Market Share: 2004 so far gives reasons to pause and ponder

So far this year, federal IT stocks have underperformed in the overall stock market amid concerns of growing budget deficits, slow government spending and election jitters. Added to the improving prospects for commercial IT spending, this has caused some investors to reduce their exposure to the sector. Federal IT stocks are down 9 percent, commercial IT services stocks are down 7 percent, and the S&P 500 is up 3 percent. Despite some investors' rotation out of federal IT stocks and into commercial IT stocks, federal stocks still outperformed over the past year. The stock prices have been supported by strong earnings-per-share (EPS) growth, partially offset by a declining price-to-earnings multiple that investors are willing to pay. The forward P/E ratio for the federal IT stocks had increased from the 10 times to 15 times range it maintained through most of the 1990s to 15 times to 20 times range in the late 1990s, with most of the leaders (since acquired), such as BDM and Nichols Research, trading near the upper range. The multiples peaked in the quarter after the Sept. 11 terrorist attacks at 27 times and are now at 19 times forward estimates. On average, I expect federal IT companies will show earnings-per-share growth of at least 17 percent this year, making the current group valuation reasonable, in my opinion. The S&P 500 is trading at 19 times, and the companies underlying the index are expected to grow EPS at 11 percent in 2004. However, we expect organic EPS growth to slow down in the federal IT space over the next few years, mostly because of less profit margin expansion. EPS will speed up in the commercial IT sector because of revenue acceleration and profit margin expansion.Fourth quarter 2003 results for the public federal IT companies were about as expected. Organic revenue growth, which excludes the impact of acquisitions in the previous year, slowed for most companies. Public federal IT companies had organic revenue growth in their federal business of 12 percent, compared to 15 percent in the third quarter and 12.6 percent in the second quarter. CACI International Inc. and SRA International Inc. showed increases in their organic growth rates from third-quarter levels, while the others fell. MTC Technologies Inc. had the highest organic revenue growth at 33 percent, followed by SRA's 22 percent and SI International Inc.'s 7 percent. PEC Solutions Inc. was down 15 percent.Computer Sciences Corp. had no federal organic revenue growth in the fourth quarter, down from 7 percent the quarter before. Total revenue growth in the fourth quarter for the companies was 25 percent, similar to three previous quarters, and up 5 percent sequentially. MTC had the highest total revenue growth, up 63 percent, while PEC had the lowest, down 15 percent. Business signings were strong for most of the companies in the fourth quarter, and as a result, all the public federal IT companies gave guidance for continued growth in the next quarter or year. While the federal IT companies have not yet announced first quarter results as I write this, I generally expect the companies to meet or exceed my revenue and EPS estimates in first quarter 2004.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.