MARKET WATCH

By Jerry GrossmanThe fundamental strengths and investment appeal of government information technology and defense technology companies ? the government technology sector ? has begun to emerge within the context of the dismal overall market psychology that began to take hold in April 2000. While the dramatic fall in technology stock prices and significant declines in most indices have been well publicized, the sea change in the debt market and commercial lending perspective has been less apparent to many businesses and investors. For industry companies actively involved in mergers and acquisitions and other shareholder liquidity transactions, the fallout from credit market tightening is abundantly clear. Capital has become more difficult to raise and somewhat more expensive. The most significant change during 2000 has been the thinking of lenders and investors, which has swung from ebullient to skeptical. Other industry and market factors should be more positive in 2001, providing the context for solid operating performance in the government technology sector.The significant factors affecting performance, public market valuation and private sale transactions include company-specific, industry and capital markets elements. The dominant issue for many information technology companies has been human resource shortages. The demise of the dot-coms will relieve some of the competitive pressure in this area, as many recent tech startups exhaust their cash resources and cut back or discontinue operations. Technology workers in many of those companies that survive will hold stock options that are under water and of little economic value. The relative stability of government technology sector companies will become more attractive for many of these workers. Another company issue is the necessary migration to product and service focus, enhanced marketing and selling skills and better contract profitability structures. The evidence is clear that many companies are on this path and, accordingly, are growing both revenues and margins impressively, turbo-charging value growth. Important industry factors include government supply chain rationalization (contract bundling), functional outsourcing, procurement trending toward flexible contract vehicles and heavy weighting of past performance. The outlook in the defense arena will improve as annual expenditures for procurement and operations and maintenance continue the upward trend that began in 1998. Overall, this is a positive environment for smaller, focused contractors with substantial domain expertise and a solution orientation. The environment also benefits large, tier-one prime contractors with strong project management capability, financial strength and diverse technical and functional experience.Capital markets trends have been generally negative over the past year. The exceptions have been stocks in the defense and aerospace element of the government technology sector, which have risen over 30 percent this year. Government IT stocks have declined a relatively modest 10 percent to 15 percent this year, while electronic government companies have been dramatically re-priced downward by 60 percent to 90 percent. The debt capital markets have become highly selective and, particularly in the high yield segment, less liquid and more expensive. The spread between Treasury securities and high yield corporate issues has expanded dramatically. (See chart.) In September, the Office of the Controller of the Currency adopted a more aggressive stance in downgrading cash-flow-based loans in bank portfolios. In response to this increased regulatory caution, bank credit departments have tightened lending criteria significantly. In the mezzanine markets, the typical yield range has broadened from 18 percent to 22 percent to a wider range of 15 percent to 30 percent. This reflects the expansion of mezzanine capital to fill a void in the senior debt component as well as in the equity tranche.This evidence confirms that the cost of capital for aerospace and defense companies has remained about constant, while the cost of capital for government IT companies has risen by more than 25 percent. Overall, the purchasing power in the government technology sector has declined, suggesting that many transactions in 2001 will close at pricing multiples more in line with long-term historical norms.