Market Watch: Strong fundamentals trump occasional problems

The federal government services business, as reflected in the performance of publicly traded federal IT companies, turned in a record performance over the past year. From June 2003 through June 2004, revenues, earnings and cash flows rose much faster than the aggregate market valuation in this sector, which rose by only 2 percent. That confluence significantly drove down pricing ratios, the relationship between market values and earnings (or cash flow).Many investors share a sense that the bloom may be off the rose in this industry segment and that the best is behind us. Reasons for the predicted fade in the sector's performance include large federal budget deficits, a wind-down in the war effort and uncertainty related to the forthcoming presidential election. The accelerated pace of mergers and acquisitions is cited by some as the root cause of the negative publicity surrounding CACI International Inc., ManTech International Corp. and Titan Corp. For each, the identified problems were traceable to acquired businesses. However, the risks associated with acquisitions are largely manageable. The recent public whippings administered to CACI, ManTech and Titan likely will have a negligible long-term impact on their operations.A modest decline in longer-term ? five-year ? earnings growth rates is likely; but for good companies in the sector, the business outlook remains positive. I continue to maintain that federal IT companies can be growth stocks, dividend paying stocks or some combination of the two. Without predicting stock prices, I will say that there is some rationale supporting continued strong operating performance by these public companies.Federal budget deficits ultimately affect federal spending, but the high priority assigned to national defense and homeland security likely will continue. The infusion of technology into defense and civil government units will continue to provide opportunities for this industry group.A change in administration would affect spending priorities, but defense and homeland security will stay important in any administration. Spending priorities in these departments would be different under Democrats than a second Bush administration. Whatever the election's outcome, it will have some impact on companies' acquisition strategies.The 10 publicly traded federal IT companies performed well last year. Compare their trailing 12 months' performance through March 31, 2003, and July 2003 pricing, with performance and pricing for those same dates in 2004. On an aggregate basis, revenues and net income increased 28 percent, and 57 percent, respectively, driven in part by 15 percent to 25 percent expansion in profit margins. However, the market value of equity and the enterprise value for these companies increased by only about 2 percent during this period, producing significant declines in price-to-earnings ratios. These declines reflect diminished investor growth expectations going forward, and increased risk associated with the factors outlined above. Decline in pricing ratios has been much greater than the drop in long-term earnings growth rates estimated for these companies. The median 5-year earnings growth rate for the sector is expected to decline only slightly, from 18 percent to 17 percent annual growth.The industry group has sufficient unused net debt capacity to sustain 12 percent earnings growth through acquisitions. Assuming no organic growth in real dollar terms and a 3 percent inflation rate, the group could produce 15 percent annual earnings growth over the next five years in a flat budgetary environment.There are no guarantees, but the industry's fundamentals remain strong. It's left to you to decide how accurately the equity values reflect the opportunities. nJerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.