Market Watch: Expect strong 2004, but 2003's gains will be hard to beat

Last year was very successful for the government IT and defense services industry. On the demand side, budgets saw significant increases, particularly in national defense, domestic security and intelligence. Much of this money has yet to be spent.Investors of all stripes reacted favorably to more government spending. Industry performance for most companies reflected the good-news environment, delivering revenue growth, margin improvement and increased market value.Mergers and acquisitions continued at a robust pace. Stock markets stayed receptive to initial public offerings and secondary stock offerings in the federal IT segment.An obvious question is: Will these favorable trends and conditions continue in the new year? Circumstances point toward a solid 2004, building on positive trends begun in 2002.Projected outlays of more than $400 billion in fiscal 2005 for defense are very close to the 2003 and 2004 levels. A more robust economy, producing increasing tax revenue, should improve the deficit picture. Threats to deficit reduction include expansion of Iraq-related spending and growth in other expenditures because of election-year congressional spending beyond expectations.Investor interest in the government market remains strong. In 2003, the 11 pure-play federal IT companies trading in the public market achieved revenue gains of 18 percent and improved profit margins of 16 percent, together driving value growth of 35 percent. These gains may be difficult to repeat. While revenue growth near 20 percent is possible, margin improvement is likely to be more modest than the 2003 pace. Threats to public company performance and pricing include: extended operations in Iraq driving down modernization spending, an industry accounting scandal or disappointing results from new public companies.Mergers and acquisitions likely will continue at a strong pace in line with the levels of the past four years, more than 50 deals per year. In 2003, the Veridian Corp. and Titan Corp. transactions transferred about $3 billion in revenue from public shareholders to General Dynamics Corp. and Lockheed Martin Corp., respectively. Another 13 transactions were announced in the government services sector, with values between $25 million and $500 million, changing control over approximately $1.2 billion in aggregate revenue. As in 2003, companies with distinguished technologies or customer depth in priority markets will command premium valuations while providing the buyers with strategic positions. Many of these companies have long participation in the Small Business Innovation Research program, demonstrating successful technology application to Defense Department priorities. Good examples are products aimed at network-centric warfare and command, control, communications, computers, intelligence, surveillance and reconnaissance applications using software-augmented, commercial components. Public markets show no signs of turning away from the government services sector. However, forward-pricing relationships have declined about 10 percent compared to year-end 2002. Today's market values, divided by the projected earnings and cash flows for the next fiscal year, are down slightly. Giving effect to this decline, price and performance multiples are still in the upper end of longer-term norms. In addition, debt capital markets have improved, and private equity investors have shown significant interest in the government services sector.Considering these factors, public companies and well-managed and financed private firms in the industry seem poised to continue growth of revenue and value in 2004. Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.