Market Watch: Federal IT firms run smooth in 2004 after initial bumps

Bill Loomis

After a rough start to the earnings season, federal IT firms are reporting good results with favorable outlooks.

Anteon International Corp. concerned investors with an unexpected pre-announcement that its fourth quarter 2003 revenue would be below expectations, though earnings per share would meet or exceed expectations. While the amount in question was not large (revenue of $280 million for the quarter instead of $287 million), and margins appear to be better than expected, the lower revenue worried investors, given Anteon's strong track record of meeting expectations, both on the top and bottom lines.

The company blamed the shortfall on less-than-expected new task orders from its defense and intelligence agency clients, and indicated that it was a temporary problem.

Fortunately, Anteon has been the only one so far this quarter to have that problem. Both CACI International Inc. and SRA International Inc. reported accelerating growth and strong contract awards. SI International Inc. and MTC Technologies Inc. preannounced as-expected results.

PEC Solutions Inc. reported disappointing results and outlook, as it did several times last year. It cited the delayed civilian budget bill and slower-than-expected homeland security spending as reasons.

One disappointment came from Computer Sciences Corp. CSC's federal unit, at 40 percent of its total revenue, showed no organic growth last quarter after a 7 percent increase the quarter earlier. CSC has lost several large contract recompetes over the past couple of quarters and faces a slowdown in some larger contracts, including the IRS modernization effort.

With the fiscal 2005 budget request announced, it appears IT spending may be up only about 1 percent vs. 4 percent in fiscal 2004 and 13 percent in fiscal 2003. Defense spending is up 7 percent, while the defense IT request is up only 1.5 percent.

The elections plus more focus on the budget deficits could lead to even lower growth rates when a final budget is signed. I believe that organic growth (growth excluding acquisitions) will accelerate this year for many of the public federal IT companies, at least those that win their recompetes, as the strong fiscal 2003 budget growth and new fiscal 2004 programs are awarded and begin to convert to revenue growth. In fact, CACI, SRA and Anteon have had very strong contract wins over the past couple of quarters.

Over the next couple of years, as slower-growing budgets result in fewer contract awards, acquisitions likely will be more important to the growth strategies of the larger federal IT firms. Several acquisitions have been announced this year by public federal IT companies, and valuations appear to be stable though attractive for sellers, generally in the range of 8 times to 10 times earnings before interest, taxes, depreciation and amortization for attractive, growing companies with good profit margins.

Companies with significant intelligence agency contracts can command higher valuations. Together with organic growth supplemented by acquisitions, I expect the public federal IT firms can deliver 15 percent to 20 percent earnings-per-share growth, well ahead of the overall budget growth rates.

Bill Loomis is a managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.com. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. For additional information and current disclosures for the companies discussed herein, please write to: Legg Mason Wood Walker, Inc., 100 Light St., P.O. Box 1476, Baltimore, MD 21203, Attn: Research Department.

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