Market Watch: Challenges loom, but fundamentals are strong

Increased head winds and storm squalls have buffeted some government services companies, but a ray of light is cutting through the gloom. The reorganization of the General Services Administration, isolated government investigations, some congressional sniping and ill-advised legislation among other events are attracting the attention of executives and investors.The bundling of contracts and small-business set asides squeeze the middle, challenging companies that are too big to be a small business, but aren't at the tier-one level. But challenges abound, no matter what a company's size. Luckily, opportunities are equally ample.Performance metrics for most services companies ? particularly well-managed and strategically positioned businesses ? remain strong.For executives, anticipating and dealing with these and similar issues are requirements for success.Fundamentally, the government-services business provides opportunity for owners and outside investors to achieve solid growth in value, with manageable risk and the potential for incremental investment returns.More than 90 percent of government services companies are privately owned, often by founding shareholders.These companies were frequently launched with a modest amount of equity capital, partly as a result of the federal government's small-business programs. Once established, these businesses can grow with little equity capital beyond earnings retained in the company.For example, a typical services contractor generates about $5 in after-tax, free cash flow for each $100 in sales. Each added $100 of sales consumes about $12 of investment capital for incremental working capital and expenditures. Because each added $100 of sales produces about $25 in new assets, low-cost bank financing can be used to support these new assets at an after-tax cost of less than 5 percent.Doing the math, the new $5 in free cash flow costs about 60 cents to finance. This high ratio of cash flow to financing cost drives attractive equity returns without the need for double-digit revenue growth.A private government services company that has these performance characteristics can generate strong equity returns while growing in line with defense spending. Long-term, real growth in Defense Department outlays is about 3 percent annually. Add inflation at 3 percent, and the annual rate of growth in outlays is 6 percent in actual dollars.A company that is growing at this rate and has a balanced capital structure can produce compounded annual returns in excess of 20 percent for owners and investors. These returns assume static profit margins and factor in no strategic element or increase in market valuation multiples.Companies with stronger growth trajectories, 10 percent and above, potentially could generate much higher investment returns to the owners. Investors in public government services companies see the same positive attributes, but pay a higher price for each dollar of revenue or cash flow.Accordingly, the weighted cost of capital for such public businesses is much lower than it is for privately held businesses.This lower cost capital is a reflection of the risk and investor expectations attached to many public companies -- specifically, larger size, more diversified customer and contract bases, a broader array of skill sets and the capital capacity to finance growth-enhancing acquisitions. Public equity markets also offer substantial liquidity to shareholders.Whether publicly traded or privately owned, government services companies participate in a large and growing market. Institutional investors are becoming more familiar with the nature of the industry and the opportunities it presents.Arguably, investor interest could support both more public companies in the sector and more private investor-backed companies in the small to midsize range, replacing those that are acquired.Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.