MARKET WATCH

Tech Success Resides In Match-Up Arena

Jerry Grossman

By Jerry Grossman

The key to success for technology companies is to match up technology and domain expertise with markets. Companies that optimize this match-up have the most convincing value-added selling proposition and the most efficient execution process.

These same companies generate relatively higher profit margins than their peers and, consequently, higher valuations. For companies weighing the benefits and risk of diversification, understanding and achieving these match-ups is of paramount importance.

Federal government technical and IT services companies develop and deploy a wide array of technology, principally for federal market needs. The explosive growth in technology as a central component of business re-engineering and re-invention has captured the fancy of institutional and individual investors alike.

Even after the large Nasdaq and tech stock market correction two weeks ago ? generally reflecting a 20 percent to 70 percent pricing drop ? the performance of technology stocks during the past three years has been impressive. "New economy" tech stocks, specifically those issued by companies involved in communications, e-commerce and Internet initiatives, have in many instances risen by 100 percent or more during the past three years.

The natural reaction of management teams and shareholders at government technical and services (GTS) companies is to ask: We have great technology, why can't we participate in the new economy gold rush?

Many companies are taking a serious look at technology spinoffs, the application of their existing technology to new markets. For example, the success of Network Solutions Inc., first in an initial public offering, then in a secondary offering, and finally in a pending sale, has enriched immensely shareholders at Science Applications International Corp., setting a new standard to the definition of home run.

Continued sluggishness in federal market procurement growth, coupled with sky-high valuations in the new-economy sector, has refocused GTS companies on technology migration and market diversification as alternative avenues to produce growth and add value.

Diversification alternatives that are closer to home and more in step with the core business of GTS companies are two industry groups: commercial IT and outsourcing companies and aerospace and defense.

The first group of businesses has technical skills that closely parallel many federal IT companies. However, commercial market buyers, their manner of procurement and vendor selection, and their contract structure differ from federal market procurement officials and the rules under which they operate.

Aerospace and defense companies serve many common federal customers, deploy similar technologies and operate under similar procurement rules and contract structures. But aerospace and defense companies focus principally upon systems and subsystems, components and other hardware elements, with a significant manufacturing and assembly component, a much different operating environment than GTS.

Serious consideration of diversification initiatives by these industry groups involves an understanding of their respective performance metrics and relative valuation multiples. Selected performance measures and pricing multiples are presented in the charts at right. The 61 companies selected are publicly traded.

The GTS/IT group includes many companies with some degree of commercial and state and local government business. Some of the commercial IT and outsourcing companies are participating in the federal IT market. This market diversification is a factor in the strong similarities in performance between federal and commercial IT.

At the median, these two groups are similar in size, in the range of $400 million to $500 million in annual revenue. Capital requirements ? net working capital and capital expenditures together ? comprise about 15 percent of revenue, with five-year projected earnings growth at 20 to 22 percent.

The identifiable differences are twofold:

? Federal IT earnings before interest, taxes, depreciation and amortization (EBITDA) margins, at 11.0 percent of revenue, are 25 percent above commercial IT EBITDA margins of 8.5 percent, a reversal of longer-term historical relationships.

? The federal IT businesses are more highly leveraged.

The commercial IT companies are priced at 25 times projected annual net income, compared with about 16 times for the federal contractors. Similarly, the commercial market players reflect enterprise values at 11 times EBITDA, vs. 8.8 times for the federal group. Enterprise values to revenue multiples are identical at 1.1 times.

The aerospace and defense group has a completely different profile, largely because of its asset-intensive operations. EBITDA margins are 15 percent (on revenue), financial leverage is twice the federal IT group, and capital requirements equal almost 19 percent of revenue.

Additionally, the projected five-year earnings growth rate of just more than 11 percent is only half the IT services groups. These performance, capital structure, profitability and growth differences are reflected in much lower cash flow multiples ? 5.6 times ? and net income multiples ? 10.3 times.

In addition to competitive conditions, employee skills and experience, these relative performance metrics, growth expectations and capital requirements are important considerations for strategic diversification planning. Just as importantly, the significant differential in valuation is an essential consideration in approving or developing diversification initiatives.

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

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