Market Share: Fewer midsize targets heat up M&A markets

For 2005, federal IT services stocks were up by 7.4 percent, ahead of Standard and Poor's 500 Index's 3 percent return, and well ahead of commercial IT service stocks' decline of 14.5 percent. However, the federal IT services stocks likely would have underperformed the S&P 500 if not for General Dynamics Corp.'s proposed acquisition of Anteon International Corp., which sent the group higher.

Public federal IT service companies generally reported third quarter 2005 results in line with their guidance ranges, but fourth quarter 2005 guidance, mostly on the revenue side, was lighter than I expected.

With the unexpected delay of the fiscal 2006 defense spending bills, as well as continued delays on several key civilian spending bills, contract award activity in the fourth quarter also was lighter than I expected.

With lower contract award activity this quarter, investors are concerned that most of companies probably will announce fourth quarter 2005 results closer to the low end of their respective guidance, and give first quarter 2006 guidance with modest growth.

For 2006, the group again should show stock price gains in the single digits, lagging the 15 percent EPS growth I am estimating for this year. Some companies will do better and some worse than the average. However, merger and acquisition activity could boost stock performance. The recently announced proposed acquisition of Anteon is not surprising ? I believe most of the public federal IT service companies will be acquired over time ? but the valuation is surprisingly high. This was about the same forward price-to-earnings ratio for which General Dynamics acquired Veridian Corp. in June 2003, when the federal IT industry was growing at a faster rate than it is today.

M&A activity in the federal space will continue at a strong pace, as the public companies, including those in aerospace and defense, feel the pressure to meet double-digit EPS growth in a slower-growth budget era. Although any of the federal IT service firms we track could be acquired, I believe it is unlikely that SRA International Inc., given its relatively high valuation, would be.

Now with Anteon to be acquired, CACI International Inc. is the largest pure-play public federal IT services company. I estimate CACI will generate $2 billion in revenue this year, enough to make a significant impact in a large acquirer's income statement and move the company up the size rankings relative to their defense company peers.

There is scarcity value now, as many midsize companies have been acquired. There are hundreds of good small federal IT service firms, but I think the amount of resources required to consolidate many of them would be greater than a large acquisition, and the impact less.

Bill Loomis is a managing director at Stifel Nicolaus & Company Inc., which recently acquired Legg Mason's Capital Markets Group. He can be reached at wrloomis@stifel.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: Stifel Nicolaus, 100 Light St., Baltimore, MD 21202, Attn: Research Department.