Small-Cap Government Firms Gain Currency

Small-Cap Government Firms Gain Currency

Jack London

By Richard McCaffery, Staff Writer

Wall Street may yawn when it looks at small-cap technology companies in the federal space, but insiders see potential for steady growth, and many are chasing the payoff with their own dollars.

Low valuations, strong performance and predictable growth have spurred a flurry of insider buying at government IT companies in the past year. And many of the purchases have been made in the open market, not simply by employees and executives exercising options.

"In terms of my own net worth, I like to have a meaningful position in the company I work for," said James Allen, senior vice president and chief financial officer of GRC International Inc., a government systems integrator in Vienna, Va. "I think it's a good long-term investment." Allen has bought 12,000 shares since January.

Or consider Eric DeMarco, executive vice president and chief financial officer at Titan Corp. in San Diego. The company has made six acquisitions since 1998. That means there have been only four days in the past 15 months when DeMarco could buy the company's stock without violating insider trading laws.

"Each of the four times I could buy, I did, because we know what we have and we know what we're doing," said DeMarco, who now owns 8,290 shares. Titan insiders own 19 percent of the stock, up from about 15 percent a year ago, DeMarco said.

Now the acquisitive company is on the move again. On June 10, Titan announced plans to purchase System Resources Corp. of Boston, an IT systems and services company whose customers include the Defense Department and Federal Aviation Administration as well as state governments.

Terms of the deal were not disclosed, but SRC had revenue of $63 million last year. Titan's stock hit $9.12 June 9, near its 52-week high of $10.

The insider story is the same for other publicly traded technology stocks in the government sector. Since May 1998, insiders and others at Government Technology Services Inc. of Chantilly, Va., have snatched more than 170,000 shares. GTSI is a computer products reseller that achieved profitability last year for the first time since 1994.

Insiders at CACI International Inc. of Arlington, Va., have bought more than 30,000 shares since last June. "It's a vote of confidence," said Jack London, CACI's chairman and chief executive officer. London owns 830,514 shares, or a 7.6 percent stake. CACI insiders hold 14.6 percent of the company.

Why the move to buy? Opportunity.

"If you're noticing insider buying at federal IT companies, I would suggest it's because insiders believe in the long-term growth," said Douglas Schmidt, managing director of Legg Mason Inc. of Baltimore.

GRC's stock reached a 52-week high of $11.37 last summer after reporting a profit for the first time in two years. The company had 1998 sales of $131 million, up from $118 million the year before, and net income of $12 million, up from a loss of $17.7 million the year before.

GRC has posted nine consecutive quarters of profitability and has a contract backlog of $600 million, its highest in at least four years, said Wayne Jackson, GRC's director of corporate communications. The stock has moved up fairly steadily in the past nine months. It closed June 8 at $7.56, well off its 52-week high of $11.37 reached last summer.

"Your popularity on Wall Street does not always reflect fundamentals of the industry," Allen said.

Movement in CACI's stock has trended upward since hitting a low of $14.62 last fall when international pressures melted stock markets worldwide. It has been a long climb back. The stock closed June 9 at $19.43, not far off its 52-week high of $22 reached last summer.

The company is pushing development of electronic commerce services and is pressing hard into the information security arena with its $42 million purchase of QuesTech Inc. in May 1998.

London expects the initiatives to soon whip CACI's growth rate over the 20 percent mark. It has been in the 15 percent range the past two years.

"I'm very committed to moving this thing along at a faster clip," he said.

There is no shortage of reasons for the low stock prices of many government IT companies, though many have shown some nice improvement since last fall.

"One is the federal sector is not nearly as sexy as the commercial sector in terms of revenue growth rates and margins," said Thomas Meagher, a director at Boles, Knop & Co., a Middleburg, Va., investment bank. Typically, growth rates and after-tax margins of federal IT services companies are about one-third the level of their commercial counterparts.

But many investors like the predictability and growth inherent in this sector.

"What you're trading for is lower rates and lower profit margins but less volatility in the stock price, because they've got five-year contracts and predictable cash flow," Meagher said.

So far this year, federal IT companies tracked by Legg Mason have outperformed their commercial counterparts, basically because their wagons are harder to tip over when the market is rocky.

As of June 4, the Legg Mason IT Services Index, which tracks 31 commercial IT stocks, had lost 17.3 percent for the year. Compare that to the Legg Mason Federal IT Services Index, which tracks six federal companies and is up 10.5 percent for the year.

The performance of commercial IT companies has been haunted by the Y2K software problem, whereas federal companies have not suffered because of the reliability of government contracts, Schmidt said.

"A year ago it didn't look like you would want to own a federal IT company, because of its slow growth," Schmidt said. "Now it looks pretty good."

Valuations of government IT companies have been affected by overall market conditions as well. For example, growth companies ? the pricey, fast-moving ships like Cisco Systems Inc., Microsoft Corp. and Dell Computer Corp. ? have been outperforming their small-cap counterparts.

The small caps, loosely defined as companies with market values ranging from $500 million to $1.5 billion, really lost their pluck in 1998. The Russell 2000 stock index, a benchmark for small-cap companies, returned a negative 2.5 percent last year, compared with 26.7 percent for the S&P 500, which performed well because of a few big companies, such as Microsoft.

"Small caps have been maimed in the last couple of years," Meagher said.

Recently, small-cap stocks have shown some life, but Andrew Ma, an equity analyst at Koonce Securities Inc. of Bethesda, Md., expects the money to stay in growth stocks until an outside factor, such as higher interest rates, sends investors back to lower priced companies.

"Right now, there's no incentive for people to put money into value, because they're making so much money on growth," Ma said.

Whatever the valuations, insider buying in much of the government IT sector should be taken with a grain of salt, said Jon Kutler, president of Quarterdeck Investment Partners in Los Angeles.

This is because many of the companies are small and dominated by key individuals who may not have a realistic view of their company's value.

"In reality, some companies look at their own companies with rose-colored glasses relative to the rest of the industry," he said. "I'm not talking specifically [about any company], but I'm saying it's a characteristic that I've often found in this sector."

Rapid consolidation in the sector plays into this, Kutler said. Potential buyers are sending feelers out to many companies, which helps fuel the belief that every player can fetch a high premium.

"The bottom line is I don't view insider buying in this sector to be the same knee-jerk buy signal that it is in many others," he said.

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