Keeping an eye on returns in a sluggish market

Merger and acquisitionactivity in the federal informationtechnology and government servicesmarkets has been strong for fiveyears, coinciding with federal spendingincreases exceeding longer-termnorms. Annual earnings growth formany companies has been 15 percentto 20 percent ? and often higher.The earnings growth outlook hasrecently moderated, and the visibilityof future revenues has diminished.Among the factors contributing tothis are slowing growth in governmentspending, an increasing proportionof services work flowing throughtask orders and diminished opportunitiesfor operating-marginimprovement.New small-businessrecertification requirementsalso are addingadventure to forecastingthe future. These factorshave contributed to a decline in public-market pricing multiples, and littleoverall gain in stock values since2004.Accordingly, owners and public-marketinvestors are re-evaluatingstrategies in search of the best path togrowing shareholder value. Companieshave come up with multiple ways toenergize shareholder returns, andwhile M&A continues to provide thepotential for enhanced returns, thereare risks that the business combinationwill perform below expectations.Solid-performing companies arepersistently deleveraging their balancesheets by generating cash flow inexcess of their organic needs. A reviewof the 11 public federal IT companies(10 U.S.-based companies and UnitedKingdom-based QinetiQ Group PLC)provides evidence of pricing, performanceand capital structure. Thesecompanies have an aggregate equityvalue of nearly $16 billion. As of Dec.31, their cash exceeded their interestbearingdebt by more than $1.5 billion,and they are adding about $800million per year to their excess liquidity.Without action to deploy thisexcess liquidity, a company's return oninvested capital will decline, and itsstock price may languish.Generally, there are two capitaldeployment strategies that can add toshareholder value ? a low-risk pathand a higher-risk, higher-return path.Paying attractive dividends or institutingan aggressive stock buybackprogram can improve shareholderreturns, while maintaining amplecapital for organic growth and moderate-sized acquisitions. Alternatively,a sound acquisition program candeploy both excess liquidity and comfortablebalance sheet leverage toamplify shareholder returns, albeitwith higher risk.For analysis purposes, we used afive-year operating period. Our hypotheticalcompany is achieving 10 percentannual organic growth ? generating10 percent earnings beforeinterest, taxes, depreciation andamortization. It requires normalworking capital support and customarycapital expenditure levels. Thecompany has no interest-bearingdebt. At a 10 percent revenue growthrate and stable margins, this businesswill produce an internal rate ofreturn to shareholders of about 11.5percent in a five-year period.With no change in the operatingplan, the company could distributedividends or institute a share buybackprogram. These two alternativesproduce similar shareholderreturns. A buyback program usinghalf the annual free-cash flowincreases the shareholder internalrate of return to 13.2 percent. Usingall of the annual free-cash flow tobuy back stock drives the shareholderinternal rate of return to 14.7percent, a 3.2 percent annualimprovement. Essentially, theseprograms are right-sizing theequity capital to fit the businessneeds, preventing returns oncapital from declining.A sound acquisition program hasthe potential to enhance shareholderreturns even more significantly. Ofcourse, the process of finding theright target companies and negotiatinga deal is not without added risk.The acquisition program used forcomparison assumed one annualacquisition, priced at the buyer'smultiples. The target companies'growth rates and margins were identicalto the buyer's, and the acquisitionswere financed with senior debt.No synergies were factored into theresults. Assuming a sale at the end offive years, this approach produces ashareholder internal rate of return ofnearly 20 percent, suggesting thatexcess returns are possible for thegreater risk involved.