`VALUE GAP' HURTING FEDERAL SERVICES COMPANIES.

Byline: Jon B. Kutler Guest Column

What's a dollar worth? That's a question Wall Street asks every day. Few in the market today dispute that a metal-bending revenue dollar is worth less than a dollar in software sales. Valuation can be segmented by end customer as well as content. A defense dollar vs. a commercial dollar? Commercial wins, of course. Or does it?

Temporary-help companies have become the darlings of Wall Street as they fulfill corporate America's short-term staffing needs. The Pentagon, however, has had legions of professional services companies fulfilling a similar ``shadow'' staff function for decades with little such recognition. Similarly, are the technological capabilities required to integrate a computer network for a military command or federal agency that different from those for a Fortune 500 company? The financial markets seem to think so.

Last year, Woodland Hills-based Litton purchased PRC, Wang bought I-Net and Tracor acquired Cordant. Industry observers who have not flinched over the sight of commercial services transactions priced three to four times as high seemed amazed by the premiums paid for these companies in the federal services sector.

When pressed for an answer, most pundits cite the obvious list of differences to justify rewarding the ``commercial'' revenue dollar more handsomely. They include higher margins and greater growth prospects.

The reality, however, is a lack of understanding of the federal sector. If one takes a closer look and adjusts performance to account for the relative risk to the investment dollar that permitted the revenue to be achieved, federal services companies are being inappropriately penalized by the financial markets.

In contrast to their commercial counterparts, these companies are awarded longer-term contracts, receive allowances for bid and proposal dollars, have reduced investment requirements, have a more financeable receivables base to borrow against, and are dominated by ``cost plus'' performance protection.

There are two major hurdles, however, to closing this large valuation gap: management skills and time horizon.

An aggressive, world-class management team deserves a higher valuation. While this characterization does not need to fall along federal vs. commercial lines, in the fragmented federal services sector it often does.

A small federal services company that has seen its growth plateau in today's more competitive market probably does not have the team in place to convincingly sell Wall Street on the merits of it scaling the ``value gap.''

It is more likely that such a company would prosper the most by selling into today's hot acquisition market, with hopes of structuring a transaction to participate in the value run-up of the acquiring company.

As for time, despite their rapid appreciation of the last few years, the financial markets still stigmatize federal sector companies because of the perceived impact of a post-Cold War military drawdown and the general image of federal government inefficiency.

Rather than fight this viewpoint, the most popular short-term model of ``value enhancement'' today is through ``image repositioning'' within that market. Federal contractors by the scores are suddenly deciding that their professional services companies are really higher-valued ``information technology'' companies.

In the longer term, however, the real money is to be made by closing the value gap with the commercial sector - not through such smoke and mirrors on the federal side.

A case in point: BDM went public at $18.50 in 1995 and last year traded as high as $61.50 - a wonderful success story that has become a model for its federal peer group. If judged as a truly commercial company, however, BDM would likely be trading today at nearly three times that level on an equivalent valuation per revenue dollar.

This does not mean that federal services companies need to acquire commercial revenues to be valued as such. Instead, they should play for the longer term: get larger, fast, to stand out among their peers and provide flexibility in contract bidding; learn to market like a commercial company; and develop an all-star management team.

If successful, these companies will be well-positioned for the coming ``closing of the valuation gap.'' It is likely to take to the end of the decade to close, but doing so will yield significant upside for those that can wait and are capable of getting there. Wall Street eventually gets it right.