Ride on the tech market roller coaster to stop soon

Market Share | Financial views of a competitive environment

Bill Loomis

The growth rates of the federal information technology budget and growth among the publicly traded federal IT services firms have been slowing on average since the start of the Iraq war. This is because funds allocated to the war have not fully covered the costs and usually have been delayed.

Even the first supplemental spending bill for the war did not pass until months after the invasion of Iraq, and there has been a series of delayed funding bills since then ? except for last fall. The passage last month of the second fiscal 2007 Defense supplemental spending bill should help ease some near-term funding concerns.

I expect an improvement in contract award activity and growth for the September quarter as government buyers spend fiscal year-end money and as the supplemental spending bill passed last month frees up funding for projects unrelated to the war. The December quarter also should be a good one for awards and growth because we should have the non-Homeland Security Department civilian-agency fiscal 2008 budgets passed on time. That should be the case given the Democrats' criticism of the Republican-led Congress last year for not passing the non-DHS civilian-agency budgets.

Although I believe the fiscal 2008 Defense appropriations bill probably will be passed on time or nearly on time, the $142 billion fiscal 2008 Defense supplemental bill could be the next target for timetables and other legislation if Congress separates it from the rest of the Defense Department's budget.

Unfortunately, delays in the fiscal 2008 Defense supplemental spending bill probably will have a dampening effect on many IT and non-war-related
programs.

The stock performance of the public federal IT services companies has reflected the war's effect on more discretionary budgets, such as IT. Federal IT services stocks have underperformed the broader stock market indexes and the aerospace/defense stock indexes ? made up of the largest defense firms such as Lockheed Martin Corp. and Northrop Grumman Corp. ? in the past few years. Year-to-date, the public federal IT services stocks are up 5 percent, while the S&P 500 index is up 7 percent and the aerospace/defense index is up 20 percent.

Although the large aerospace/defense firms are also the largest IT services providers in the industry, weapons systems and platforms are still the dominant profit drivers for those firms, and those segments had strong market growth in recent years. Based on the fiscal 2008 budget request from President Bush, this trend will likely continue over the next year at least. As costs for the Iraq war begin to wind down, it will be a better business environment for federal IT services firms.

Assuming the fiscal 2008 budgets are passed on time, I estimate that organic revenue growth (growth without the impact of acquisitions) and earnings-per-share growth will have bottomed out for the public federal IT services companies this year in the low single digits. But they should show improvement in 2008, with EPS growth of about 12 percent expected next year.

The budget growth slowdown and delays have not had much influence on mergers and acquisitions in the government services sector, with Multimax Inc. being acquired by Harris Corp., the latest transaction at press time. I expect that acquisition activity might accelerate further in the next couple of years because the aerospace/defense firms are under pressure from investors to use their strong balance sheets to either do share buybacks or acquisitions. Acquisitions usually win.

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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