Taking Booz Allen public could be company's undoing, says Steven Pearlstein

By Steven Pearlstein
Wednesday, June 23, 2010

From the moment the Carlyle Group purchased the government-contracting arm of Booz Allen Hamilton two years ago, it was almost inevitable that the contractor would be going public before too long.

Carlyle, after all, is a private-equity firm that is able to deliver those spectacular returns to investors only when it sells what it buys. And in the case of Booz Allen, whose niche is to provide high-level advice to government agencies on hardware and software acquisitions, the government's conflict-of-interest rules prevent its sale to another big contractor. The only other exit strategy would be to sell the company to public shareholders. And this week, Carlyle set that process in motion by announcing its intention to float a $300 million stock offering, with other installments to follow.

This is certainly good news for Carlyle, which owns about 80 percent of Booz Allen, and the company's top executives, who own the rest. Booz Allen's revenue and profit have climbed more than 40 percent during the two years since it was sold, and with other contractors now selling for eight times their annual earnings before interest and taxes, that means Booz Allen is now worth roughly $3 billion, or about $500 million more than what Carlyle paid for it.

Since Carlyle has already recouped half of the $1 billion in cash it put into the deal, through special dividends that Booz Allen paid out last year, it means that in just two years Carlyle and its investors have already earned a return of more than 100 percent on their investment. (For the record, Booz Allen says the $300 million proceeds from the IPO will be used to pay down debt taken on to pay the special dividend.)

What's less certain is whether this is good for Booz Allen, its government customers or its neighbors here in the Washington region.

Booz Allen is one of the crown jewels of the local economy. It is respected and feared by its competitors while engendering unusual levels of loyalty from its customers and its well-paid employees, 15,000 of whom live in the D.C. area. It has a strong corporate culture that stresses quality, collaboration and putting customer interests before its own. Its steady growth in sales and profits has been organic, the result of sustained investment in people and technology without resort to costly and culture-diluting acquisitions. In its philanthropy and community involvement, it has been a model corporate citizen.

Central to all of this is the fact that Booz Allen has been, for most of its existence, a private company whose executives have had the luxury of managing for the long term. During the 1970s, the company briefly went public, only to discover that the demands of public shareholders were inconsistent with both its business model and its partnership culture, and quickly took itself private again. And when the decision was made several years ago to separate its fast-growing government contracting division from it slower-growing corporate consulting division, it was no coincidence that the partners preferred to raise the needed capital from a private-equity fund rather than selling out to a public company.

On Tuesday, Booz Allen chief executive Ralph Shrader took pains to assure that none of that -- not the culture, the management team or the core values -- would change once his firm became a public company.

"We have a truly unique culture here that is the hallmark of our success," Shrader said. "We understand that preserving that culture is the best way to preserve and enhance the value of this franchise."

But while Shrader may understand that, history suggests that the markets will not. At some point, the growth in the government-contracting sector will slow, or a contract will blow up, or the company will need to make a costly investment to achieve its next increment of growth. And that will be the moment when Shrader or his successor will find that what comes first is not the customer, or the employees, or the culture, but the imperative of delivering double-digit earnings growth to investors quarter after quarter after quarter.

At that point, Booz Allen will become just like all the others -- good, but no longer great -- desperate to meet its earnings targets by chasing after low-margin contracts or buying up mid-size competitors. And while that might satisfy Wall Street, the Pentagon is discovering that that kind of growth-driven consolidation has done little to lower costs or improve quality, while hollowing out the middle of the market where much of cutting-edge innovation used to take place.

It might be argued that a company that has averaged 18 percent average annual growth over the last 15 years is ideally suited to the meet the incessant demands of Wall Street. But even Booz Allen is about to encounter some head winds in the form of deficit-induced budget-cutting and a strong push by the Obama administration to shift work out of the hands of private contractors and into the hands of government employees. Booz's growth prospects are also limited by those conflict-of-interest rules that severely limit what other contracts it can compete for in the agencies where it already does business. Increasingly stringent enforcement of those rules has recently led both Northrop Grumman and Lockheed Martin to spin off their profitable engineering and consulting divisions.

In selling out to Carlyle, and now to Wall Street, Booz Allen may well have found a way to unlock the tremendous value of its franchise for its partners and its outside investors. What is less clear is whether Booz Allen can unlock that value without degrading itself. Put me down as skeptical.

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