Keeping an eye on returns in a sluggish market

Market Watch | Financial views of a competitive environment

"Owners and public-market investors are re-evaluating strategies in search of the best path to growing shareholder value." Jerry Grossman

Merger and acquisition
activity in the federal information
technology and government services
markets has been strong for five
years, coinciding with federal spending
increases exceeding longer-term
norms. Annual earnings growth for
many companies has been 15 percent
to 20 percent ? and often higher.

The earnings growth outlook has
recently moderated, and the visibility
of future revenues has diminished.
Among the factors contributing to
this are slowing growth in government
spending, an increasing proportion
of services work flowing through
task orders and diminished opportunities
for operating-margin
improvement.

New small-business
recertification requirements
also are adding
adventure to forecasting
the future. These factors
have contributed to a decline in public-
market pricing multiples, and little
overall gain in stock values since
2004.

Accordingly, owners and public-market
investors are re-evaluating
strategies in search of the best path to
growing shareholder value. Companies
have come up with multiple ways to
energize shareholder returns, and
while M&A continues to provide the
potential for enhanced returns, there
are risks that the business combination
will perform below expectations.

Solid-performing companies are
persistently deleveraging their balance
sheets by generating cash flow in
excess of their organic needs. A review
of the 11 public federal IT companies
(10 U.S.-based companies and United
Kingdom-based QinetiQ Group PLC)
provides evidence of pricing, performance
and capital structure. These
companies have an aggregate equity
value of nearly $16 billion. As of Dec.
31, their cash exceeded their interestbearing
debt by more than $1.5 billion,
and they are adding about $800
million per year to their excess liquidity.
Without action to deploy this
excess liquidity, a company's return on
invested capital will decline, and its
stock price may languish.

Generally, there are two capital
deployment strategies that can add to
shareholder value ? a low-risk path
and a higher-risk, higher-return path.
Paying attractive dividends or instituting
an aggressive stock buyback
program can improve shareholder
returns, while maintaining ample
capital for organic growth and moderate-
sized acquisitions. Alternatively,
a sound acquisition program can
deploy both excess liquidity and comfortable
balance sheet leverage to
amplify shareholder returns, albeit
with higher risk.

For analysis purposes, we used a
five-year operating period. Our hypothetical
company is achieving 10 percent
annual organic growth ? generating
10 percent earnings before
interest, taxes, depreciation and
amortization. It requires normal
working capital support and customary
capital expenditure levels. The
company has no interest-bearing
debt. At a 10 percent revenue growth
rate and stable margins, this business
will produce an internal rate of
return to shareholders of about 11.5
percent in a five-year period.

With no change in the operating
plan, the company could distribute
dividends or institute a share buyback
program. These two alternatives
produce similar shareholder
returns. A buyback program using
half the annual free-cash flow
increases the shareholder internal
rate of return to 13.2 percent. Using
all of the annual free-cash flow to
buy back stock drives the shareholder
internal rate of return to 14.7
percent, a 3.2 percent annual
improvement. Essentially, these
programs are right-sizing the
equity capital to fit the business
needs, preventing returns on
capital from declining.

A sound acquisition program has
the potential to enhance shareholder
returns even more significantly. Of
course, the process of finding the
right target companies and negotiating
a deal is not without added risk.
The acquisition program used for
comparison assumed one annual
acquisition, priced at the buyer's
multiples. The target companies'
growth rates and margins were identical
to the buyer's, and the acquisitions
were financed with senior debt.
No synergies were factored into the
results. Assuming a sale at the end of
five years, this approach produces a
shareholder internal rate of return of
nearly 20 percent, suggesting that
excess returns are possible for the
greater risk involved.

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

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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