Market Watch

It's been a great ride over the past year for investors in the government information technology and defense services industry. Most pricing indexes are up 40 percent to 50 percent or more since February 2001.While very few seasoned industry executives, investors or analysts would characterize the industry as explosive, the dramatic increase in stock market valuations in the government technical services sector gives rise to the question: Is there a rational basis for these pricing levels? With some exceptions, the answer is yes.There are three components of market pricing to understand: industry performance, projected growth in industry revenues and earnings, and the relative investment appeal of the sector. All three are positive.Industry performance is trending up. Double-digit growth has been common among public companies, with profit margins steady to expanding. Better balance sheet management has helped improve leverage ratios. The industry outlook is bullish as government budget increases provide optimism about prospects for higher earnings growth rates.Because the actual outlays anticipated by budget changes haven't been targeted to specific companies or contracts, the actual impact upon individual company performance is not yet evident. Consequently, stock prices have risen without increases in underlying earnings, producing an expansion of price to earnings multiples. For some publicly traded, government technical services companies, the median price-to-earnings multiple is about 25 times, or about 20 percent, above the 1999 to 2001 average. The enterprise value to earnings before interest, tax, depreciation and amortization multiple is nearly 25 percent above its three-year average.As companies receive increased revenue from contract expansion, higher earnings will put downward pressure on the earnings multiples.Another factor contributing to robust stock prices is the strength of the government market compared to other sectors experiencing downward performance and cloudy expectations. Both individual and institutional investors have migrated to government services and defense.Notwithstanding these factors, the question remains whether the industry can grow its earnings and cash flows rapidly enough to justify pricing. To answer this, let's examine the organic growth picture as well as the growth-by-acquisition strategy.Organic growth is based upon the business environment, including opportunities for strong management teams to increase earnings, exclusive of acquisitions. There are three fundamental sources for organic earnings expansion: ? Market growth, comprised of budget-based growth, generally in the range of 4 percent to 8 percent; and growth due to government outsourcing, estimated in the 3 percent to 5 percent range; ? Capital structure management ? judicious use of debt or stock buyback programs ? 3 percent to 5 percent potential;? Margin improvement, from 0 percent to 2 percent growth potential.These earnings growth opportunities suggest that well-run, aggressive companies can grow earnings per share, organically, by a 10 percent to 20 percent compounded annual rate.Alternatively, when a public company adds revenue equal to 20 percent of its existing base each year, it can produce growth in value per share of 15 percent to 20 percent or more. Two factors driving this outcome are modest post-deal synergies of 1 percent of target company sales, and an expansion of the earnings multiple of 15 percent to 30 percent, from the transaction multiple paid to the post-deal public market level.Some combination of organic growth and acquisition-induced growth can produce compounded annual earnings growth of 20 percent or more, supporting earnings and cash-flow multiples at or near the current levels. If this assessment is rational, then the current pricing ? for good companies ? is not reckless.