Market Share: Jitters get the better of investors

Investor nervousness over higher interest rates, record oil prices and global unrest have pushed down most stock indexes and have pressured the shares of the federal IT firms. As I write this, the S&P 500 is down 2 percent this year, NASDAQ is down 4 percent, commercial IT services firms are down 15 percent, and federal IT services firms are down 13 percent. Investors do not seem to be coming into federal IT stocks as defensive plays in a weak market. Their main concerns are about other factors that pressure the valuation of stocks, such as higher interest rates. The public federal IT service firms are trading at 17 times forward earnings estimates, down from 20 times earlier in the year and a peak of 27 percent after the Sept. 11 terrorist attacks. While growth rates for defense and civilian agency IT spending won't likely return to 2003 levels for a while, spending still grows as evidenced by continued strong contract wins and organic growth of the public federal IT service firms. The average organic federal revenue growth of the public federal IT services' firms increased from 12 percent in fourth quarter 2003 to 13 percent in first quarter 2004.Despite concerns over budget deficits and lower budget growth rates, most of the leading federal IT firms are quite bullish on their outlook based on recent wins and their bid and proposal pipeline. Civilian agency spending seems more uncertain than that from defense agencies. The delay of the Homeland Security Department's Spirit contract request for proposals could suggest some delays in the agency's IT spending, which has been disappointing. However, the multibillion dollar U.S. Visit contract is expected to be awarded soon and should get off to a fast start based on what the agency has told the vendors. On the defense side, we may see accelerating work despite the exploding price tag for Iraq and other overseas operations, which is now estimated at $66 billion in fiscal 2005. Defense Secretary Donald Rumsfeld said in testimony to the Senate Appropriations Committee recently that 10,000 jobs will be converted from military personnel to civilian personnel this year, and 10,000 next year, to effectively increase the military force. The surprise in first quarter revenue from several federal IT firms, ManTech International Inc. particularly, seemed to be largely from work accelerated to support the military effort. There will be puts and takes though, as some defense programs will be deferred in favor of more critical programs. At the start of the Iraq war, the net impact to the defense business of the federal IT firms was positive. This could be the case over the next year as well for well-positioned firms. IT and intelligence services are strong areas, but certainly engineering capability in sustainment and modernization of weapon systems and platforms will be in demand as equipment is spent more rapidly and money for new weapon systems and platforms becomes scarce in the face of growing deficits and the cost of war. While there are a lot of issues concerning investors, the outlook for the federal IT industry continues to be favorable, particularly for those focused on defense services.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.