Federal market retains strong investment appeal

For investors in any asset class or sector, risk is defined as uncertainty about the magnitude and timing of investment returns. For now in federal markets, the lack of visibility into possible program curtailments or cancellations and funding levels makes revenue forecasting more difficult. Bailouts, deficits, challenged financing markets and a shrinking economy add to investor unease. The perceptions of investors over the past year have been altered, challenging their ability to establish appropriate valuation levels and to determine investment appeal. So a federal market re-assessment seems appropriate at this time.

Arguably, during the past year, federal markets have become more complicated and more uncertain. The Barack Obama administration and the Democratic-majority Congress have big plans and new priorities. Over the next 12 to 18 months, the impacts of these changes, and the regulatory and oversight enlargement that is accompanying them, will become clearer for individual companies and their investors. Insourcing is in, outsourcing is out. Overall, the perception is that investment risk is higher and expected growth is lower. Accordingly, pricing levels for most public companies focused on federal markets have declined, some significantly. Pricing in mergers and acquisitions has adjusted to those factors as well. Looking ahead, is the glass half empty or half full? And, what changes in pricing, performance and valuation might we expect under the circumstances? I offer no guarantees, just some observations.

Naturally, this kind of assessment requires some stratification of contractors relative to their size, ownership and customer standing within the identified priorities of the government.

Let’s start with four large, domestic, tier-one aerospace and defense prime contractors: Lockheed Martin Corp., Northrop Grumman Corp., General Dynamics Corp. and Raytheon Co. In the aggregate, this group delivers nearly $135 billion in annual sales, more than $16 billion in earnings before interest, taxes, depreciation and amortization (EBITDA) and about $9 billion in net income. These companies have minimal financial leverage with net debt of about $11 billion. While elements of their defense platform business will decline, they are likely to achieve growth in priority areas including intelligence, cybersecurity, sensors and health care.

Currently, this group is trading at less than 5.5 times EBITDA, and about 9.0 times net income. These valuation levels imply almost no revenue growth and some decline in margins. In fact, their current 11.5 percent net income return on market value can be sustained with zero revenue growth and lower margins, leaving plenty of opportunity for upside performance and stock price growth. Their substantial cash flows and $30-plus billion secured borrowing capacity provide ample flexibility for acquisitions and portfolio repositioning to better align with evolving market priorities.

At the opposite end of the size and ownership spectrum are the “small businesses,” which include those generally under $30 million in revenue and privately held. Most often ownership is in the hands of founders, active management and employees. Many are founded and managed by seasoned industry executives. Most of these companies participate in federal contracting preference programs. Armed with preferential award opportunities, the probability of success is good. Growing to 100 or more employees over a 10-plus year period is well within reach.

Likewise, the investment potential of these companies is substantial. For example, a startup federal services company, capitalized at $200,000 and growing to $15 million in sales over 15 years, will reward its owners handsomely. At below market pretax margins of 4 percent to 6 percent, with an exit (sale) at four times EBITDA, founding investors would achieve a compound annual investment return of more than 25 percent. While there are thousands of small businesses that don’t achieve those levels, their returns to owners remain attractive. And, the hundreds of businesses that have exceeded those levels demonstrate the upside possibilities.

For most midsize public and private contractors – bigger than small, but smaller than large – the environment is challenging, but the investment returns remain attractive. At the end of the day, the federal market continues to provide compelling reasons for investors to participate.