Market Watch: How to judge the value of federal IT companies

Do market valuations of federal information technology companies accurately reflect risks and opportunities?Obviously, if we knew the answer to this question, we would be formulating plans to spend our stock market profits. Asking whether individual stocks, industry indices or other market composites correctly reflect risks, prospective returns and growth possibilities is what analysts do daily.However, with most pure-play federal IT stocks trading at 10 percent to 15 percent below their pricing peaks from fourth quarter 2003, this question arises again among investors, as well as executives and shareholders in privately held businesses.Publicly traded federal companies and large aerospace defense primes have been among the most active buyers of middle market government services companies. Accordingly, the public valuations of these buyers will affect the pace and pricing of acquisitions in the federal IT arena.So what are the characteristics and trends shaping the market valuations of federal IT companies? Long-term market demand for the government services industry is expected to grow in the single digits. Earnings are growing because the government is outsourcing more work and infusing more technology into programs and processes. The sector also has high levels of revenue and earnings visibility, and companies in this sector generate strong cash flow.The single-digit growth rate of overall government procurement must be viewed in light of the extremely low level of inflation built into these future dollar outlays. Using the three-month London Inter-Bank Offered Rate as a proxy for inflation levels, it is noteworthy that the current rate of about 1.1 percent is one-half the level of two years ago, and less than one-fifth the level of three years ago. Therefore, in terms of "real returns," a 10 percent growth rate as of March 2001 is roughly equal to a 6 percent growth rate today. The difference is simply reflective of much lower inflation. The single-digit overall spending growth rate gets higher for many government services companies because of their significant involvement in technology implementation. For contractors serving defense and intelligence agencies, the technology deployment could align with transformation, network-centric warfare and other system modernization.Throughout government, both defense and civilian elements, implementing better technology is a continuing process, not a periodic event.The expanding goals for federal outsourcing are another factor producing growth potential beyond the rate of increase in spending. Outsourcing requirements are fueled by both policy initiatives and shrinking ranks of government employees managing procurement activities and complex programs. Add to all of this the initiatives related to homeland security, and the picture may suggest double-digit annual spending growth in priority areas.The predictably strong cash flow of federal IT businesses, relative to many other industry sectors, is another attribute we should not forget. For typical contractors, the free cash flow, after tax, approximates the company's net income. These cash flows can be used for acquisitions, strategic staff building and debt reduction. As an alternative, this cash could be returned to shareholders through dividend payments, more attractive in today's interest rate and tax environment.The federal IT industry group is currently trading at about 20 times 2004 earnings. This forward price-to-earnings ratio is slightly above the projected five-year earnings growth rate for most of these companies. This PE is also modestly above the longer-term norms for the industry. These are some things to consider as we measure performance and valuations for 2004.Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.