Market Share: Growth is good ... and it will get better

Bill Loomis

Federal IT stocks have been weak over the past couple months for a number of reasons, including uncertainty from civilian budget delays and potential reallocation of funds because of the possible conflict with Iraq. Some investors are also saying that growth may have gotten "as good as it could get." As an example, they point out that defense spending growth in fiscal 2004 is currently proposed at about 4 percent, compared to double-digit increases the two previous years.

But while growth rates may have peaked in fiscal 2003, growth in the industry is far from over. Following a recent round of meetings with several federal IT service firms, I noticed some consistent trends, including:

*Some recent pickup in funding on existing contracts now that the civilian spending bills have been signed;

*Bid and proposal activity is high, in some cases at record levels;

*Companies are much more concerned with how and where they will get the staff to do the work later this year, as opposed to whether the work will come;

*Reminders of the federal government's practice of obligating dollars before the end of the fiscal year;

*Continued optimism on further potential for profit margin improvement.

Specifically on the Defense Department side, company comments indicate that defense spending appears to be on track with expectations and with where we are in the government fiscal year. A couple executives noted that defense funding was being prioritized to support the warfighter as well as related logistics, procurement and supply chain systems and activities, ahead of potential conflict with Iraq. This means a good deal of spending in the near term is devoted to related operations, support and maintenance, which could, for the time being, emphasize these areas over back-office IT investments.

While the general message from the meetings and presentations was positive, potential issues remain that investors should monitor.

First, while there is some early, positive activity now that the civilian spending bills have been signed, companies generally indicate that client agencies were not uniform in how fast they were moving to get work started and funds flowing. Companies cited a potential lag of 30 to 60 days between civilian bills being signed and funds being available, so we think there is still some risk that some companies might come in with results a little light for the first quarter of 2003 -- probably more risk to revenue than to earnings -- or give detailed second quarter guidance slightly below expectations.

The Iraq conflict also presents uncertainty as to fund allocation within defense agencies, though in our meetings companies indicated there had not yet been any major project delays or cancellations because of conflict preparations.

Second, we believe a major issue this year in federal IT will be the greater desire of Congress and the Office of Management and Budget to make sure IT dollars are well spent. OMB is getting serious about business cases surrounding large IT programs. There are about $7 billion in projects out of the $59 billion that are "at risk" because the business plan is inadequate. Companies will have to monitor their key programs and offer assistance if appropriate.

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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