Market Watch: Cash-rich federal IT firms make strong buyers

Jerry Grossman

The capital structure of companies in the federal information technology sector is overweighed on the equity side. I'm referring to the mix of equity capital and interest-bearing debt capital used to support assets. Typically, in industries with the risk attributes of federal IT -- visibility of revenues, low capital requirements and predictability of cash flows -- some judicious amount of debt is used to amplify returns.

At present, the 12 public federal IT companies are not using debt, as most of them have accessed the public equity markets one or more times in the past two years. These companies, excluding Titan Corp., have excess cash levels well above their debt totals.

It is interesting to note that companies using somewhat higher proportions of debt in their capital mix are generating higher returns on the equity capital invested.

In the aggregate, the pure-play, public federal IT companies generate just under $5.2 billion of sales. Most have been actively engaged in acquisitions, and collectively, this group has completed about 25 deals since 2000, buying $1 billion of revenue.

Notwithstanding this acquisition pace, these companies have combined cash reserves of nearly $500 million vs. only $290 million of debt.

Consider that these companies generate free cash flow equal to 4 percent to 4.5 percent of revenue annually, or approximately $220 million in 2003. This cash flow is available for acquisitions, as is excess cash and available borrowing capacity.

To estimate a borrowing level that is attainable within lender parameters, low risk for the company and not threatening to equity investors, a debt level approximately equal to total accounts receivable and about two times earnings before interest, tax, depreciation and amortization

(EBITDA) was used.

Using existing cash, ongoing cash flow and manageable senior debt, the industry group could complete nearly $1.5 billion in acquisitions during the next year without issuing any additional stock.

Buying revenue at 80 cents on the dollar, these deals would transfer $1.8 billion in revenue to the public buyers, or more than 35 percent of their revenue base. The prospective 4 percent after-tax return on sales, about $72 million, would amply cover the after-tax interest cost of about $45 million at a 3 percent rate.

This simplified example, using only these 12 federal IT companies, illustrates the capacity readily available to support continuing acquisitions. Analyzing returns on equity by each of these companies reveals a direct correlation between each company's return on equity and its use of debt.

As a group, these companies achieved a 10 percent net income return on stockholders equity, based upon an EBITDA margin of 8.5 percent to 9 percent. Anteon International Corp. deploys a greater proportion of debt in its capital structure -- 48 percent of total invested capital, four times the group aggregate level of about 12 percent.

There is some risk attendant to four times the group's financial leverage level. Typically, investors expect higher returns on their equity investment as the tradeoff for bearing higher risk. The 27 percent net income return on earnings Anteon delivered in the most recent year, more than 2 1/2 times the group level, indicates that higher equity returns are possible with a more leveraged capital structure.

Invested equity capital in the pure plays exceeds 40 percent of revenue at present. Using debt to complete acquisitions, in lieu of equity and within the parameters outlined, could enhance returns on equity by more than 20 percent during a four-year investment period. For some companies, this approach may be worth considering.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

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