Market Share: Investors, keep a sharp eye on acquisitions

The federal IT services industry has seen a lot of merger and acquisition activity, and I expect it will continue. Several factors are driving this activity: the industry's size, its high degree of fragmentation with no truly dominant players, relatively low total-market growth, good access to capital and strong free cash flow.Although the public federal IT service firms have been flush with cash the past few years following a series of stock offerings, most have used their cash and have leveraged up with debt.At the end of last quarter among the public companies, only SRA International Inc. had no debt, with most of the others having debt-to-capital ratios in the 30s or 40s.Lenders are willing to leverage beyond these levels for additional acquisitions, but history suggests there could be another round of stock offerings in coming quarters, as companies try to reload their balance sheets for larger acquisitions.Investors should be factoring in potential acquisitions for federal IT service firms.Acquisitions in the industry can be quite accretive, making the seemingly high forward price-to-earnings ratio look attractive when acquisitions are included in earnings estimates.Although it can be tough to predict the size, profitability, cost and timing of an acquisition, reasonable assumptions can be made based on the company's track record and capability to do acquisitions, particularly its financial capability.However, this initial accretion to earnings per share does not necessarily add value to the stock if the company overpaid for the acquisition, driving down the overall return on invested capital.Financial theory says that the spread between the return on invested capital and cost of capital, together with growth and risk, determines a business' value. The lower the spread ? as the return on invested capital drops because of overpaying for acquisitions ? the lower the value.The market will adjust for the overpayment by giving the company a lower price-to-earnings multiple on the higher earnings, leading to little or no increase in overall enterprise value and stock price, or even a decrease.Most companies would not be able to make a reasonably sized acquisition at a price that would result in no initial reduction in return on invested capital. But if the company can accelerate growth, find cost synergies or boost free cash flow through better working capital management, it can accelerate the return substantially.It might be difficult for outside investors and analysts to estimate the return from an acquisition over the next couple of years. There may be benefits such as accelerated revenue growth, potential profit margin expansion or lower risk as a result of increased diversification of contracts and customers that may not be readily apparent, but would likely add value.Acquisitions make companies more difficult to analyze and value, but we believe investors, particularly in a consolidating, yet growing, industry such as the federal IT space, need to consider acquisitions when valuing these stocks and the total value added to the acquiring firm, which is more complex than just EPS accretion.Bill Loomis is a managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.com. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. For additional information and current disclosures for the companies discussed herein, please write to: Legg Mason Wood Walker, Inc., 100 Light St., P.O. Box 1476, Baltimore, MD 21203, Attn: Research Department.