Close to a Contracting Price Pinnacle
If anyone out in Beltway Land can lay claim to knowing when to buy and when to sell, it's Ken Bajaj.
That would be Ken Bajaj who sold I-Net, which helped government agencies manage their computer networks, to Wang Laboratories for $167 million in 1996, just before Wang imploded. And Ken Bajaj who sold AppNet, a designer of e-commerce systems, to Commerce One for $1.4 billion in June 2000, just before the Internet bust sent the whole thing into bankruptcy. And that is the same Ken Bajaj who rolled up a couple of defense contractors into DigitalNet, which he sold late last year to BAE Systems for $595 million, cashing in on the frenzied consolidation in the "government IT space."
But these days, Bajaj has set his sights on the commercial sector, looking for companies that can help health care and financial services firms reengineer and automate some of their processes. His new shell company is called SystemsNet, and I'd call it one intriguing piece of evidence that prices for government contracting firms are at or near their top.
Exhibit B comes from Fairfax, where Nortel Networks recently snapped up PEC Solutions, a government information technology firm with 1,700 employees and a portfolio of homeland security, intelligence and defense contracts.
Ever since the bursting of the telecom bubble, the once-highflying Nortel has been in a tailspin, shedding its manufacturing operations, running through top executives and corporate strategies and dealing with accounting problems and shareholder lawsuits. Desperate to find something new for Nortel to do, the new chief executive, Bill Owens -- a former admiral and vice chairman of the Joint Chiefs of Staff -- decided to hitch a ride on the government contracting gravy train.
In his desperation to get Nortel back on the offensive, Owens overpaid for PEC. The $448 million cash price represented a 38 percent premium over PEC's stock price at the time, and nearly 15 times its earnings before interest, taxes, depreciation and amortization -- the metric favored by Beltway dealmakers. Until the current frenzy, any price above an "EBITDA" multiple of 10 was considered rich.
A similar warning can be gleaned from the recent announcement by Ciena, the floundering telecom equipment maker in Linthicum, Md., that it was launching a new "government solutions" subsidiary, the latest in a series of strategic repositionings that has only frittered away Ciena's substantial pile of cash.
But the clincher, it seems to me, is the arrival of foreign acquirers into the government contracting market. Just as the Japanese purchase of Pebble Beach and Rockefeller Center marked the top of the 1980s real estate market and the arrival of the French heralded the telecom bust, the current buying spree by British firms signals an imminent top to the government IT and defense market. The prices paid by Serco Group for Resource Consultants of Vienna ($215 million), BAE for DigitalNet ($595 million) and QinetiQ Group for Apogen Technologies ($288 million) were all at double-digit multiples, substantial premiums over market valuation. These prices were premised not only on the assumption that the U.S. government contracting pie will continue to grow as fast as it has, but also that each newly combined company will be able to increase its share of it -- which, as the British might say, isn't bloody likely.
Much of the impetus for the recent buying spree has come from large corporations trying to make good on their overblown promises to Wall Street of double-digit earnings growth. But according to one investment banker I spoke with, the sky-high levels at which companies are now being offered have already begun to scare away potential buyers, leaving relatively few bidders for many recently announced deals. And more than a few behind-the-scene auctions have reportedly been called off after potential buyers refuse to pay the premium prices that sellers now expect.
If you're keeping score at home, the company to watch is SI International in Reston, a well-run, fast-growing IT contractor. Although its share price has doubled in the past year, it is still selling at "only" about 10 times EBITDA. And with annual sales of about $400 million, it is one of the last remaining mid-size firms that is ripe for acquisition. Founder Ray Oleson's recent announcement that he was stepping down as chief executive could signal he's ready to cash out before valuations fall back to earth.
Steven Pearlstein can be reached firstname.lastname@example.org.