Market Watch: Wall Street demands growth ? growth demands M&A

The continuing strength in merger and acquisition activity in government IT and defense services must be viewed with a clear understanding that acquisitions are a strategic necessity.To maintain current pricing of their stocks, relative to earnings and cash flows, public government services companies must grow at rates greater than twice the growth of federal spending. Even for the best companies, sustaining organic growth of more than 15 percent, roughly doubling every five years, becomes increasingly difficult.The strategic alternative to energizing growth with acquisitions would be paying shareholders steady dividend distributions, recognizing that single-digit organic growth will provide substantial cash flow to fund distributions. A company paying out 80 percent or more of earnings in dividends and growing at a rate of 6 percent annually, can achieve compounded internal rates of return for their investors above the 10 percent to 11 percent cost of capital level.Dividend distributions could be combined with acquisitions to enhance shareholder returns further. At present, no public companies have undertaken either of these dividend strategies.Public government contractors are augmenting organic growth with acquisitions, seeking to achieve 18 percent to 20 percent growth rates. To sustain high growth, these companies work continuously to align their capabilities with the priority programs of government customers. It is nearly impossible to evolve a company's staffing in line with changing customer needs through recruiting alone. Achieving sufficient size and management scope to win larger, complex, consolidated procurements dictates faster growth through a continuing process of portfolio shaping.Most industry executives and analysts agree that acquisitions can augment value, but many harbor incorrect beliefs about what constitutes a good deal for shareholders. Frequently heard refrains are: "Sellers have unrealistic expectations," and "Most acquisitions cost too much, and I refuse to overpay." And sometimes they're right. However, when an acquisition that adds targeted capabilities and customers is found, the critical question should be: Will the company and its shareholders be better off if we complete the deal? More precisely, what target company attributes will increase investment returns for shareholders and raise the price of their shares above where it would have been without the transaction?Can a public company growing at 20 percent annually buy a company growing at 5 percent to 10 percent and enhance shareholder value? If a public company buyer is trading at a price-earnings multiple of 15 times earnings, can it pay 20 times earnings for a target company and increase value? The answer to each of these questions is yes. Is the answer the same for investors holding the stock for one, two, five or more years? Yes.As a public company executive, could I consider an acquisition of a slower growing, lower margin company, while paying an acquisition multiple 30 percent to 40 percent above that of my own company and still enhance value for my shareholders? In most instances, the answer is still yes. Although factors such as the availability and cost of capital, public market pricing levels, and industry profitability levels have an impact on this kind of analysis, the fundamental characteristics of government services companies remain intact. These businesses produce strong operating cash flows while requiring a modest level of working capital and fixed asset investment.Comprehensive financial analysis, combined with in-depth industry understanding, is essential to make the right decision about whether to pursue a potential deal and what terms and conditions must be negotiated to ensure that shareholders realize added value from such a deal.Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.