Market Share: Acquisitions can push down federal IT stock prices

Bill Loomis

In a bit of a switch, commercial information technology stocks have outperformed federal IT stocks over the past couple months. Is this the rotation out of federal stocks and into commercial that many federal IT investors have been fearing as commercial business picks up?

While there may be a little rotation, it is more the timing of a number of factors among the federal companies, including subpoenas issued to three federal IT companies to investigate procurement practices on an Air Force contract, an unrelated subpoena to another federal IT company, insider selling and a lack of upward guidance revisions following generally strong third-quarter earnings reports.

Before the recent decline, investors were concerned that valuations in the federal IT group are at historically high levels and that further valuation expansion from price-to-earnings ratios of 25 to 30 times forward earnings per share is unlikely. Increased insider selling at most of the publicly traded federal IT companies has not helped this concern.

While I generally agree with these thoughts, there are some exceptions for companies that have above-average growth or profitability.

Also, these price-to-earnings ratios usually do not include the accretive impact of acquisitions, which investors need to consider. Acquisitions can be quite accretive, making the seemingly high price-to-earnings ratios look attractive when acquisitions are included in earnings estimates.

While it can be difficult to predict the size, profitability, cost and timing of an acquisition, reasonable assumptions can be based on the company's track record and capability to do acquisitions, particularly financial capability.

However, this initial accretion to earnings per share does not necessarily add value to the stock if the company overpaid for the acquisition, driving down the company's overall return on invested capital, or ROIC. Financial theory says that it is the spread between the ROIC and cost of capital, along with growth and risk, that determines a business' value. Therefore, the lower the spread as the ROIC drops because of overpaying for acquisitions, the lower the value, all else being equal.

The market will adjust for overpayment by giving the company a lower price-to-earnings multiple on the higher earnings, leading to little or no increase in overall enterprise value and stock price.

Most companies would not be able to make a reasonably sized acquisition at a price that would result in no initial reduction in ROIC. However, as the company accelerates growth or finds cost synergies or boosts free cash flow through better working capital management, it can accelerate the return dramatically.

It is difficult for outside investors and analysts to estimate the return from an acquisition over the next couple of years. Benefits may result from an acquisition -- such as accelerated revenue growth, potential profit margin expansion from cost savings or lower risk because of increased diversification of contracts and customers -- that are not readily apparent, yet still add value.

Acquisitions definitely make companies more difficult to analyze and value, but we believe investors, particularly in a consolidating yet growing industry such as the federal IT space, need to consider acquisitions when valuing these stocks. And they need to look at more than just earnings-per-share accretion.

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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