Defense Deals Are Far From Over

Smaller contractors are linking up like crazy--and many are undervalued

The big defense contractors may all have paired off, but defense linkups continue apace. Instead of the melding of behemoths such as Lockheed and Martin Marietta, the action is now in smaller, high-technology concerns catering to the federal government. These information-technology services companies provide the Pentagon and other federal agencies with everything from knitting together old and new computers and software to averting year-2000 computer snafus. But unlike their high-technology brethren that cater to the broad business market, these firms are often overlooked and undervalued in the stock market.

AGGRESSIVE ADVICE. This new round of defense deals is being fueled by relatively low prices for target companies and changes in federal procurement policies. Jon B. Kutler, president of Quarterdeck Investment Partners Inc., which specializes in defense and aerospace investment banking, explains that "since the investment community made billions of dollars from the consolidation among prime contractors, they're actively looking for the next wave."

Defense info-tech services companies are dirt cheap compared with their peers in the commercial sector. Because of their lower margins and growth prospects, these companies have price-earnings ratios of roughly 20 (table)--about a third of the current price-earnings ratios at commercial information-technology service providers such as Keane Inc. or Computer Horizons Corp.

Changes in federal procurement policy will intensify the merger trend. Washington is consolidating small contracts into larger ones, which only bigger bidders can handle. The government is also placing more emphasis on experience and track record rather than the lowest bid, a shift that gives incumbents a leg up. So it can be easier to win a contract through a merger than a bid.

Sales of $1 billion may be the minimum needed now that titans such as Lockheed Martin and Litton Industries are horning in on the service market, says Peter A. Bracken, president of Computer Data Systems (CDSI). His $400 million Rockville (Md.) company bought privately held Analytical Systems Engineering Corp. in June and is in the market to make more acquisitions. Companies with under $500 million in sales "are beginning to see that they need the efficiencies of a larger company to compete effectively against these giants," says Bracken.

IN THE PIPELINE. CDSI itself could be an acquisition target, says William R. Loomis, who follows information-technology services companies for Legg Mason Wood Walker Inc. CDSI's stock has taken a hit lately because of earnings disappointments. But Loomis likes its strong management and expects the stock, now trading at 28 7/8, to rise to 42 in the next 12 to 18 months as planned investments in a lottery contract in Argentina and other ventures start to pay off.

Another potential consolidation play is BTG Inc. Thomas M. Meagher, an analyst with Washington-based Ferris, Baker Watts, Inc., believes that several major government contracts that BTG has won in the past year will lead to a 25% earnings jump, to 81 cents per share, in fiscal year 1998, up from 65 cents per share in fiscal 1997. That, he says, could push the stock up to 17 from 14.

Defense consolidation, phase two, won't grab headlines the way the first go-round of billion-buck deals did. But the windfalls awaiting investors could be just as eye-catching.

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