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Federal IT Draws Commercial Interest

Bill Loomis

By Bill Loomis

Merger and acquisition activity remains robust in the federal IT market. But while there are several smaller acquisitions of private companies each month, the larger public acquisitions are fewer.

With consolidation continuing in the industry, and one publicly traded company acquired this year (Analysis & Technology Inc. by Anteon Corp.), takeover speculation is on federal IT investors' minds. Shares of both CACI International Inc. of Arlington, Va., and Nichols Research Corp. of Huntsville, Ala., have been aided by takeover speculation over the past couple of months.

I am often asked about the likely buyers of federal IT companies. The list includes the usual, large suspects, but never commercial IT companies.

I was quite surprised in September 1997, when Affiliated Computer Services Inc. of Dallas announced its intention to acquire Computer Data Systems Inc. of Rockville, Md. It surprised investors as well, evidenced by ACS' falling stock price following the announcement. In fact, the first question on the conference call between ACS and CDSI management and Wall Street analysts was from an investment analyst that was recommending ACS, and asked, "Why government?"

The acquisition has turned out to be a smart move for ACS and has resulted in true synergies between the companies. ACS' shares have recovered fully and have outperformed most of the company's peers since the acquisition.

At the time of the acquisition, CDSI had trailing revenue of $327 million and operating profit margins of 5.9 percent. While ACS does not break out operating profits of CDSI, we estimate it is more than 6 percent and that revenue is now about $500 million. Internal growth has been more than 20 percent annually over the past few years, with the rest coming from two acquisitions of defense-oriented companies.

The acquisition was done for about one times trailing revenue, a multiple that is similar to the other large federal IT transactions done since.

Following the acquisition, about 65 percent of ACS' revenue was commercial and 35 percent federal, a ratio that remains about the same today.

The merger between the two has worked because ACS management understood the differences and similarities (and pluses and minuses) between commercial and federal IT work.

Both companies had significant overlap in technical abilities, such as custom software development and data center outsourcing. CDSI has tapped ACS' outsourcing experts to bid and win several federal desktop outsourcing contracts and migrate the best commercial practices to the federal market. CDSI's federal outsourcing work has helped leverage ACS' data center infrastructure.

Also, ACS brought very strict financial controls and targets to CDSI, and CDSI management has to answer to ACS' Texas headquarters in person should goals slip.

The improved financial discipline and synergies between companies have resulted in increased growth and expanding margins for CDSI. With federal outsourcing (business process outsourcing and data center/desktop outsourcing) expected to grow over the next few years, ACS should be well-positioned.

Much has changed at CDSI since the acquisition, including its name and senior management. CDSI has been renamed ACS Government Solutions and, as of last month, has a new president. Pete Bracken, who joined CDSI in 1996 as CEO and accelerated the company's growth, is now vice chairman of ACS Government Solutions. Bill Woodard, who joined CDSI in 1998 from Computer Sciences Corp., is now president of ACS Government Solutions. The company recently named replacements to head two of its operating units, IT Solutions and Business Applications Solutions, and formed a third, ACS Defense.

With the success of ACS, I would expect a few other commercial IT companies to look to the federal market. However, with Wall Street focused on near-term performance and investors' perception that the federal market is much less attractive than commercial, it will take brave management teams to pull it off. Those teams must be willing to take a short-term hit to the stock price and spend many hours explaining the virtues to analysts and investors of such acquisitions.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Inc., Baltimore. He can be reached at wrloomis@leggmason.com. This information should not be construed as advice designed to meet the investment needs of any investor.

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