Is Another Bubble Building

Though it seems that the economic rebound is just getting started, there's already concern that another bubble-burst may be coming. It may not be right around the corner, but that doesn't mean it's far away.

In the blink of an eye, numerous companies have climbed in value--too far and too fast by some standards. Take EDS, for example. The troubled Plano, Texas-based company that has endured management upheaval, contract disputes and sales shortfalls today trades near its 52-week high and nearly double what its shares traded for last March. So much for bad news. In fact, despite all that the company has endured in the past 12 months, including the firing of top executive Richard Brown and the appointment of Michael Jordan as CEO, shares of EDS stock have very nearly matched the remarkable gains that the Nasdaq saw in 2003 and into 2004, at least until recently.

The same is true for scores of stocks, including many on the most recent VARBusiness 500 ranking of the largest IT service providers in North America. Computer Sciences Corp. (No. 6), CDW (No. 18), Ikon Office Solutions (No. 33) and American Management Systems (No. 53) are all trading near their yearly highs. Scores of others are, too.

Several factors help explain the extraordinary gains made by VARs, solution providers, IT consultants and systems integrators. A return to more normal buying patterns by customers is one. Promising new innovations, including VoIP, that require solutions selling is another. But the main factor, according to executives who run some of the biggest and most successful companies on the VAR500, say it's improved net results that have lifted the price of their shares.

"It all has to do with earnings per share," explains Joel Ronning, CEO of Digital River (No. 265), an Eden Prairie, Minn.-based solution provider that specializes in electronic software distribution (and also profiled on page 96). In two years, Ronning's company has gone from negative profitability to posting quarters with earnings per share (EPS) of around $0.12. Now it's looking to quadruple those results, thanks to improved spending by corporate customers and the willingness of software and other publishers to green-light projects that put Digital River's e-commerce back-end capabilities directly on their Web sites. Digital River's stock now trades for around $22 and change--nearly three times what it traded for last March.

The rise in share value raises several possibilities for the company. With a market cap of $700 million and more than $125 million in cash and investments, Digital River is in an ideal position to pursue some acquisitions. Trouble is, the companies Ronning would like to look into to see if they make sense for him to combine with have also increased in value, making any possible deal more expensive than it was just six months ago.

For Ronning, that's not a terribly important issue, so long as he doesn't overpay for any company. But for others, the fast rise in share prices raises some concerns. Mark Shappee, for example, is the founder and managing principal of Ventura, Calif.-based Venture Management. The company's specialty: hooking up IT buyers and sellers, especially those in the solution-provider community. Shappee's company has helped facilitate a number of deals involving VARs and integrators; he notes with some alarm how fast and how high valuations have climbed. While that has been a godsend to those who struggled throughout 2002 and 2003 and found that they couldn't sell their companies for but a fraction of what they considered them to be worth, the rise in values raises the question of whether some IT shares are overpriced.

At this juncture, those looking to acquire or sell don't seem all that concerned. In fact, the number of solicitations that Venture Management has received from private-equity companies looking to invest in VARs and integrators has spiked enormously in the past several weeks. The primary reason, obviously, is the rise in value of these companies. Venture Management's research, for example, notes that the median valuations for publicly traded applications-development and systems-integration firms had increased 57 percent by the third quarter of last year. And while Shappee believes that's a good thing, he is keeping a wary eye on the rapidly rising price to earnings (PE) ratios of many companies. Although earnings are improving for many companies, as they are for Digital River, they generally aren't keeping pace with the rise in share prices. And that has sent PE ratios zooming to near-record levels.

Digital River, for example, has a PE above 40. So do plenty of other VAR500 companies. Acxiom (No. 58) has a PE above 90. These ratios not only rank up there with those last seen at the height of the dot-com boom, they are also well above the historic norm for successful companies of this ilk, which are more accustomed to PEs of 20 to 30. Furthermore, the current PEs of several VAR500 companies are well above some of the industry's most successful IT companies. Consider the following: Microsoft has a PE of just 33, while Oracle has one of 28. IBM, meanwhile, has a PE of around 22, while Intel has one of 36.33.

Despite this situation, Shappee, for one, expects to see a spike in the number of transactions involving IT solution providers. Many traditional factors, of course, will influence actual purchase prices, including business conditions, underlying financial performance and even customer satisfaction. But there are new issues business owners should take note of before considering either selling or buying a solution-provider organization. Take offshore outsourcing. Financial experts are keeping a close eye on just how much work American end users seem to be willing to see go offshore. In an election year where job growth and unemployment are likely to be critical issues, the percentage of IT work that heads offshore is not only likely to influence votes, but company transaction prices, too.

Just one more reason why 2004 is shaping up to be a year like no other.

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