Edison Ventures Community: D.C.’s IT Economy: Readying for the Seismic Shift - Edison Ventures Community

D.C.’s IT Economy: Readying for the Seismic Shift

With the 2011 budget impasse and its automatic cuts to the defense budget looming, the Washington, D.C. area is set to see a major overhaul to its IT company landscape. Washington Post Pulitzer Prize winning business columnist Steve Pearlstein wrote on January 6th, “the government IT industry that has driven the D.C. area economy for the past decade must be replaced with more commercial IT.” While Edison had a 6X return success and IPO with BTG in the 1990s, the federal IT contractors are generally sub-10% EBITDA companies, which means longer time periods to get to the $50M-$300M exit values that drive venture returns and fit in Edison’s expansion stage strategy.

Edison has a 25-year history in backing commercial software companies in the region. Edison winners include: Best, 25X; Visual, 25X; Vocus, 13X; and POMS, 11X. Two recent Edison additions with a commercial focus are Notable Solutions and Motionsoft. Notable Solutions has also done well selling into the government market, recently winning a $3.5M contract with U.S. Department of Defense Military Health System.

Edison’s Enterprise 2.0 group is looking for unserved niches within government IT. In the federal market, the focus is primarily on information security, an industry led by Lenard Marcus. Information security remains one of the few federal IT niches where a small software vendor’s products can be solely sourced. Edison has had two prior investment successes in information security with Axent and NFR, both of which are based in Rockville, Maryland.

In state and local markets, I am seeking to invest in software applications that are critical to daily operations. The premise is that states and larger municipalities often look at and purchase IT like the commercial enterprise customer. Market size issues go away with a global market target, as the largest cities in the world have the same needs. A younger generation of chief information officers is more comfortable with the flexibility of off-the-shelf solutions.

I recently attended Raymond James’ 10th Annual Government Services & Technology Summit on January 5th. Raymond James analyst Brian Gesuale discussed the likely impact of budget cuts across the tiers of contractors. Don Blair, a longtime Raymond James investment banker in this sector, discussed the accelerated M&A activity among the small and mid-sized federal contractors. Consistent themes of the conference were products and services with recurring revenue and globalization for government IT providers.

Two presentations stuck out due to their recurring revenue business models with the potential for 25%+ EBITDA margins at the Raymond James conference: Cubic (NYSE: CUB) and Maximus (NSYE: MMS). Cubic is a leader in payment systems for transit agencies worldwide and has morphed from tokens into electronic currency on smartphones. What I found to be attractive about Cubic’s business model was that their ten-year contracts guarantee exclusivity on all services and upgrades to their systems. As we know and espouse, selling back to one’s customer base is much more profitable and capital efficient. I also noted the global nature of Cubic’s business, as their SmarTrip initiative is based in Sydney, Australia.

Maximus, which is based near Edison’s McLean, Virginia office, manages human services contracts for states and municipalities that come from the federal government via block grants. With revenue of nearly $1B and 16% EBITDA, Maximus gets six-year business processes outsourcing (BPO) contracts to manage programs such as welfare-to-work and child support enforcement. Impressively, many of Maximus’ contracts are on a pay-for-performance basis. Like Cubic, Maximus is growing globally, with strong results from Canada, the UK, and Australia.

We see three emerging trends that favor Edison’s targeted investment themes in Government IT. Information security will continue to be an urgent requirement for the Federal Government and allow emerging growth companies to achieve sole source contracts directly with the intelligence agencies. The increase in moving social program funding through block grants from the federal government to the states, will create application software , data analysis and grants management IT opportunities. These are all areas Edison has begun to build a pipeline of investments. We expect these companies to be able to achieve 60%+ Gross Margins through long term contract business models. Finally we will pursue IT companies with transaction based pricing and pay for performance business models in state and local markets where business and consumers pay fees. We expect that state and local government facing tighter budgets will move to charging fees that are based upon the cost to provide services.