Shaky Faith in Tech Firms Leads Investors Back to Basics

Shaky Faith in Tech Firms Leads Investors Back to Basics

Jerry Grossman

The love affair between market investors and technology companies is on the rocks. This is true for both mature companies and young businesses. We've come back to basics in these markets to focus on profits, cash flows and proven success.

Investors reaffirmed that "trees do not grow to the sky." The exception to the technology market downturn is the defense and aerospace group, one of the three segments of the government technology sector.

The defense and aerospace stock price index has risen nearly 50 percent during 2000. The other two government technology sector segments are government IT, including technical services, and electronic government. Companies in these two segments have suffered significant pricing declines of 12 percent and 84 percent, respectively, in the year-to-date period.

The absolute and relative strength of defense and aerospace stocks has contributed to the aggressive acquisition posture of the top-tier companies, particularly Northrop Grumman Corp., Boeing Co. and BAE Systems Plc.

Historically, these international defense companies have been principally focused on aircraft, weapons systems and defense electronics products. Recently, public-sector spending has been most robust in IT, technical services and outsourcing.

Accordingly, tier-one prime contractors have directed their acquisition programs toward services companies with large government sector involvement. Collectively, Northrop Grumman, Boeing and BAE Systems have announced or completed 13 acquisitions in 2000, of which five have significant IT services components.

Boeing, which has completed or announced seven acquisitions in 2000, has achieved positive investor response as reflected in a doubling of its stock price since March.

Active acquisition programs by these defense and aerospace primes have partially filled a void created as the aggressive midsize government IT consolidators have slowed or suspended their acquisition activity.

These acquirers, active in the 1997-1999 period, are dealing with three issues:
  • The need to sort out and rationalize a large number of recent acquisitions.
  • Significant tightening in debt capital markets.
  • Stock price declines in the government IT sector.

    These negative market trends confirm a reduction in the acquisition capacity of government IT and technical services companies. While merger and acquisition transactions that closed during the first six months of 2000 do not reveal a decrease in government IT acquisition prices, transactions in process are being affected.

    A comparison of public market pricing for government IT companies with enterprise value (EV) to earnings before interest, tax, depreciation and amortization (EBITDA) ratios for industry merger and acquisition transactions reveals a "negative arbitrage" picture.

    That is, public government IT companies are trading at pricing multiples below those paid in acquisitions.

    The differential is particularly significant in 2000. It would be difficult for buyers to achieve growing post-transaction earnings per share with acquisition pricing at this level, except in instances with significant cost synergies and seller earnings adjustments.

    Based upon these facts and circumstances, it is reasonable to expect in most transactions going forward that acquisition pricing ratios will converge on longer term industry norms.

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