MARKET WATCH

Hearty Gov't Market Spurs Public-Sector Value

Jerry Grossman

By Jerry Grossman

Both in the United States and around the world, government markets are gaining visibility and attracting the attention of successful businesses and sophisticated investors.

The convergence of several positive factors ? most significantly the Internet and communications technology ? is driving a redefining of business opportunities, a re-engineering of government processes and providing the foundation for stock value appreciation.

Technology companies serving these markets have tremendous opportunities to grow revenue and profits and to brand themselves for longer-term market participation. The re-invention of government, a well-worn phrase from the mid-1990s, has never quite met expectations, notwithstanding an 18 percent reduction in the federal work force between 1993 and 1999.

However, the Internet, turbocharged by communications and information technologies, provides the platform for improving efficiency and upgrading constituent services. That is a positive in the eyes of voters and Congress.

Accordingly, Internet-based re-invention has significant support "on the ground," and that suggests today's initiatives actually will produce results tomorrow. Web-enabling government, or e-government, is the label markets have attached to the implementation of communications, work flow and constituent services on the Internet platform.

The scope of e-government encompasses business-to-government, government-to-government and citizen-to-government applications. According to the Census Bureau and Credit Swiss First Boston estimates, there are more than 87,000 government entities in the United States, representing over $5 trillion in annual transaction volume. That's quite a market.

Implementation of e-gov processes is applicable to most public-sector entities: federal, state and local governments along with international government units. Worldwide, the market for e-government implementation services will exceed $100 billion over the next 10 years, including products and services such as communications equipment, data security software and other technology-based services.

This sizable market provides significant revenue-growth potential for well-positioned providers. More importantly, the emergence of improved procurement processes offers the opportunity for vendors to significantly expand profit margins.

Alert investors have begun to do the math, and they grasp the opportunity for earnings growth in this environment. Companies are expanding profit margins in the federal sector through improved, flexible contract structures, moving from cost-based to value/solution-based contracts.

Many state and local government entities are outsourcing functions and services to providers on a revenue-sharing contract basis. Contractors are infusing technology-enabled processes to gain efficiency, scalability and re-usability of their domain expertise. These trends are producing strong earnings growth, improved potential and better market pricing for many companies with significant government market participation.

A comparison of the performance and market pricing of 23 government IT services companies ? including those with one-third or more of their sales to government entities ? with 20 commercial IT services companies reveals the increased appeal of public-sector markets on a relative basis.

Government IT services companies are achieving EBITDA (earnings before interest, taxes, depreciation and amortization) margins of 11.1 percent in the 12-month period ended June 30, compared with 9.2 percent for commercial IT services companies.

Higher margins are a recent development that reflect two factors: the increasing profitability of government contract vehicles and the difficult post-Y2K marketplace for the commercial IT sector. Analysts expect slightly higher long-term growth (5-year projection) for commercial IT companies.

But more than half of the commercial market providers in our analysis expect earnings to decline over the next year. Government IT companies, conversely, anticipate 15 percent to 20 percent earnings growth next year, consistent with their longer-term outlook.

In addition, many successful communications and IT services companies with historically modest public-sector market participation have stepped up their government-oriented initiatives. Recent examples in the communications arena include AT&T Corp., Bell Atlantic Corp., Lucent Technologies Inc., Nortel Networks Corp., Qwest Communications International Inc., Sprint Corp. and Winstar Communications Inc.

The Metropolitan Area Acquisition (MAA) contracts are a principle attraction for communication companies. MAA is a multiyear program under which telecommunications needs in each city will be met by the winning companies. Services include local voice and high-speed data transmission. Thus far, AT&T and Winstar have won most of these contracts.

AT&T expanded its government services segment with its acquisition of GRC International. And Lucent recently announced the creation of a public-sector unit, carrying about $8 billion in annual revenue, that will target e-government opportunities worldwide. Bell Atlantic Federal, US West Federal Services and Sprint's Government Services Division are among others aggressively pursuing government markets.

The collective wisdom of these companies and others confirms that government markets are highly attractive to tech-based companies. When investors consider the positives ? procurement trends, government re-invention and Web-enablement, outsourcing, the technology recruiting and retention issue and improved contract structures ? the outlook for government market providers in both communications and IT services sectors looks very good.

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

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