 In April, ManTech announced a partnership with Google Cloud to help expedite the U.S. federal government's adoption of cloud and analytics services. “This partnership combines Google Cloud’s secure, scalable infrastructure with ManTech’s decades of experience supporting the U.S. government,” Mike Daniels, Vice President of Global Public Sector at Google Cloud said in a press release.12 “We’re excited to work closely with ManTech to help government agencies grow their digital capabilities, efficiently serve constituents, and complete their most critical missions with the cloud.” Also of note, Leidos (NYSE:LDOS) reported an impressive 18% climb in YOY Q2 revenue, supported largely by a 62% increase in its Health segment and 14% increase in Defense Solutions.13 In June, Leidos announced a $2.5 billion contract with National Aeronautics and Space Administration (NASA) to improve communication, data center, cloud and cybersecurity capabilities across the agency’s centers and facilities.14 Cloud adoption has been a recurring theme across the industry, and Capstone expects to see continued high demand for solution providers in the space.
Gartner, "Gartner Forecasts Global Government IT Spending to Grow 6.5% in 2022," https://www.gartner.com/en/newsroom/press-releases/2021-08-31-gartner-forecasts-global-government-it-to-grow-in-20220, accessed September 2, 2021.
Axios, "Half of the pandemic's unemployment money may have been stolen," https://www.axios.com/pandemic-unemployment-fraud-benefits-stolen-a937ad9d-0973-4aad-814f-4ca47b72f67f.html, accessed September 8, 2021.
S. Department of Labor, “DOL-OIG Oversight of the Unemployment Insurance Program,” https://www.oig.dol.gov/doloiguioversightwork.htm, accessed September 7, 2021.
S. Department of Labor, “U.S. Department of Labor Announces Funding to States to Modernize Unemployment Insurance System, Combat Fraud, Address Equity,” https://www.dol.gov/newsroom/releases/eta/eta20210811, accessed September 7, 2021.
Amazon S3, Center for Disease Control and Prevention, https://s3.documentcloud.org/documents/7209474/Mitre-Contract-for-Covid-19-National-Track-and.pdf, accessed September 7, 2021.
Huntington Ingalls Industries, “Huntington Ingalls Industries Completes Acquisition of Alion Science and Technology,” https://newsroom.huntingtoningalls.com/releases/huntington-ingalls-industries-completes-acquisition-ofalion-science-and-technology, accessed September 7, 2021.
Business Wire, “SAIC to Acquire Federal Health IT Company Halfaker and Associates,” https://www.businesswire.com/news/home/20210603005984/en/SAIC-to-Acquire-Federal-Health-IT-Company-Halfaker-and-Associates, accessed September 7, 2021.
Peraton, “Peraton Completes Acquistion of Perspecta, Creating Leading Mission Capabilitiy Integrator and Transformative Enterprise IT Provider,” https://www.peraton.com/peraton-completes-acquisition-of-perspecta/, accessed September 7, 2021.
CACI, Investor Relations, “Q4 and FY2021 Earnings Conference Call,” https://investor.caci.com/investor-home/default.aspx, accessed September 7, 2021.
CACI, “CACI Awarded Prime Position on $12.6 Billion Multiple-Award Defense Intelligence Agency Contract,” https://investor.caci.com/news/news-details/2021/CACI-Awarded-Prime-Position-on-12.6-Billion-Multiple-Award-Defense-Intelligence-Agency-Contract/default.aspx, accessed September 7, 2021.
ManTech, Investor Relations, “Investor Presentation, Second Quarter 2021,” https://investor.mantech.com/static-files/01f23b57-261d-410a-a48b-a86df9bec918, accessed September 7, 2021.
ManTech, “ManTech and Google Cloud Partner to Provide Cloud Services for U.S. Government,” https://investor.mantech.com/press-releases/press-release-details/mantech-and-google-cloud-partner-provide-cloud-services-us, accessed September 7, 2021.
Leidos, Investor Relations, “Leidos Q2 2021 Presentation,” https://investors.leidos.com/investor-relations/default.aspx, accessed September 7, 2021.
Leidos, “Leidos awarded $2.5 billion contract to support NASA’s enterprise IT operations,” https://www.leidos.com/insights/leidos-awarded-25-billion-contract-support-nasas-enterprise-it-operations, accessed September 9, 2021.
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