MARKET WATCH

By Jerry GrossmanIndustry executives and shareholders have been thinking a lot more about the implications of recent capital market trends on their business strategies, particularly their use of acquisitions and divestitures to achieve top-line growth, business focus and critical mass.These growth-acceleration and portfolio-shaping activities will continue to be essential elements in the corporate strategies of technology businesses in public-sector markets. The major market factors that impact government information technology and defense technology companies ? customers, contracts, human resources and technology ? are substantially unchanged from the first quarter of 2000. However, the increasingly dramatic changes in the capital markets have implications for strategies going forward.As usual, the trends unfolding have positive and negative implications. Our view is that, on balance, the "reconnection" of stock market pricing to traditional business performance fundamentals is positive for government IT and defense technology companies.We refer to this industry group as the government technology sector, or GTS. The following are some observations about the impact of current market trends.The relative appeal of GTS companies is on the rise. Well-managed GTS companies fit very well into the traditional value themes that are re-emerging among investors.These companies demonstrate: ? revenue and earnings visibility;? substantive backlog of contracts and other business;? an increasingly healthy customer (U.S. government producing substantial budget surpluses);? modest working capital and capital expenditure requirements;? consistently positive cash flow from operations.The icing on the cake is the vast store of high-end technology invented and deployed by GTS companies. As these attributes become increasingly clear, we would expect increased investor interest in the GTS industry group.Government supply chain rationalization is continuing, as evidenced by very large, bundled procurements. Recent examples include the Navy-Marine Corps Intranet contract and the information assurance procurement being administered by the Defense Information Systems Agency, called I Assure. Multibillion-dollar bundled procurements such as these have generated anxiety among small to mid-sized contractors. These tier two and tier three companies must strengthen their relationships with partners and primes further up the chain, as well as with government customers. The logical path to strengthened relationships for tier two and three companies is through distinguishable performance. The typical basis for distinguished performance is through subject matter expertise and depth of knowledge (domain expertise). These sources of intellectual value provide competitive advantages at both the procurement and marketing phase as well as in contract execution.Large, tier one primes need subcontractors with depth of knowledge and focus as team members. The government retains its goals relative to supporting small business and ensuring their continuing participation in government contracting and outsourcing.Accordingly, we expect well-managed, small to mid-sized companies to have ample opportunities for success in this environment. While GTS stocks are down from their Dec. 31, 1999, levels, their decline has been much less dramatic than other technology sectors, including e-business, commercial IT and e-government. These indices have dropped by 43 percent, 44 percent and 87 percent, respectively, during the first nine months of this year, compared to a 3 percent decline in the GTS sector. Within the GTS sector, there are contrary results from the two segments: government IT and defense and aerospace technology. Price-weighted indices have declined by 32 percent in the government IT segment and risen by 51 percent in the defense and aerospace technology segment. Naturally, these declining prices have reduced the buying power of public government IT acquirers by hundreds of billions of dollars. For public defense and aerospace acquirers, buyer power has increased this year. The tier one companies in this segment, notably Northrop Grumman's Logicon unit, have been active buyers in the government IT segment.For cash acquisitions, the sources of debt capital have become more discriminating and more expensive. In addition, the public markets are not particularly receptive to secondary offerings as a means to raise cash for acquisitions.Our expectation in the context of these events is for somewhat fewer GTS deals in 2001, with some downward pressure on acquisition prices. Giving effect to this anticipated slowdown and pricing adjustment, merger and acquisition activity in the government technology sector still will continue at levels above longer term historical norms.