Jerry Grossman | To win in federal services, look forward

Market Watch | Financial views of a competitive environment

Jerry Grossman

Many industry analysts and investors have expressed concern about the outlook for federal services companies. They seem to believe that the industry's best years are in the rearview mirror.

Stock prices and pricing multiples (i.e., price/earnings ratios) for many public federal information technology companies have stagnated or lost ground in the past few years. Businesses with a major focus on defense and intelligence agencies are often perceived as higher risks than those with more diversified federal portfolios.

External factors, many of which are difficult to predict, swirl around the business. Those factors include political uncertainty, federal deficits, congressional intervention, slow budget growth and volatile capital markets.
At such times, it is important to step back and revisit industry fundamentals to better gauge investment risk and market opportunity. Despite the many variables, the federal services sector continues to offer stability, visibility and growth potential.

It is important to consider investment choices more carefully ? and be more discriminating about them ? in times such as these.

Without question, the growth rate of federal outlays for IT and professional services has slowed to a single-digit rate, down from
double-digit levels a few years ago. However, it is important to remember that this rate of budget growth is in line with longer-term norms.

On the industry side, compound annual growth rates for revenues and pretax cash flows have diminished. From 2003 to 2005, industry revenues grew at a 25 percent compound annual rate, while cash flows grew at a 30 percent rate. A margin expansion of 50 basis points for earnings before interest, taxes, depreciation and amortization (EBITDA) drove the higher growth rate for cash flows.

From 2005 to 2007, compound annual growth rates for revenues and cash flows declined to about 10 percent. Meanwhile, EBITDA margins have remained steady. The current outlook for 2007 to 2009 assumes growth rates in revenues and cash flows of about 10 percent. Public market pricing multiples have declined due to slowing growth and the increasing complexity of external factors.

Annual double-digit growth in federal budget outlays is not normal or sustainable, nor is it necessary to sustain the investment appeal of federal contractors.

However, it is important to consider investment choices more carefully ? and be more discriminating about them ? in times such as these. The stronger companies will outperform the industry average, position themselves better and grow faster.

Achieving those goals will require an effective corporate development capability to position the business in line with customer priorities. Mergers and acquisitions will continue to be important components of business building. For example, take the expectation that pure-play public federal IT companies will generate earnings growth at twice the rate of budget growth.

The value of many federal contractors grows faster than federal outlays, primarily due to strong cash flows. Companies that perform well generate $5 of free cash flow for every $100 of revenue. Accordingly, a federal services contractor that grows at 5 percent annually, in line with federal outlays, can produce a compound annual growth rate in value of about 12 percent, organically. That annual return is attractive when compared with broad stock market indices and diversified portfolio performance. A successful M&A program could add another 3 percent to 5 percent to annual growth in value.

Given the persistence of national security priorities and the specifics of budget submissions, it seems premature to discount companies with a strong concentration in defense and intelligence. Although changes in congressional and presidential leadership have implications, the lion's share of government expenditures and programs will continue.

Seasoned companies have demonstrated their ability to adjust.

Turbulence in the capital markets, particularly the debt component, should not be an impediment to industry financing. The industry has a solid capital base and plenty of borrowing power to support transaction financing. The overall industry outlook still looks fine from here.

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

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