Market Share: Growth ahead despite increasing hurdles

The publicly traded federal IT services firms have had a wild ride the past couple of months. Several companies' stocks are reaching new 52-week highs following the announcement of strong second quarter 2003 financial results, and the announcement of Lockheed Martin Corp.'s proposed acquisition of Titan Corp. However, after several Wall Street investment firms downgraded their views on aerospace and defense stocks, investors sent the shares of federal IT services firms lower. Enthusiasm is dropping about the aerospace and defense industry because many believe defense spending could decline in a couple years. Domestic issues, such as the economy and job growth, seem to be dominating political discussions. Moreover, the increasing costs of reconstruction in Iraq and Afghanistan, growing local unrest in those countries, and questions about intelligence reports before the Iraq war have not helped make the case to taxpayers for more defense spending.Despite the possibility of flattish, or even lower, defense spending in fiscal 2005 or 2006, well-positioned federal IT service firms can continue to show good growth through market share gains.Based on the valuations at which aerospace and defense firms are acquiring federal IT service firms, I believe they must see few high-return on investment opportunities in their core business, but increasing returns in the federal IT services business. While investors may be concerned about budgets two to three years out, fundamentals continue to look strong for most of the public federal IT service firms over the next year. Given the strong IT budget growth for both defense and civilian agencies in fiscal 2003, the organic (nonacquisition) revenue growth of most publicly traded federal IT service firms could accelerate next year as 2003 contracts are awarded and produce revenue. In second-quarter 2003, the public federal IT service firms had an average organic revenue growth rate of 13.6 percent, down from 16 percent in fourth-quarter 2002, but up from 9.6 percent in the year-ago quarter. The organic growth rate this year reflects a slowdown in most of the companies' business with civilian agencies, which suffered from the budget delay, and organizational issues and delays at the Department of Homeland Security.As civilian agency contract awards pick up, and defense contract awards continue at a good pace, not only will organic growth pick up, but we also will likely see additional profit margin expansion. Also, the federal IT services firms are participating in the industry consolidation as well, with most of them having made acquisitions in the past few quarters that have been accretive to their earnings per share. Despite my view of higher growth and greater margins, the next year likely will prove volatile for the group, particularly in the face of the presidential elections. Investors tend to look ahead, but how far ahead depends on overall market sentiment and the relative attractiveness of other investment opportunities. Long-term oriented investors who stick with high-quality companies that are gaining market share and delivering quality service should do well, despite the ups and downs in the short term. Also, the management teams running these businesses should be aware of, but not distracted by, the fluctuations on Wall Street. 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.