Market Share: Acquisitions stir investor interest in federal IT sector

Bill Loomis

After a busy year of consolidation, the rapid pace continues.

Nortel Networks Corp. has acquired publicly traded PEC Solutions Inc., and L-3 Communications Corp. has proposed buying public federal IT company Titan Corp.

The purchase of private federal firms by public firms also continues at a brisk pace.

SRA International Inc. has announced two acquisitions this year, and ManTech International Corp. and SI International Inc. have completed one each. MTC Technologies Inc. has been particularly busy with three acquisitions this year.

Anteon International Corp. and CACI International Inc., two of the larger public federal IT firms, have yet to make an acquisition this year; but both have indicated they are looking for deals.

PEC was acquired at 12 times earnings before interest, taxes, depreciation and amortization, 22.6 times its 2005 earnings per share estimates, and 20.2 times its 2006 projected EPS estimates -- an attractive valuation, in my view, given the company's below-average organic revenue growth rate.

L-3 proposed buying Titan at 13 times trailing enterprise value to EBITDA, a price-to-earnings ratio of 20.3 times its 2005 projected EPS, and 17.6 times its 2006 projected EPS.

This compares to the publicly traded average of 15 times trailing EBITDA, 20.8 times 2005 estimated earnings, and 17.8 times 2006 estimated earnings.

Despite the acquisition price being above the $22-per-share initial offer from Lockheed Martin Corp. in Fall 2003, the acquisition multiples are lower than those of the original Lockheed deal that was 18 times trailing EBITDA, 31.0 times projected current year EPS, and 25.6 times projected next year EPS.

The new offer price is only 5 percent higher than Lockheed's original offer Sept. 30, 2003. Since then, stocks of other public federal IT companies have risen much higher. SRA's saw a 100 percent appreciation, SI International's rose by 80 percent, CACI had a 57 percent increase in its stock and Anteon's enjoyed a 42 percent rise.

I expect most of the consolidation will continue to be from aerospace and defense companies, as well as from large federal IT service companies such as Science Applications International Corp. and Computer Sciences Corp.

Stock valuations and acquisition valuations in the federal IT services area are at the high end of historical averages, but the pace of business also remains above historical averages, with the average organic revenue growth of public federal IT service companies remaining in double digits the last several years, reaching 15.7 percent in the first quarter of 2005.

Investors likely will get a little nervous early next year as details begin to leak about President Bush's fiscal 2007 budget request, but I believe the federal IT service stocks will have good performance for the rest of the year as contract award announcements pick up, and the companies generally report solid earnings.

Continued acquisitions by the federal IT service companies could drive further upside to earnings estimates this year, and we could see another public company acquired in this consolidation trend, which could further boost investor excitement about the group.

Bill Loomis is a managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.com. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. For additional information and current disclosures for the companies discussed herein, please write to: Legg Mason Wood Walker, Inc., 100 Light St., P.O. Box 1476, Baltimore, MD 21203, Attn: Research Department.

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