Market Share: Investors like Bush's 2006 budget request

Bill Loomis

Despite investors' concerns over slower defense and IT spending, President Bush's fiscal 2006 IT budget request to Congress asks for a 7 percent increase, better than the 0.9 percent request in 2005 ? subsequently revised to 3.9 percent by the Office of Management and Budget ? and better than the increase I was expecting.

The strong increases in the large Justice Department (20 percent) and Homeland Security Department (25 percent) budgets look particularly good. Only six of the 26 civilian federal agencies face a decline in spending, and only one, the Office of Personnel Management, faces a double-digit decline (-14 percent).

The Defense Department's spending request for 2006 would raise the budget 4.8 percent to $419.3 billion. The department's IT spending would increase by 4.9 percent to $30.1 billion.

The spending increases do not include supplementals, which further boost spending, particularly for the Army.

I expected overall defense spending growth to be moderate, though I believe it remains healthy and in line with ? or even ahead of ? investor expectations.

Although investors have reacted positively to the president's requested budget for fiscal 2006, so far the reaction to reported fourth quarter earnings has been mixed.

CACI International Inc. had solid results, meeting analyst estimates and raising their earnings guidance. However, the stock has sold off over concerns of slower earnings-per-share growth as CACI reaches the anniversary of its acquisition of American Management Systems Inc.'s defense business.

On the other hand, SRA International Inc. saw its shares move higher on better-than-expected results and expectations for continued strong double-digit earnings growth through the year.

Computer Sciences Corp. had mixed results in its federal business. The business it is keeping showed a 4 percent drop in revenue, while the federal business it is selling (DynCorp International and other units) showed a 63 percent revenue growth in the quarter. Also, for the first time, CSC disclosed the profitability of the federal business it is keeping (about 5.8 percent operating margin) and on the part it is selling (8 percent operating margin).

That CSC appears to be selling the higher margin, much-faster-growing part of its business, coupled with the uncertainty of how the proceeds will be invested (Will it be to acquire another company, and if so, who, when and at what price?) has caused the stock to drop since its otherwise better-than-expected earnings report.

I do agree with CSC's timing and decision to sell non-core, non-IT business while that business is at peak margins and growth rates. However, looking at the shorter-term impact, investors appear to have had a different reaction.

I believe the bearish investor sentiment that has settled on the group this quarter will fade as the federal IT firms generally report solid results, the budget outlook remains favorable, and deal flow improves through the year.

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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