Defense, cybersecurity drive rosy outlook

Market Share | Financial Views of a Competitive Environment

Federal information technology and professional services
stocks have rallied over the past couple of
months due to good second-quarter earnings reports
and investors seeking less economically sensitive investments.
The federal IT group has almost broken even for the year,
with a decline of 0.4 percent, which is better than the S&P 500's
11.6 percent and Nasdaq's 7.5 percent decline. The group still
trails aerospace and defense stocks, which are up 11.2 percent for
the year and continue to benefit from strong defense procurement
and war-related spending.

The public federal IT services companies
reported good second-quarter
2008 results, with average organic revenue
growth (growth without the
impact of recent acquisitions) of 13
percent, down from 16 percent in the
first quarter, but about the same
growth rate as a year ago. The average
operating profit margin was 7.7 percent
in the quarter, up just slightly
from a year ago.

Most of the companies also reported
good good growth in the volume of
sales orders waiting to be filled and contract
bids awaiting decisions. I expect awards will
be strong for the September quarter as the
government fiscal year ends and then probably
be soft later in the year until fiscal
2009 budgets are passed, probably through
an omnibus bill next spring.

There seems to be more uncertainty than
usual about the future of federal IT spending,
because the two presidential candidates
have not been specific about policy and
spending plans, and there should be substantial
turnover of leadership in the federal
government next year. Also, the federal
budget deficit is heading to $400 billion
this fiscal year, and it is worsening given the
sluggish economy (and therefore tax
receipts) and continued high government
spending overall.

As in the 1990s, the
large defense budgets
seem to be a likely source
of funds to pay for growing
mandatory spending
and promised discretionary
spending initiatives.
However, the sight of
Russian tanks rolling
through Georgia and missile
tests in Iran are reminders that there
are other threats beyond those concerning
terrorism in the world. These events reinforce
the idea that the United States needs a
strong defense.

Federal IT spending fared quite well in
the 1990s, despite overall defense budget
cuts. Also, the defense agencies are using IT
even more in weapons programs. The Army
is a good example. It is shifting money from
heavy vehicle programs to programs that
support light infantry brigades such as
Ground Soldier Systems, Joint Tactical
Radio System, Warfighter Information
Network-Tactical and Future Combat
Systems.

Cyber warfare and cybersecurity are also
increasingly important areas of defense, as
shown by the well-publicized cyberattacks
on Georgia's government Web sites before
and during its conflict with Russia in South
Ossetia. Dozens of Georgian government
Web sites were shut down by denial-ofservice
attacks.

President Bush's classified multibilliondollar
Comprehensive National
Cybersecurity Initiative has been shifting
undisclosed billions of dollars into offensive
and defensive cyber warfare and cybersecurity
programs. The defense agencies have
been responding to the threat, too. Although
the Air Force Cyber Command might not
get off the ground as planned, the larger
goals of the command will be continued in
an undetermined organization.

Despite uncertainties in the
next few years, I believe the long-term
outlook for federal IT firms
remains solid. Technology is
clearly playing a bigger role in the
economy, government and
defense, and this trend is likely to
increase in my view.

Bill Loomis 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 herein, please go to
the research page at www.stifel.com.

About the Author

Bill Loomis is a managing director at Stifel Nicolaus.

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