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Time to Realize Value On Fed IT Companies

Bill Loomis

by Bill Loomis

The list of publicly traded federal information technology services companies continues to shrink, following the closure of the Advanced Communication Systems Inc. acquisition by Titan Corp., and the announced acquisition of GRC International Inc. by AT&T Corp.

The price paid was quite attractive for GRC and its investors, and could raise the bar on valuation, as well as accelerate the level of acquisitions in the space. A large new buyer willing to pay an attractive price is sure to cause some federal IT acquirers some concern, and perhaps accelerate their acquisition timetable.

There have been several federal IT companies backed by private funds that need to build enough size to come public or be sold at a "big company" premium. There can be real value creation in federal IT by consolidating small companies (under $50 million in revenue) with good reputations, client lists and margin work, and paying prices well below the public comparables of 70 percent of annual revenue.

Most of these investor-backed companies would like to see their goals achieved in the next couple of years, which also could drive merger and acquisition activity.

The IPO market for technology companies continues to be very strong, opening a window for faster-growing, higher-profit margin federal IT companies. Also, if a company is partaking in the hotter areas of government IT, such as package software implementation (enterprise resource planning, customer relationship management, etc.) and e-government initiatives, investors will be more excited.

ERP modules such as financial management systems have been increasingly popular in the federal government over the past two years, with mixed success. American Management Systems Inc.'s Momentum federal financial management software was installed at seven federal agencies last year, and AMS has financial systems at more than 50 government agencies.

While AMS may have been in this market long before other commercial players, SAP AG, Oracle Corp., PeopleSoft Inc. and others also are aggressively targeting the federal market. Commercial e-procurement software makers Commerce One Inc. and Ariba Inc. recently have partnered with integrators to target the federal market, as are the makers of customer relationship management systems, which include Siebel Systems Inc.

What would make investors excited about a federal IT services company? In our view, the factors would be a market capitalization, post IPO, of at least a few hundred million dollars; operating profit margins of at least 7 percent; annual growth of 20 percent to 25 percent; and a strong market position in the areas above, particularly e-government consulting and systems development.

Large, long-term contracts tend to give comfort to company management, but also tend to attract a lot of competition and include lower margin work, which drives down the contract's overall margins. Proactively marketed, shorter-term, smaller contracts using indefinite delivery, indefinite quantity can be better focused on higher-margin business, leaving lower-margin, lower-bill rate business to other contractors. Of course, these shorter contracts make backlog less important, management more stressed and tend to be higher risk, just like commercial work.

Now seems to be a good time for owners of federal IT companies to realize value in their business, based on a combination of post-Y2K IT spending, e-government excitement, a strong technology IPO market and an accelerating merger and acquisition environment at attractive valuations.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker in Baltimore. He can be reached at wrloomis@leggmason.com. Within the last three years, Legg Mason has managed or co-managed an underwriting of Advanced Communication Systems. This information is based on sources believed to be reliable but is not guaranteed as to completeness or accuracy.

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