Market Share: General Dynamics-Veridian deal turns spotlight back on fed IT

The consolidation trend is alive and well in the federal information technology industry. General Dynamics Corp.'s agreement to acquire Veridian Corp. for $35 per share in cash, or $1.5 billion including debt, certainly got the attention of industry, as well as investors. The cash deal is a premium of 28 percent to Veridian shares' pre-deal close of $27.35, and represents a 28-times multiple of 2003 consensus earnings-per-share estimates of $1.26, and a 23-times multiple of 2004 consensus EPS estimates of $1.50. These multiples are higher than any other publicly traded federal IT company, and compare to the group average multiples at the time of 20.3-times for 2003 and 17.4-times for 2004. The valuation General Dynamics is paying is higher than I would expect, particularly given it is all cash. The valuation suggests General Dynamics expects Veridian to significantly exceed the consensus earnings estimates, which General Dynamics indicated in its press release. It expects Veridian to post $1.4 billion in revenue in 2004, vs. the current consensus estimate of $1.3 billion. In calculating our estimate of an internal rate of return for the acquisition, I get a range of 6 percent to 13 percent, assuming a 5 percent free cash flow yield on revenue, and revenue estimates after 2004, ranging from 8 percent growth to 15 percent growth. Unless General Dynamics is willing to accept relatively low returns due to the current low interest rate environment, it probably anticipates much better results from Veridian than investors expected, perhaps through overhead synergies or more efficient operations. This acquisition is certainly not the start of a trend; consolidation has been going on in the federal sector for decades, and will likely continue. Much of the consolidation has been by defense and aerospace companies, similar to General Dynamics.In fact, Veridian itself was grown primarily through a series of acquisitions in 1998 and 1999, and made a large acquisition last year, buying Signal Corp. There have been several examples of publicly traded federal IT companies being acquired over the past several years, such as Computer Data Systems, bought by Affiliated Computer Services Inc. in 1997; BDM, bought by TRW Inc. in 1998; Analysis & Technology, bought by Anteon International Corp. in 1999; Nichols Research, bought by Computer Sciences Corp. in 1999; Advanced Communication Systems and BTG, both bought by Titan Corp. in 2000 and 2001, respectively; and GRC, bought by AT&T Corp. in 2000. I would expect to see some existing federal IT companies acquired over the next few years, as well as the occasional initial public offering. One positive effect of the Veridian acquisition is that it refocused investors' attention on the sector. For the first five months of this year, investors seemed to be rotating out of the federal IT stocks and into commercial technology companies, trying to play an economic rebound.However, the combination of continued lackluster economic news and commercial IT spending, and attractive valuation of the Veridian acquisition, has resulted in renewed interest in the sector, with some federal IT stocks approaching or hitting new all-time highs.Time will tell whether General Dynamics' move will push other large companies into accelerating their acquisition plans. Bill Loomis is a managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.com. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. For additional information and current disclosures for the companies discussed herein, please write to: Legg Mason Wood Walker Inc., 100 Light St., P.O. Box 1476, Baltimore, MD 21203, Attn: Research Department.