MARKET WATCH

Over the past few years, many industry executives and shareholders, as well as government officials, have expressed concern about the increasing risk faced by smaller government information technology companies in the evolving federal procurement environment.Supply chain rationalization (contract bundling) by the government has increased and shows no signs of abating. However, in the face of this trend, there is clear evidence that many tier 3 government IT companies ? those with revenue under $100 million ? are doing very well: that is, not just surviving, but achieving rapid growth and increasing profit margins.While this "private company peer group" is very small (12 companies) and not randomly selected, the companies included perform a wide variety of IT and technical services functions for predominantly government customers. Most of these businesses were formed before 1990 and have seasoned management teams.This private group was compared with a publicly traded group (24 companies) having a similar focus on government markets, providing mostly services, with the exception of four companies that have significant aerospace and defense manufacturing segments. The median revenue level of the public group is about $600 million with a size range of $40 million to $16 billion. Performance measures for this group were reviewed during the past four quarters.Most of the public companies in this group have made at least one acquisition during the past four years, with several of them having completed many deals. Accordingly, the publicly owned companies have significantly greater invested capital (equity plus interest-bearing debt) than the private group. Invested capital for the public group is about 46 percent of revenue, compared to only about 19 percent of revenue for the private peer group.This differential is roughly equal to the level of intangible assets carried by the public companies, deriving from their many acquisitions at prices well above net asset value. Intangible assets as a percentage of revenue for the public group is 20 percent to 25 percent of revenue. After adjusting for these intangibles, the tangible invested capital level is 21 percent to 26 percent of revenue, very similar to the private company level. The tangible book value median for the public group is about 11 percent, slightly above the norm of 10 percent for the private group.The financial structure and performance charts present comparisons of the public and private industry peer groups. The private companies reflect competitive performance metrics relative to their much larger public competitors. Net working capital levels are very similar, while the fixed assets and intangibles (goodwill) are quite different. These differences reflect the aggressive acquisition pace of the public companies and their greater levels of investment in fixed assets, influenced in part by product building activities.Examining return on tangible invested capital is the most accurate measure of comparison between the public and private groups. Net income return on equity is much less meaningful because of the depressing impact of purchased goodwill or amortization on earnings. Completing this calculation using tangible equity in the denominator produces a net income return on tangible equity of about 30 percent, slightly above the longer term average for the private group.The performance metrics comparison reflects higher profitability as return on sales for the public group, but much higher one-year growth for the private group. This high-performance private group is not the norm for all private companies in terms of revenue growth. However, these rates demonstrate that tier 3 private companies can grow at double-digit rates, significantly above the overall market and well above most of their public competitors. The average annual growth rate for the public group during the past five years was about 12 percent, compared to 20 percent for the private peers.Most of the companies in the private peer group are focused either as to customer set and market or in terms of their function and domain expertise. It would be sensible to conclude from these comparisons that the government markets continue to provide tremendous opportunity for smaller, focused companies to grow their businesses profitably, and increase stockholder value at 20 percent annual rates or higher. In the more turbulent markets of the past year, the government sector looks attractive, both in terms of its own performance as well as relative to other industry sectors.