Market Watch: Slow federal growth doesn't slow some contractors

Jerry Grossman

Investors in defense and federal IT companies have become more cautious about the growth potential for companies, mainly because of slowing growth rates in U.S. defense budgets and the constraining impact of federal government deficits.

This view, simply stated, is that modest future growth in government and defense budgets means slower growth rates for companies in the sector. One impact of this thinking is reduced price-to-earnings multiples for public stocks.

But I would argue that this "macro view" distorts and oversimplifies the diversified fabric of the industry. Just as importantly, it understates the evolving dynamics of the defense and government markets.

This macro view suggests that the major driver of growth for any individual company is the top-line momentum in Defense Department and federal government spending.

A more informed "micro" assessment, looking under the covers and into individual agencies, budgets, technology deployments and other specifics reveals a much different picture. Beneath the surface, there are dramatic differences in budget trends and customer needs.

Political influences, security concerns and a host of other factors strongly support the need for micro-level analysis. Clearly, the transactional priorities of industry buyers are -- almost without exception -- micro-based, company specific in nature.

The market appeal and valuation of any specific company is not a function of macro-budget trends. In fact, evolving priorities and transformational initiatives in government and defense, coupled with slowing top-line budget growth often produce higher transaction valuations for well-positioned companies with the right stuff.

Knowledgeable transaction participants, including companies, investors and advisers, are aware that sale values can vary from six times trailing EBITDA (earnings before interest, taxes, depreciation and amortization) to 10 to 12 times or more, depending upon the specific needs of the buyer and attributes of the seller.

Consider that the typical defense and federal IT company sold in 2004, with revenue in the $40 million to $60 million range, was too small to offer a wide range of services and products, and not likely to be serving more than five to 10 principal customers.

Accordingly, the outlook for each of these sellers was directly related to their micro attributes, rather than being tied directly to overall government spending. Some additional thoughts about the fallacy of painting all defense and federal IT companies with the same brush are set forth in the following.

For the large, tier-one aerospace and defense primes, slowing spending could translate more directly into slowing in their organic growth. But for the other 99 percent of companies, their growth rates and business opportunities are a function of their specific customers, core capabilities, technologies and program participation.

Companies well-positioned in the "sweet spots" within the Defense Department, intelligence agencies and Homeland Security Department are achieving faster rates of growth in line with the priority markets they serve. The bottom line is that, for any particular company, a detailed analysis of its specific positioning and growth opportunities is essential to understanding its market appeal and valuation.

For analysts and public market investors, it is very difficult to gain in-depth perspective about the competitive positioning of a company, the strength and applicability of its technologies and the contract-to-customer component of its revenue base. However, knowledgeable strategic buyers are fully capable of conducting a thorough assessment of a target company, to more accurately identify differentiated businesses while sorting out the less-distinguished companies.

The business characteristics that have produced strong performance by good companies within the defense and federal IT sectors remain substantially in place.

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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