Market Watch: A bullish long-term outlook for fed IT, defense companies

Jerry Grossman

The sun has shone brightly during the past year on federal information technology and defense companies. Revenue growth, profit margins and public market valuations have grown significantly. More importantly, the evidence supporting a longer-term period of sunshine continues to accumulate.

Factors contributing to this positive outlook come from five areas: government needs and purchasing capacity, procurement mechanisms and rules, company attributes, industry structure, and debt and equity sources, both public and private. Positive elements within each of these suggest sustainable value growth in this sector.

Federal customer needs for IT and technical services, about $80 billion in fiscal 2002, continue to grow. Federal agencies face retirements of key personnel, while the volume of information and transactions keeps expanding. Upgrades to manual processes and legacy computer systems are an essential part of the solution.

While federal spending for defense, IT and technical services will grow at just 5.5 percent to 7.5 percent over the next five years, priority programs such as national defense and homeland security will grow two to three times as rapidly. The 2002 election appears to have provided additional momentum to defense and homeland security priorities.

Procurement rules and practices have evolved into more flexible contracting vehicles with more focus upon effectiveness, past performance and relationships. Reductions in the proportion of cost reimbursable contracts have contributed to improved margins and greater potential synergies in mergers and acquisitions.

Additionally, federal procurement officials continue to provide preferential treatment to small and disadvantaged businesses, supporting the early stages for thousands of small companies. Also, the Bush administration has re-emphasized its commitment to small contractors.

Well-managed companies are seizing the opportunities to develop stronger customer knowledge, formulate and propose solutions, not just manpower, and deliver under a better contract mix. For good companies, operating cash flow margins are 8 percent to 9 percent or more, and organic growth is 15 percent or more.

Management teams are developing a stronger strategic orientation and better appreciation of capital market perspectives. For example, from 1998 to 2001, defense and government IT companies raised $25 billion in public debt and equity capital, roughly equal to the total raised from 1990 to 1997.

The federal IT and technical services sector remains fragmented with more than 4,000 companies competing for business. About 30 percent to 40 percent of this market is captured by large public defense primes, federal IT companies, diversified IT firms and major private competitors -- about 30 companies. The rest of the market, split among the 4,000 other companies, reflects an average of $10 million to $15 million in revenue per company.

Both public and private market investors, as well as transaction capital sources, have gained significant knowledge of the federal sector and some appreciation for its manageable credit risk and positive investment attributes. These factors provide the basis for favorable public market perceptions and strong valuations. Organic growth opportunities should remain ample, particularly for small to mid-sized companies.

New business creation and growth at the smaller end of the market will provide a continuing supply of companies for larger acquirers, feeding both the acquisition appetite of the buyers and the needs of private company owners for liquidity.

Divestitures by large, tier one primes in portfolio shaping activities meet the investment demand for industry assets from financial investors and management teams.

Overall, these are the ingredients for long-term industry health and success. *

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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