Market Watch

Investors and defense stocks: Will you still love me tomorrow?

Jerry Grossman

The most common question among industry executives and investors in the government information technology and defense sector is: Will public market receptivity to the industry remain high, continuing to support new initial public offerings and valuations?

My bet is investor interest will endure beyond the next few calendar quarters and well into the future, based on the match between industry investment attributes and evolving investor psychology. I'm speaking of longer-term investors here, not "day traders and momentum players."

Please note I offer no guarantees: I am neither a fortuneteller nor the legendary Johnny Carson sage, Karnak, who divines the answers having never seen the questions. Notwithstanding this lack of clairvoyance, the factors supporting industry appeal are logical and, in the main, enduring.

For analytical purposes, our proxy for the government IT industry, as to pricing and performance relationships, is comprised of the eight "pure play" publicly traded government IT companies: Anteon Corp., CACI International Inc., Dynamics Research Corp., ManTech International Inc., PEC Solutions Inc., SRA International Inc., Titan Corp. and Veridian Corp.

Until there is meaningful negative change in the principal factors driving market investment behavior, the positive public market environment is likely to continue. The four most important factors are:

  • Solid and growing market demand: increasing importance of government spending, focused on defense, domestic security, intelligence and the apparent public support for these priorities with continuing emphasis on technology infusion and outsourcing to successfully accomplish goals within budgetary bounds.

  • Business visibility, predictability and credibility: growing revenue and cash flow, reasonably on target with expectations, without the need for aggressive, arcane accounting and tax avoidance strategies.

  • Weaker performance, market demand and stock performance in other sectors.

  • Demonstration of management ability to successfully execute acquisition programs.

Consider the factors below and reach your own conclusions. I've divided these into two categories: industry and business attributes and market attributes.

The industry and business attributes: strong patriotic mindset; solid, honest executives generally seeking fair returns on investment for value delivered to customers; long-term market need for solid dependable services and products; shrinking pool of skilled government workers; substantive need in government to re-engineer technology processes and infusion; a clear mandate to deploy communications and IT to the interfaces within government and with suppliers and constituents; increasing flexibility in procurement process allowing for reduced sales cycle time and expense; government agency managers and procurement officials giving strong consideration to contractor performance and commitment, in addition to cost.

The market attributes include, among other things: a return to traditional investment fundamentals, such as profits and cash flows, business predictability, sound balance sheets and sustainable, growth; straightforward accounting practices, reinforced by government audits; modest working capital and expenditure requirements; barriers to entry of new competitors ; sector rotation into defense and homeland security; an escape from "death and destruction" in commercial technology markets.

Are there downsides here? Of course. One example would be the persistent attempts by Congress to undermine efficiency and effectiveness with legislation, such as the TRAC Act and like-minded initiatives to limit outsourcing.

All of the usual uncertainties in a political environment are here, along with the fickle nature of investor loyalty. Notwithstanding, there are many positives here.

So go figure.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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