Market Share: Bountiful contract awards to drive company growth in '06

Bill Loomis

Federal IT companies' stock is up by 6 percent so far this year. That's better than the 4 percent from the Standard and Poor's 500, but below the 19 percent gain of commercial IT stocks.

Over the past year, federal IT service stocks are up by 18 percent, above the 9 percent from the S&P 500 and the 17 percent from commercial IT service companies.

Looking to the future, as contract activity improves through the year, and mergers and acquisitions inevitably are announced, federal IT stocks may trade higher.

Near the end of the year, concerns about a timely fiscal 2007 budget passage, how the fiscal 2008 budget will shape up, and noise around congressional elections could stall the group's stock performance.

Shorter term ? over the next few weeks ? investors will focus on first quarter 2006 results. I'm comfortable with the consensus first quarter estimates and believe that most companies will meet or modestly exceed guidance on earnings per share. As usual, revenue will be less predictable than EPS as a result of potential subcontractor or pass-through revenue, which has smaller impact on EPS.

I estimate average organic revenue growth, i.e., revenue growth excluding the impact of acquisitions, for the group in first quarter 2006 will be 7 percent. It was 12 percent in fourth quarter 2005 and 16 percent a year ago. Average first quarter 2006 EPS growth should be 12 percent for the group, down from 15 percent in fourth quarter 2005 and 20 percent a year ago. As we work through the year, EPS growth should rise to 16 percent by fourth quarter 2006 as new awards kick in.

As we approach the fall, attention will focus on fiscal 2008 defense and IT budgets, following as it does the only slightly higher federal IT budgets of fiscal 2007. Some potential shifts in spending are coming in the Defense Department, though history shows that Congress often dilutes some of the changes desired by the Pentagon. The Defense Department would like to reduce its costs of operations and maintenance, as well as redundancies between contractor and defense personnel roles, which could have direct implications for IT contractors.

The heady defense budget days of post-Sept. 11 are over, but well-managed federal IT companies should understand where client spending is headed and should position themselves accordingly.

Think back to the declining defense budgets of the 1990s. IT research firm Input Inc. estimates that federal IT services spending will rise at a 4.4 percent compound annual growth rate over the next five years, with civilian IT budgets growing at a 5.1 percent CAGR, and defense IT spending growing at a 4.3 percent CAGR.

A key focus will be the value of contract wins the companies had in the quarter, the growth of their backlogs and what the pipelines for bid opportunities look like. In general, contract awards for companies likely will be higher in first quarter 2006 than in fourth quarter 2005 and higher yet in second quarter 2006 and third quarter 2006.

My discussions with companies during the quarter suggest bid pipelines generally have improved over the past quarter, and funding on business also improved. Contract awards likely will improve each quarter as we move through the year, which would drive higher growth in coming quarters.

Bill Loomis is a managing director at Stifel Nicolaus, which acquired Legg Mason's Capital Markets Group in December 2005. He can be reached at wrloomis@stifel.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: Stifel Nicolaus, 100 Light St., Baltimore, MD 21202, Attn: Research Department.

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