Market Watch: Federal IT companies hold steady but uncertain lead
<FONT SIZE=2>Before mid-2000, commercial information technology companies, those serving predominantly commercial and state and local markets, outperformed the federal IT companies, both on an operating basis and in the stock market. </FONT>
Jerry Grossman
Over the past two years, the federal IT group has significantly outperformed commercial IT, both in profitability and stock performance. With the establishment of the Department of Homeland Security via legislation signed in November, the potential exists for IT companies that serve state, local and commercial markets to participate effectively in the support of many of the department's initiatives.
This opportunity is particularly relevant for commercial IT companies with some existing federal market presence. Examples include Affiliated Computer Services Inc., Computer Sciences Corp., Keane Inc., Maximus Inc. and American Management Systems Inc. To the extent these companies can capitalize on their diverse market presence for purposes of the Department of Homeland Security, they may improve their relative pricing and operating profitability.
Naturally, high-performing federal IT companies, including PEC Solutions Inc., Anteon International Corp., ManTech International Inc., Veridian Corp., CACI International Inc. and SRA International Inc. are pursuing opportunities as well. Once homeland security funding begins to flow into the market, both opportunities and competition will be robust.
Over the past two years, federal IT companies have experienced a reversal of historical norms. Using the commercial and federal companies listed above as proxies for their groups, the past two years' results are revealing.
Median operating margins were nearly identical for commercial and federal in 2002. Market valuations, as reflected by price and earnings multiples at the median, were about 15 times for the commercial group, compared with about 43 times for the federal IT companies.
At the median, analysts' estimates reflect about a 16 percent compounded annual earnings growth rate for these commercial firms, versus a 20 percent projected earnings growth rate for the federal group. The significant difference in price-to-earnings ratios may reflect both the previous two years' relative performance of the stocks in each group, as well as greater investor certainty about near- term revenue growth in the federal sector.
For the two-year period ended Dec. 31, the five commercial IT companies listed above produced a median stock price decline of 25 percent. This compares to a median stock price increase of 95 percent for those federal IT companies that were public during the full two-year period.
Examining only the best performing stocks in these groups during this period -- ACS, PEC and CACI -- the results were good for investors in each instance, but for different reasons. For ACS, the stock price rose 70 percent, with earnings per share rising 76 percent, driven by both strong revenue growth and 50 percent margin expansion. Their price-to-earnings ratio was stable at about 30 times.
For PEC, the stock price rose more than 250 percent, with earnings per share expanding by about 130 percent, fueled by significant revenue growth, principally organic. PEC's price-to-earnings ratio grew by more than 60 percent.
Finally, for CACI, the stock price grew by more than 200 percent, with earnings per share up by 49 percent, driven by revenue growth and margin growth. They experienced a 118 percent expansion of their price-to-earnings ratio.
Inevitably, a strengthening of both the overall economy and commercial IT markets should help to shore up state and local budgets and provide some increased growth opportunities for the commercially oriented IT group overall. Only time will reveal the timing and magnitude of any of these changes, as well as the effect of these things on performance and market valuations. *
Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.