MARKET WATCH

The evidence is compelling that commercial and government technology markets will continue to converge, creating significant opportunities and predictable risks for public-sector technology providers.Competitors in government IT and defense technology markets must focus on this and the underlying factors driving it in order to properly position their companies for revenue growth, profitability and shareholder value acceleration. As investors in both public and private markets gain greater understanding of these trends and factors, government market companies should receive stronger support ? higher stock values.The simplest way to think of these trends is to recall the actions of major domestic and international corporations in the early to mid-1990s. These companies were reacting to market factors, among them: the deregulation of several industries; dramatically reduced pricing power; expensive hierarchical organization structures with large embedded fixed costs; rapid technological changes; increased staff turnover. The companies' reactions were to re-engineer processes; deploy technology more effectively, especially off-the-shelf software; reduce layers; outsource noncritical functions; and rationalize supply chains. These are just the things that governments are doing. The mindset of government executives is evolving to where business arrangements with vendors are less cumbersome and closer to customary commercial practices. These trends are evident in the tremendous growth in General Services Administration schedule use; multiple-award, indefinite delivery, indefinite quantity contracts; and consideration of past performance in contractor selection.Procurement officials have recognized government is not usually a unique environment requiring customized products and services, but an entity whose functional requirements substantially mirror the private sector. Off-the-shelf products and professional services will work well. Most vendors delivering such products and services prefer to have simplified procurement rules and processes. When these are used, more qualified vendors will participate.The Defense Department and federal intelligence agencies have adapted their procurement and contracting arrangements to take advantage of private-sector technology and know how. These agencies know the wealth of these products and encourage their vendors to use off-the-shelf components. Using these components has three distinct advantages: lower cost, shorter new system cycle times and more rapid infusion of cutting-edge technology into defense and intelligence systems.The goal of public-sector entities to buy and integrate the latest technology into procured systems and services paired with the idea of supply chain rationalization has created opportunities, as well as anxiety.There is opportunity for larger contractors to expand market share as government bundles contracts to simplify its supply chain. Strategic acquisitions can build critical mass and skill sets to further enhance competitiveness on large procurements. Smaller contractors are anxious about these trends. They have three strategic alternatives: sell the company, narrow the focus and build depth to provide differentiation for smaller projects and greater appeal as a subcontractor, or diversify market orientation.For defense and aerospace companies, these trends have had additional significance, specifically an increase in the frequency of cross-border mergers and acquisitions. During the 1998 to 2000 period, more than 40 percent of the largest industry transactions involved non-U.S. companies. In most of these deals, the buyers were European companies and the sellers were based in the United States.U.S. government officials have accommodated these deals, in part because they recognize a broader implication of integrating more commercial technology into weapons platforms and systems. That is, many of the commercial technology companies that develop and sell cutting-edge technology are foreign-based, foreign-owned or multinational in scope. Accordingly, where feasible within the context of national security, dealing with non-U.S. owned vendors is consistent with procurement goals.These trends plus the anticipated upturn in domestic defense spending should provide the basis for improving performance of public defense and aerospace companies and their stocks. The pricing and performance information for our public peer group does not yet reflect improved expectations. The ratios of enterprise value to revenue and assets reflect very consistent patterns over the past four years. Price to earnings ratios, however, reflect declines from 1997 to 1999, with a rebound in 2000. The trailing 12 months price to earnings ratio is 13.5x, while the projected (next 12 months) multiple is 11.0x. Enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization) multiples had fallen to 5.9x in 1999, from 8.1x in 1997, before rebounding to 6.7x in 2000. EBITDA margin trends were opposite from pricing, reaching a high point of 14.4 percent in 1999.Defense and aerospace mergers and acquisitions reflect the industry consolidation and increased cross-border activity. The Mergerstat transaction data shows a steadily increasing number of deals and a ratio of aggregate consideration paid to target revenue in a range of 90 percent to 95 percent. Mergers and acquisitions pricing very closely mirrors stock market valuations of peer group companies. In general, this suggests that transactions must provide synergistic benefits, including cost savings to be accretive to shareholders on the buy-side.Many of the these trends provide increased opportunities for public-sector companies in technology segments, both in terms of performance and pricing.