PROBLEM 11–4 IT service companies develop Web storefronts that are integrated with back-end implementation systems. Only a small number of companies offer such extensive e-business integration. The industry continues to grow because of customer demand. Unlike traditional valuation, companies in the IT services sector are valued based on revenue multiples. Following are two tables that summarize comparable valuation multiples and operating metrics as of November 22, 2005—a leading Wall Street investment bank, using its own estimates and company data, compiled these tables.

Valuation Multiples REVENUE ESTIMATES REVENUE MULTIPLE Price at Shares Market Latest Quarter Company 11/22/05 (millions) Value 2005 2006 Growth Revenue Growth 2005 2006 Breakaway Solutions....... $ 62.63 23.9 $1,497 25 43 72% 7 38% 59.9 34.8 Rare Medium .................. 31.25 78.0 2,438 50 100 100 5 100 48.8 24.4 Scient ............................. 129.38 38.9 5,033 95 222 134 31 88 53.0 22.7 Viant............................... 87.00 26.0 2,262 59 110 86 19 71 38.3 20.6 Proxicom ......................... 73.50 29.2 2,146 79 122 54 24 45 27.2 17.6 US Interactive ................. 41.25 22.1 912 34 55 62 10 29 26.8 16.6 Razorfish ........................ 73.50 46.5 3,420 148 230 55 41 20 23.1 14.9 AppNet............................ 48.63 31.3 1,522 109 150 38 30 20 14.0 10.1 iXL Enterprises................ 37.00 64.5 2,388 200 370 85 64 39 11.9 6.5 Modem Media ................. 54.00 11.7 632 71 102 44 21 32 8.9 6.2 Luminant Worldwide ....... 38.38 23.7 909 94 149 58 25 — 9.6 6.1 USWeb/CKS..................... 42.50 89.1 3,787 506 925 83 138 22 7.5 4.1 Selected averages ........... — — — — — 73% — 46% 27.4 15.4 Selected medians............ — — — — — 67% — 38% 25.0 15.7 Operating Metrics Gross Revenue/ Billable Billing Annual Average Company Margin Headcount Headcount Rates Turnover Utilization Breakaway Solutions.................. 52.4% $214,000 140 $138 20% 73%
Rare Medium ............................. 51.0 188,000 327 200 — 70 Scient ........................................ 53.8 303,000 484 — 12 71 Viant.......................................... 55.0 324,000 254 — 28 67 Proxicom .................................... 48.8 214,000 492 149 17 79 US Interactive ............................ 44.2 187,000 212 160 24 68 Razorfish ................................... 57.8 197,000 868 153 18 62 AppNet....................................... 45.1 175,000 715 115 16 73 iXL Enterprises........................... 44.0 217,000 1,260 152 30 73 Modem Media ............................ 44.7 209,000 455 132 8 78 Luminant Worldwide..................— 180,000 — — 24 73 USWeb/CKS................................ 40.0 223,000 3,190 155 21 69 Selected averages...................... 48.8% $219,283 — $150 20% 71%
Selected medians ...................... 48.8% $211,500 — $152 20% 72%
Required:

a. Considering that the IT services sector is still in its infancy, explain why analysts employ a revenue multiple model when valuing these companies. How do the “nonfinancial” operating metrics supplement this model?

b. Can you explain why the distribution of revenue multiples appears to have such a wide variance? Notice that billing rates do not appear to be as varied.

c. Most operating metrics are based on headcount. This can be a problem for an industry enjoying such rapid growth. Can you explain how this can be a problem? (Hint: Average utilization is the percentage of the 2,080 normal work year that is billed to clients beginning on the day that the employee is hired.)

d. Explain why the revenue multiples for year 2006 are all lower than the comparable revenue multiples for 2005.

e. With such rapid industry expansion comes consolidation through business combinations. Shortly after the above tables were compiled, Razorfish completed a merger with International Integration (I-Cube), another company in the IT services sector. Razorfish offered I-Cube shareholders 0.875 share of Razorfish for each one I-Cube share. The deal was valued at $24.72 per share, nearly 18% above what I-Cube was trading for prior to the announcement. At the time of the acquisition announcement, I-Cube was trading at a price-to-revenue multiple of seven. What is your assessment of the price that Razorfish paid to acquire I-Cube?