Market Share: Investors still favoring federal IT contractors

After commercial IT spending began slowing in 2000 and the economy weakened, federal IT services stocks began outperforming commercial IT service stocks and the broader market indexes. In 2003, federal information technology service stocks were up 45 percent, while commercial IT services stocks showed gains of 38 percent, and the S&P 500 increased by 26 percent. Over the past five years, the federal IT service companies index is up 522 percent, the commercial is down 23 percent and the S&P 500 is down 10 percent. The investment environment for federal IT stocks has been great during the past few years, with higher revenue growth rates driven by record budget increases, coupled with investors' need for defensive investments in a rocky economy and stock market.Public federal IT companies are better run now than they were in the 1990s, their financial performance is more consistent, and they enjoy higher margins and return on invested capital, largely as a result of their focus on federal business.Most publicly traded federal IT companies in the 1990s tried to diversify and cultivate commercial and state and local customers. All incurred earnings hits, charges and distracted management teams. Today, most publicly traded federal IT companies have sold their commercial businesses and seem firmly committed to the federal market. Federal IT service companies are trading at 21 times the 2004 earnings estimate, ranging from Dynamics Research Corp., trading at 14 times earnings, to SRA International Inc., trading at 28 times earnings.Commercial IT service companies are trading at 21 times earnings, and the S&P 500 is trading at 19 times 2004 earnings estimates. Although, at press time, none of the federal IT companies have reported fourth quarter financial results, expect a strong quarter. Between 1990 and 2001, federal IT stocks traded between 10 times and 18 times forward earnings, reaching a high of 27 times forward earnings soon after the Sept. 11, 2001, terrorist attacks. Look for federal IT companies to stabilize near current levels: about 20 times forward earnings, which will be supported by long-term earnings growth of between 15 percent and 20 percent (between five percent and 10 percent organic growth and more than 10 percent growth from acquisitions). Key issues for investors this quarter: the thus far minimal impact of the civilian budget delay; contract award activity, which has been light on civilian awards and good on defense awards; and fast-paced acquisition activity.As fiscal 2003 contracts are awarded and convert to revenue for companies, look for the organic revenue growth of most publicly traded federal IT service firms to accelerate in 2004. If Congress, which at press time is not yet in session, doesn't pass fiscal 2004 civilian spending bills, we could see less growth later this year. As commercial IT spending improves, and federal budget growth rates slow, I think it will be difficult for federal IT stocks to show the outperformance they have enjoyed in recent years. But with solid earnings growth, I still expect the leaders will show good stock performance over time. 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.