The safe haven in an economic storm

Recent turmoil in debt and equitymarkets highlights the contrastbetween federally orientedbusinesses and companies servingprivate-sector customers. It remindsus of the attractive, fundamental characteristicsof the government servicesindustry: stability, visibility, predictablecash flows and modest capitalrequirements. These attributes flowfrom the environment created by thegovernment. Growing procurementbudgets, clear acquisition rules, predictablecontract structures and fullpublic disclosure create a businessenvironment and an investment arenathat is sheltered from many elementsof private-sector markets.In the federal mergers and acquisitionsarena, strategic buyers continue topursue transactions, and they have plentyof capacity to fund them. Financialbuyers, however, are confronted with theextremely cautious posture of capitalsources, which is driving up the cost ofcapital while slowing down the due diligenceand approval processes. Both thecontinuing interest rate on debt andfront-end fees have risen materially. Insome instances, the effective cost of debthas doubled during the past fewmonths, while lenders' terms have significantlytightened. In the near term,some slowing in M&A activity is likelypending a sense of equilibrium in financialmarkets and knowledge of electionoutcomes.What is clear in this extraordinaryenvironment is the flight to safetyexhibited by most investors. The relativestability of the market values ofmost federal information technologycompanies becomes clear through acomparison of those companies withbroad market indexes. In the one-yearperiod that ended Oct. 9, the DowJones Industrial Average declined 35percent, the Nasdaq Composite 38 percent,and the S&P 500 37 percent.During this same one-year period, theaverage change in stock price for 10public federal IT companies was adecline of about 7 percent.Whether their stocks are up or down,these federal businesses have the balancesheet strength and predictable cashflows to pursue double-digit revenueand profit growth in this environment.In times like these, cash is king.Opportunities are greatest for thosebusinesses with dry powder ? that is,cash or unused borrowing capacityunder revolving lines of credit to use forcorporate development purposes orshareholder dividends.Alternatively, there are concerns withinthe sector. For example, there isincreased uncertainty about the federalspending outlook beyond 2009, theoutcome of the election and the economiceffects, including fiscal policy, ofexpensive and illiquid credit markets.Federal spending shows no signs ofactually declining anytime soon. It ispossible that the costs of the rescueprograms will force some reductions inagency budgets, but many priorities,with strong political support, will befunded.The election outcome, notwithstandingthe differences in philosophiesbetween the parties, will not affectspending priorities until fiscal 2010.The credit crunch should begin to easein a matter of months, although lendingcriteria are likely to remain moreconservative for considerably longer.For most strategic buyers in the federalmarket, these conditions do not presentan impediment to their acquisitionprograms and will strengthen theirpricing advantage over the financialbuyers in most auctions.Federal IT markets remain a solidplace to be for investors in public andprivate companies. Clearly, changeswill occur, but the leading companiesin this sector tend to adjust and positionthemselves to grow their businessesand deliver value to shareholders.