Market Share: Contract pace to pick up in second half of 2003

As we enter first-quarter earnings announcement season, it appears to be another difficult quarter for commercial information technology service firms, yet a good quarter for federal IT service firms. On the commercial side, lacking a new technology or other catalyst, I believe IT spending is cyclical and will be driven largely by revenue-led corporate profitability improvement and overall economic growth. Despite Federal Reserve comments on the underlying strength of the U.S. economy, growth expectations seem sluggish, there is some increased talk of a double-dip recession, and other major IT spending geographies, especially Europe, are challenged. In addition, there have been some disappointing results from software providers, such as Oracle Corp. and PeopleSoft Inc., and the Iraq war could have a negative impact on IT spending and the economy, though it will be difficult to separate that from the continuation of economic uncertainty in previous periods. Overall, commercial IT demand remains weak but does not appear to be falling off a cliff like it did in 2001 and 2002. Pricing appears relatively stable, though at low levels, and negative preannouncements in the space, at least among IT service firms, are much less common. IT services growth will be a function of the economy, and in that light one can argue 2003 could be a bottoming year. In the federal IT services industry, I expect first quarter results to meet investor expectations generally. I expect defense-related spending to continue to be strong, driven by rising budgets, the war on terrorism and more emphasis on intelligence activities, as well as broader trends, such as the government's need to replace antiquated technology and the increasing number of federal employees eligible for retirement. The war has prompted much change at the Defense Department. Some programs are being deferred, while those more directly war-related are being accelerated. For companies with diversified defense service businesses, the net impact seems neutral. The key risk I see is how quickly the supplemental spending bill before Congress can be completed and signed by the president. I hope this will have happened by the time this article is published. Without a timely, sufficiently large supplemental bill, war funding is likely to have a negative impact on Defense Department programs. The federal civilian side has been challenging as well, because funding of the civilian spending bills was not approved for a while. This, along with project delays from agencies being rolled up into the Department of Homeland Security, has led to slower-than-expected pickup in business in the first three months of 2003, most notably with a negative earnings preannouncement from PEC Solutions Inc.However, I believe we will see an unusually high amount of requests for proposals and award activity in the second half of the year as money flows down to the civilian agencies, and the dollars are awarded before the government's fiscal year ends in September. While the federal IT companies have their share of challenges to work through, investors continue to expect strong, double-digit earnings growth this year from most of the publicly traded companies, such as Anteon International Corp., CACI International Inc., ManTech International Corp. and Veridian Corp. among others. *Bill Loomis is a managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.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: Legg Mason Wood Walker Inc., 100 Light St., P.O. Box 1476, Baltimore, MD 21203, Attn: Research Department.