Market Share: War's uncertain impact causes anxiety

First quarter results in the federal IT industry were generally good, but the industry kept investors on their toes the past couple of months: A big positive earnings surprise by ManTech International Corp. was followed about a month later by a big negative earnings surprise from ManTech. Then the U.S. Visit contract went to the underdog team led by Accenture Ltd., followed shortly after by a congressional effort to prevent the award, because Accenture is headquartered in Hamilton, Bermuda.The House Appropriations Committee voted 35-17 approving an amendment to the fiscal 2005 budget for the Homeland Security Department that would restrict funding for contracts to foreign-based vendors. The amendment effectively precludes Accenture from the U.S. Visit contract. The amendment has a long way to go, including getting past the White House, but it throws a wrench in the biggest federal IT contract to be awarded this year. And the Iraq war continues to cause budget concerns as well as other fallout for the industry. I am hearing more concern recently about the growing cost of the Iraq war. Although there have been no financial preannouncements or earnings guidance reductions, such events could overtake some companies this summer should the Iraq war supplemental bill be delayed, or even if it goes into effect Oct. 1. Fortunately, congressional pressure has prompted the Bush administration to submit a $25 billion supplemental bill before the elections, and the head of the Senate Appropriations Committee wants it effective as soon as it passes Congress this summer. The cost of the Iraq and Afghanistan operations is escalating. Recent estimates put costs at $4.8 billion to $4.9 billion per month, and possibly at $75 billion for fiscal 2005, so additional supplemental bills will be necessary. As the administration faces pressure on the cost of the war and we see delays in supplemental appropriation bills, funds could shift from lesser priority defense programs to funding for overseas operations. This is the biggest risk to the federal IT services sector financial performance this year. However, higher than expected troop levels necessary for overseas operations could result in an acceleration of outsourcing for federal IT companies, as additional back office jobs done by uniformed military personal are outsourced.CACI and Titan continue to face problems relating to their Iraq operations. CACI's shares, in particular, have been hurt by investigations into its interrogation contract in Iraq. CACI indicates that it has not received any negative information from the Army and that the client remains pleased with its work, but weekly a new issue seems to arise.Despite these difficulties, CACI indicates that its defense business is quite strong. It continues to integrate AMS's defense and intelligence business. The company continues to be confident in its earnings per share accretion assumptions from the acquisition, though the assumptions will be challenging to meet in my opinion.While there excitement in the industry remains high, fundamentals continue to look good and can create opportunities for investors. 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.