Budget boost doesn't quell investor fears

As expected, President Bush asked Congress for the largest increase in defense spending in 20 years: $379 billion. Federal information technology spending would grow from $48 billion to $52 billion.

It is somewhat surprising that many of the federal IT and engineering services firms around the Beltway have grown as they have over the past decade in the face of a difficult federal spending environment. With the strong increase in spending, and the administration's desire to continue it, what will the next few years hold for these firms?

Wall Street has recently shown increased interest in federal services companies, believing that growth in these firms, particularly those with exposure to defense or law enforcement areas, will accelerate in the face of higher spending over the next several years. We may already be seeing signs of increased growth, as several federal services firms reported increased internal revenue growth in the fourth quarter.

On the other hand, spending by state and local governments seems to be slowing in the face of large budget deficits. Virginia, a state that should benefit from the growth of federal spending, is facing a $3.5 billion deficit over the next couple of years and will implement a 7 percent across-the-board budget cut for fiscal 2003.

Affiliated Computer Services Inc., a Wall Street favorite because of its consistent earnings growth, spooked investors a few weeks ago when it indicated growth in its state and local unit was slower than expected in the fourth quarter. Maximus Inc., one of the leading business process outsourcing companies in the state and local market, recently lowered its fiscal 2002 earnings guidance, citing, in part, a slowdown in new state and local contract awards likely due to the uncertain state budgets.

One would expect that the awards of long-term outsourcing contracts would continue relatively unaffected in a tough spending environment, as we are seeing in the commercial sector, and that shorter-term IT contracts would be cut quickly.

Currently, the opposite seems true, as Maximus had very strong sequential revenue growth in its IT services unit. KPMG Consulting Inc., one of the leading state and local systems integrators, indicated in its recent earnings report that its state and local IT services practice continues to grow as well.

While fourth quarter earnings reports from commercial IT service firms have been relatively poor, they generally have been close to investors' expectations, and their outlook for IT services demand in first quarter and 2002 is generally improved from 2001 levels. Economic news, while mixed, seems to be improving, and even the federal government is signaling that the economy is improving.

Of course, Enron's accounting scandal has had a negative effect on the market. A direct consequence of the scandal will likely be the forced split between accounting firms and their IT services units. The number of large, public IT service firms will likely increase as a result, as other large accounting firms follow Accenture and KPMG Consulting's lead, and either sell their consulting units or have an initial public offering.

The timing of these transactions may be quite good, since it appears that commercial IT spending has stabilized and could improve through the year.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.com. Within the last three years, Legg Mason Wood Walker has managed or co-managed an underwriting of the securities of Maximus. Legg Mason Wood Walker Inc. makes a market in the shares of KPMG Consulting. Maximus is a Legg Mason Select List core holding. The information contained herein has been prepared from sources believed reliable but is not guaranteed by Legg Mason and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. 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. From time to time, Legg Mason Wood Walker Inc. and/or its employees involved in the preparation or the issuance of the communication may have positions in the securities or options of the recommended issuer.