Govt. Technology Sector: What's Not to Like?
By Jerry Grossman
Government IT and defense technology companies in the federal sector continue to deliver solid and predictable performance to investors, with an improving market outlook.
A review of our private government technology sector database reflects steady performance among a cross-section of industry competitors ranging in size (annual revenue) from $10 million to $1 billion-plus. Examining an array of approximately 20 performance metrics confirms remarkable consistency over the past eight to 10 years.
Those performance measures that are improving include revenue growth rates, operating profit performance (earnings before interest and taxes) and net income return on shareholders equity. More about these measures is presented later.
Of enduring interest to industry acquirers, investors and management teams is the determination of the right strategy to maximize shareholder value. An examination of industry performance and market dynamics provides a sound basis for a financial modeling analysis of how best to harvest value in today's government markets.
Key factors impacting performance of GTS companies indicate improved performance is ahead. Federal budget surpluses provide both the Bush administration and Congress with the capacity to fund priority programs.
The Bush administration has prioritized, among other things, national defense and intelligence agencies for increased funding. The forthcoming Quadrennial Defense Review is likely to continue emphasizing government deployment of technology to deal with projected threats.
The federal government goals to hold the line on or reduce employee headcount while increasing "throughput" leaves the government with only two viable paths to achieving these goals.
One, the federal government must continue identifying operating units which can and should be outsourced, followed by completion of an A-76 review, and on through contractor proposal solicitation and selection.
Two, the government should deploy information technology and communications technologies more comprehensively in operating units to improve productivity, decision making and quality of output.
Moving back to the issue of GTS industry performance, here are some ranges of performance metrics taken from recent analysis. The most significant change among our private company group is the increase in year-over-year revenue growth during 1998-1999, relative to previous periods.
At the mediums, our group grew revenue 18 percent to 20 percent in each of these years, compared to 10 percent to 12 percent in each of the previous five years. Acquisitions by several active private companies contributed to this result.
Also, since the 1994-1996 period, the cost of interest-bearing debt has increased about 230 basis points, or about 25 percent above the 9 percent level prevailing then.
For analysis purposes, using a percentage of revenue as a standard measure to compare and contrast companies and time periods is very informative. During the 1996-1999 period, total invested capital ranged from 17 percent to 22 percent of sales, with about one-third in interest-bearing debt and two-thirds in equity.
Effective net working capital (current assets, less cash, minus current liabilities, less interest-bearing debt) ranges from 10 percent to 12 percent of sales. Typically, net fixed assets fall in the range of 3 percent to 5 percent of sales.
A firm understanding of these relationships is critical to gaining a solid perspective about the investment value of GTS companies.
A fundamental question for each company in the industry is what is the best strategy to increase shareholder value. The answer for most companies is either to accelerate revenue growth or to expand profit margins. Naturally, achieving both would be optimal.
We examined this question using a hypothetical GTS company, with typical income statement and balance sheet metrics, including 10 percent annual revenue growth and a 5 percent EBIT margin. The graphics here reflect the growth in per-share value produced by faster revenue growth, higher profit margins and a combination of these improvements.
Margin improvement is projected to occur at either 1/4 percent per year or 1/2 percent per year. Revenue growth rates are compounded annually. The starting value per share is $10. The base case company has revenue growth of 10 percent. Over five years, value per share grows by 85 percent to a per-share value of $18.50.
Achieving annual revenue growth of 20 percent increases value to $25.90 per share. Moving revenue growth to 25 percent annually delivers a share value (in year five) of just over $30.
A potential alternative is to focus on a more discriminating selection of contract opportunities, where higher profits are possible. Frequently, this approach would result in less revenue growth. Accordingly, achieving 1/4 percent margin increase per year, with no change in revenue growth rate produces a 140 percent value increase, to $24 per share. Achieving 1/2 percent annual margin increase, while retaining a 10 percent annual sales growth, produces a per share value of about $29.50.
This assessment indicates that a capable industry competitor could accomplish a tripling of share value over five years by either increasing revenue growth to 25 percent compounded annually, at a steady 5 percent EBIT margin, or increasing the EBIT margin by 1/2 percent per year, while retaining a 10 percent annual revenue growth rate.
The best strategy will reflect each company's strengths, competitive posture, customer positioning and history. Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va.