Market disruption presents silver lining

Market Share | Financial views of a competitive environment

One comment I often hear lately about the financial
markets is that their volatility has increased. The
increased volatility is an indicator of uncertainty, causing
investors to react quickly to each piece of financial,
economic or political news.

We have seen this volatility in the big
swings of the broader stock index averages,
commodity and currency prices, and
spreads of debt instruments, and we have
also seen it in the stocks of the public federal
information technology services firms.

Even some of the companies that
reported results in line with expectations
were punished by declines of 10 percent or
more in their stock prices as investors
worried about future results. Federal IT
services stocks are down 10 percent year-to-
date, about the same as the S&P 500,
as the broader market benefited recently
from a rebound in financials.

Some of investors' skeptical views have
developed after three years of disappointing
federal budget news, including budget
passage delays and diversions to war funding,
which have slowed growth in the
group and resulted in several companies
lowering earnings expectations the past
few years. At this point, investors and analysts
are trying to figure out what next
year's changes in Congress and the administration
will mean for the group. Many
headlines about the group have not built
investor confidence. The political environment
seems to be more hostile now than
in some time.

Congress has bolstered oversight hearings
and is pushing for less outsourcing of
essential or critical government services.
One of the more publicized examples is
the call by Sen. Hillary Clinton (D-N.Y.) to
eliminate 500,000
contractor positions.

The Defense
Department has
been pushing to
reduce time-and-material
contracts,
which generally
carry better margins than cost-type contracts
? assuming good contract management.

Although contract protests and the
resulting longer sales cycles have slowed
business for many companies, the situation
likely will get worse. A change included
in the fiscal 2008 Defense Authorization
bill, which becomes effective at the
end of May, will allow protests on task
orders of more than $10 million. Task
orders previously could not be protested.

Changes in small-business rules and contract
consolidation also have had some
negative impact on midsize firms.
Despite some of the headwinds in the
industry, I remind investors that this is a
large and fragmented marketplace, allowing
well-managed firms the opportunity
to gain market share and show strong
double-digit earnings growth. We see
many examples of that happening today.
The disruption caused by changes in
the industry usually also offers an
opportunity.

Also, the federal IT and professional
services industry has good financial
characteristics: There is little capital
expenditure required, and it has solid
free cash flow that is near net income
levels, strong return on capital potential
and relatively moderate risk. If you
do the work right and bill properly, the
client will pay, and the client is not
going away anytime soon.

There will continue
to be budget delays and
changes. For example,
we might see the fiscal
2009 budgets delayed
until early next year.
But the better companies
will be able to
adapt and take advantage
of the changes. And although federal
IT and services budget growth has slowed,
it is still huge and still growing.

Bill Loomis (wrloomis@stifel.com) is a managing
director at Stifel Nicolaus. 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 above,
please write to: Stifel Nicolaus, One South St.,
Baltimore, MD 21202, Attn: Research
Department.

About the Author

Bill Loomis is a managing director at Stifel Nicolaus.

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