Budget battles could trigger funding delays

Market Share | Financial views of a competitive environment

Bill Loomis

During the next few weeks, the public federal information technology and professional services firms will be reporting their second-quarter 2007 results. I generally expect the government IT services companies to report second-quarter results that are in line with projections but to be cautiously optimistic on third-quarter 2007 and full-year results.

CACI International Inc. and SRA International Inc. finish their fiscal years in June. CACI already gave its guidance for fiscal 2008, which was in line with investor expectations on revenue but disappointing on earnings per share (EPS). CACI cited two recompeted contract losses, slower-than-expected contract growth due to budget delays and higher personnel costs as primary reasons for the lower profit margin outlook in the next year.

I believe SRA will likely also be conservative on its fiscal 2008 outlook, with guidance likely below my estimate but revised higher during the year as business picks up.

I project second-quarter 2007 organic revenue growth (revenue growth excluding the impact of recent acquisitions) of 7 percent for the public federal-services firms, down from 10 percent last quarter because the delayed passage in late May of the fiscal 2007 defense supplemental bill created funding uncertainty for key government programs. We expect organic growth to bottom out at 6 percent in third-quarter 2007 and then pick up to 8 percent in fourth-quarter 2007 as companies benefit from government year-end spending and contract awards.

I am expecting 2008 revenue growth of about 10 percent for the public companies, assuming the defense and civilian agency spending bills are passed reasonably on time. However, with little progress so far in Congress on the fiscal 2008 defense spending bill ? or anything at all in the Senate ? the likelihood of another year of late spending bills and continuing budget resolutions is increasing.

In terms of EPS, I project growth to bottom out at 5 percent in second-quarter 2007, down from 9 percent last quarter, and increase to 8 percent and 13 percent in third-quarter 2007 and fourth-quarter 2007, respectively. I expect EPS to average 20 percent growth in 2008, driven by higher organic growth and leveraging significant business development and bid and proposal costs incurred by government IT companies last year, and relatively easy earnings comparisons. Again, this assumes the fiscal 2008 spending bills are not delayed significantly.

In the near term, many companies are observing more contract award activity from the Homeland Security Department under the Enterprise Acquisition Gateway for Leading Edge contract and others.

Also, Army indefinite-delivery, indefinite-quantity task order awards are picking up, such as the Army Information Technology Enterprise Solutions 2S and the first award under the Army's Field and Installation Readiness Support Team contract.

Most of the companies I speak with generally seem more concerned about budget battles this fall potentially causing more funding delays. After several years of delayed budgets, the companies are generally expecting more delays this fall, with continuing budget resolutions likely going into fiscal 2008.

It appears that a "usual" delay of two to three months for most budgets has been factored into company business plans. However, we believe that more severe delays will likely result in lower 2008 earnings expectations for the group.

With Congress at a record low approval rating in the latest polls and being criticized heavily in the polls for not doing more to stop the Iraq war, we expect the Democrats to continue to push hard for some type of Iraq withdrawal or other provisions in one or more appropriations bills ? probably the defense supplemental spending bill ? in addition to the defense authorization bill, which could cause delays.

Bill Loomis is a managing director at Stifel Nicolaus. 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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