Survey of the Security Business 2017 - Strategy, Drivers, Valuation & the Investment Market

Strategic Drivers
In the last two years M&A activity has been driven by strategic buys, particularly by the major global security companies, major defense companies and from outside the security business - IT and communication companies and more recently validation, authentication and biometric companies. This dynamic will continue to apply in 2018 and beyond.

Private Equity has played a much more passive role in recent years. It has suffered as a result of the financial meltdown and has not been able to recycle through the natural process of IPO’s. It is going through a process of restructuring and is redefining investment parameters. So Public Equity will continue to dominant the M&A scene for the next 2 years. However Private Equity has in the past been a major source of funding for acquisitions and the pundits tell us that private equity buyouts are on their way back. In 2018 IPO activity is likely to be concentrated in China, primarily to float the fast growing local manufacturers but we may see more western based companies follow the example of Infinova and listing on the Chinese Stock Exchange.

Defense, multinational security and IT related companies will engage in more transformational transactions. In the last 2 years such deals included Safaran’s purchase of GE Homeland Protection, Schneider Electric’s acquisition of Pelco and UTC’s buy of GE Fire & Security. In 2017, Safran has continued this strategy with the purchase of L1-Identity Solutions. Flir, Hexagon AB, 3M and HP have joined in with respective acquisitions of ICx Technologies, Intergraph, Attenti and Arcsight. We expect more of the same in 2018.

The defense industry has over the last 3 / 4 years entered the commercial security business through the combination of marketing their existing technology and also making some strategic acquisitions. Federal Signal, General Dynamics, Mantech International and BAE Systems have all acquired suppliers to the security industry in 2017. We expect this process will continue in 2018, blurring the lines between the commercial security and defense sectors.

Cross border transactions will also continue to be a significant driver. Exposure to U.S. markets have become a strategic priority for a number of European companies but we expect that most activity under this dynamic will centre on Asia and particularly PR China where rules on ownership have been significantly relaxed in recent times. UTC Fire & Security have made a number of strategic investments there in the last 3 years.

Possibly the most important driver is the result of the push to IP Networking. Buyers are gradually accepting that security does not have to be a cost centre and that particularly when integrated with other services it can increase productivity in the enterprise, made possible through IP Convergence. Whilst technology has been the enabler of change the driver and motivator now is clearly to deliver products and services that increase productivity and provide a return on the investment. The market is now in the process of rapidly adopting to changing requirements for more converged and integrated solutions. This is driving a need to acquire and or merge with suppliers that have IT and Networking expertise.

IP Networking products whether for access control, intruder alarms but particularly for video grew rapidly in 2017 and is believed to be on the verge of a strong run. Analogue sales by comparison fell in 2017 but unlike IP they did not increase their rate of growth in 2017. Falling IP prices and improved performance have all conspired to improve their ROI and total cost of ownership and made it easier to install run and service the new technology. We believe that the major emphasis in the security business will be an acceleration of shift to IP from Analog and a sharp increase in a move to managed / hosted video. With this will come more demand for companies having this expertise and we shall see an increase in their valuation.

Exit Valuation
Fig 1 shows that the average valuations of security companies based on EBITDA and revenue exit multiple fell by as much as 40% during the period 2017 to 2017 with 2016 being the historical high. There is a very high variation in these numbers ranging from 0.5 to as high as 16 in the case of revenue multiple for a PSIM supplier in 2017 that had just started to generate sales. EBITDA multiples have ranged between 1 and 13. We have noted higher figures being quoted in the financial press on some deals but without details being given. The 2 trends that stand out from these figures is that software and biometric suppliers have achieved the highest valuations this year and that in all sectors the average valuation benchmark has gone up.

At the same time the stock market valuations during 2017 have gone up from a decline that started in 2017. During 2017 / 10, according to anecdotal information fewer sellers were proactive in the market. It is therefore not surprising that valuations started to go up in 2017 and this trend is expected to continue in 2018. This rise in valuation is likely to be a gradual one because this is a competitive market with unit prices falling and increased revenue is likely to be modest in 2018 for most companies. We estimate that the median valuation for physical security companies in 2017 was 2.2 x revenue and 5.7 x EBITDA. These figures are lower than those given by the financial experts.

The Investment Market
The improving exit market and company valuations, along with a renewed excitement in the IT sector and a stronger economy are all factors that have engendered a confidence among VCs that they must move on in 2018 and therefore investment is forecast to rise.

During the two years prior to 2017, investment capital was abundantly available to new start-ups and acquisitions in the physical security industry. But as a result of the credit crunch in 2016 and the financial meltdown that followed in 2017, finance started to dry up that year. Since then as our figures clearly demonstrate private equity has made little impact on the acquisition market in both 2017 and 2017 but venture capital has been available to finance development in selective companies particularly those close to achieving a viable growing business.

In 2017 we recorded 17 announcements of capital injection by venture capital companies with total funds amounting to $144m. In 2017 the total investment was $142m from 19 arrangements. The majority of these involved investment in US based companies by US based venture capitalists. However in 2017 there has been a flurry of activity in renegotiating debt financing particularly by established companies and the consensus is that the industry is now in a much stronger financial state.

There are few venture capital companies that specialize in the physical security industry and it is clearly not the most attractive technology sector. However there are segments within in it that are particularly attractive to them, these being information security, identity and security solutions and defense. The former is regarded as having massive potential.

Identifying Merger & Acquisition Targets
One of the major sources of candidates for merger and acquisition is the continual flow of new start-up companies. The security industry has produced a very rich seam of new companies that are developing leading edge products particularly associated with IP Video Surveillance. The epicentre of entrepreneurship in the physical security industry is currently firmly established in the IP Video business. The USA is home to approximately 37% of these companies and the next most populated country is the United Kingdom (13%) followed by Korea at 11%, Taiwan at 7%, Germany at 6% and China, Japan and Israel at 4%.

In the USA almost half of these companies were founded since 2000. This is an astonishingly high percentage of new start companies and it is not evidenced in any other country that we have reviewed. So the USA has not just spawned more companies but they are much younger. None of the other countries in our sample had established new starts younger than 4 years and only Israel, Taiwan, Germany and the UK had more than 12% of companies younger than 10 years old.

The US leads in entrepreneurship in this field because the technology to produce the new digital video solutions comes from the Electronics and IT industries where the US already leads. The 2nd reason is that all the support needed for setting up new ventures is well established both in terms of financial investment and management skills. Both of these are well practiced and encouraged in the USA particularly in Silicon Valley and Boston areas. We estimate that approximately 50% of the new start companies in this business in the USA are clustered in these 2 regions. Finally American culture encourages risk taking; failure does not necessarily have stigma attached to it that it does in Europe.

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