Third-quarter awards feed a hungry sector

Market Share | Financial views of a competitive environment

Bill Loomis

Public companies that provide federal information
technology services have continued
to see their stock prices rise since mid-
August, when most of the companies reported
second-quarter results and issued outlooks
that excited investors.

So far this year, federal IT
services company stocks are up
25 percent. In comparison, the
aerospace and defense companies
are up 30 percent ?
excluding recently acquired
EDO Corp. ? and the overall
stock market is up 6 percent as
measured by the S&P 500.

Growth in the industry has
been slowing during the past
three years, with organic revenue
growth rates ? that is,
revenue growth from internal
operations, not recent acquisitions
? for the public federal
IT services companies falling
from 20 percent soon after the
start of the Iraq war to 5 percent
early this year. However,
organic revenue growth picked
up to 12 percent in the second
quarter of 2007 following an
increase in contract awards
and backlog in 2006. The average
growth for contract awards
and backlog has been under pressure
this year, but third-quarter awards
have been strong and should help
move the average backlog growth
higher, driving growth in the 5 percent
to 10 percent range next year.

Progress on the fiscal 2008 spending
bills has been slower than I
expected. At press time, it appeared
that most of the civilian spending
bills would be rolled into an omnibus
spending bill in the next month or
two, with the defense spending bill
also passing. The key issue for the
federal IT services companies will be
the amount of the defense supplemental
bridge funding because the
Democratic leadership has said it will
not consider the $196 billion defense supplemental spending bill until next
year.

A bridge supplemental will buy
some time, but if Congress takes the
supplemental spending bill down the
same path as the one earlier this year,
we could see reprogramming of funds
and delays to pay war costs. This type
of action last year led to weaker
results and underperformance in the
stocks in the first half of 2007, and it
is looking like 2008 could be a repeat.

Overall, we expect the business
environment for the federal IT companies
to remain challenging during
the next couple of years, though with
less contention between Congress
and the next president. Moreover, a
reduction in war spending should
help reduce funding delays and
uncertainty that have hurt the federal
IT budgets during the past four
years. The Government Electronics
and Information Association recently
issued its forecast on federal IT
spending, which indicated that it
expected total federal IT spending to
grow at a 1.4 percent compound
annual growth rate during the next
five years. GEIA expects federal IT
spending to be flat during the next
two years and then rise on higher
civilian-agency IT spending after the
new administration formulates its fiscal
2011 budget.

The profit margins of federal IT
companies also have been under
pressure during the past few years as
budget growth rates slow down,
slowing growth while companies
continue to increase their investments
in new solutions and business
development.

With organic growth stabilizing
and companies having adjusted their
organizations
through cost cutting
or efficiencies, I
expect profit margins
to stabilize and
inch higher during
the next year to
about 8 percent for
the industry.
Despite modest
budget growth and
margin pressures, with more than
$100 billion in annual spending in
the federal IT and professional
services market, I believe well-run,
agile companies can show strong
growth and produce strong returns
for shareholders.

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, One South St., Baltimore, MD
21202, Attn: Research Department
.

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