The safe haven in an economic storm

Market Watch | Financial views of a competitive environment

Recent turmoil in debt and equity
markets highlights the contrast
between federally oriented
businesses and companies serving
private-sector customers. It reminds
us of the attractive, fundamental characteristics
of the government services
industry: stability, visibility, predictable
cash flows and modest capital
requirements. These attributes flow
from the environment created by the
government. Growing procurement
budgets, clear acquisition rules, predictable
contract structures and full
public disclosure create a business
environment and an investment arena
that is sheltered from many elements
of private-sector markets.

In the federal mergers and acquisitions
arena, strategic buyers continue to
pursue transactions, and they have plenty
of capacity to fund them. Financial
buyers, however, are confronted with the
extremely cautious posture of capital
sources, which is driving up the cost of
capital while slowing down the due diligence
and approval processes. Both the
continuing interest rate on debt and
front-end fees have risen materially. In
some instances, the effective cost of debt
has doubled during the past few
months, while lenders' terms have significantly
tightened. In the near term,
some slowing in M&A activity is likely
pending a sense of equilibrium in financial
markets and knowledge of election
outcomes.

What is clear in this extraordinary
environment is the flight to safety
exhibited by most investors. The relative
stability of the market values of
most federal information technology
companies becomes clear through a
comparison of those companies with
broad market indexes. In the one-year
period that ended Oct. 9, the Dow
Jones Industrial Average declined 35
percent, the Nasdaq Composite 38 percent,
and the S&P 500 37 percent.

During this same one-year period, the
average change in stock price for 10
public federal IT companies was a
decline of about 7 percent.

Whether their stocks are up or down,
these federal businesses have the balance
sheet strength and predictable cash
flows to pursue double-digit revenue
and profit growth in this environment.

In times like these, cash is king.
Opportunities are greatest for those
businesses with dry powder ? that is,
cash or unused borrowing capacity
under revolving lines of credit to use for
corporate development purposes or
shareholder dividends.

Alternatively, there are concerns within
the sector. For example, there is
increased uncertainty about the federal
spending outlook beyond 2009, the
outcome of the election and the economic
effects, including fiscal policy, of
expensive and illiquid credit markets.

Federal spending shows no signs of
actually declining anytime soon. It is
possible that the costs of the rescue
programs will force some reductions in
agency budgets, but many priorities,
with strong political support, will be
funded.

The election outcome, notwithstanding
the differences in philosophies
between the parties, will not affect
spending priorities until fiscal 2010.
The credit crunch should begin to ease
in a matter of months, although lending
criteria are likely to remain more
conservative for considerably longer.

For most strategic buyers in the federal
market, these conditions do not present
an impediment to their acquisition
programs and will strengthen their
pricing advantage over the financial
buyers in most auctions.

Federal IT markets remain a solid
place to be for investors in public and
private companies. Clearly, changes
will occur, but the leading companies
in this sector tend to adjust and position
themselves to grow their businesses
and deliver value to shareholders.

Jerry Grossman (jgrossman@hlhz.com) is
managing director at Houlihan Lokey
Howard and Zukin.

About the Author

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

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