Online extra: Market Share -- As Bush prospects rise, so do federal IT stocks

Bill Loomis

Despite no change in strong business trends among the federal IT service companies over the past few quarters, investors have been driving stocks higher in the past couple of months.

After being down 12 percent for the year in the second quarter, versus a slightly up overall market, federal IT companies jumped 14 percent in the third quarter, and are up 2 percent for the year, versus the S&P 500 declining 1 percent in the quarter and being flat for the year.

The acquisition of DigitalNet Holdings Inc. by BAE Systems plc has helped boost valuations in the space. Other factors driving investors to federal IT services have been an increased likelihood of President Bush being reelected (the federal IT service stocks sold off earlier in the year when Kerry gained some early momentum) and disappointing results from commercial hardware and software companies.

Most of the federal IT service firms we track are indicating record bid and proposal activity, mostly focused on defense agencies, and are quite upbeat about their outlook over the next couple of quarters. These trends are collectively unchanged from what we have been hearing for the past few quarters.

I generally expect good revenue and earnings per share growth from the public federal IT firms when they start reporting third quarter results this month. Based on consensus estimates, the strongest EPS growth is expected from CACI International Inc. (41 percent), SI International Inc. (39 percent), SRA International Inc. (34 percent), Anteon International Corp. (25 percent), and MTC Technologies Inc. (20 percent).

Lower results are expected for ManTech International Corp. (down 14 percent), Dynamics Research Corp. (down 7 percent) and PEC Solutions Inc. (down 7 percent).

I expect SRA to lead on organic revenue growth (growth excluding acquisitions) in the third quarter. I am estimating 32 percent organic revenue growth for SRA, 16 percent from CACI, 15 percent from Anteon, and 13 percent from SI.

Looking ahead to next year, it will likely be a tougher environment for earnings growth for most companies in the federal space. The overall fiscal 2005 federal IT budgets have little to no growth, and the presidential election will likely have some disruptive effect on new contract award activity.

Even if President Bush is reelected, there have been press reports indicating that key advisors, cabinet and agency heads could leave after the elections. With such turnover, significant decisions and larger programs could experience delays.

Also, profit margin expansion will become more difficult given the strong margin improvement most of the public federal IT service firms have accomplished over the past several years (the average operating margin among the public federal IT companies is 8.6 percent currently, up from 5 percent a decade ago, and 7 percent in 2000).

The average price-to-earnings ratio of the group is above the S&P 500 on estimated 2005 EPS, at 19 times versus 16 times for the market. While the group has historically traded at a P/E below the market, it has generally traded at a premium to the market's valuation over the past three years due to strong earnings growth, which will have to continue, to support current valuations.

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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