Market Share: IT firms need action on supplemental funding bills

After three consecutive quarters of improvement in business performance, commercial IT spending dropped in June. Dozens of commercial software and hardware companies preannounced weak second-quarter results, blaming customer purchase delays and a lack of large sales. Although, as I write this, no federal IT service firms have preannounced negative results, investor sentiment seems to have weakened across most areas of the stock market, including federal IT stocks. Year-to-date, federal IT stocks are down 13 percent, underperforming the S&P 500, which is up 1 percent.Federal IT stocks are trading at a reasonable 17 times my fiscal 2005 earnings per share (EPS) estimates. The forward price-to-earnings ratio for federal IT stocks has increased from the 10-to-15 times range through most of the 1990s to the 15-to-20 times range in the late 1990s, peaking at 27 times after the Sept. 11 terrorist attacks. I estimate that, on average, federal IT companies will show EPS growth of at least 16 percent this year. I expect organic EPS growth to slow in the federal IT space over the next few years, mostly due to less profit margin expansion, and to accelerate in the commercial IT sector, due to revenue acceleration and profit margin expansion. The outlook for the federal IT services market still appears solid. With the fiscal 2005 defense bill approved by both the Senate and House, the conference committee will likely complete a final bill in a month or so, allowing the president to sign the bill before fiscal 2005 begins Oct. 1. Attempts to cut the president's defense budget did not succeed in the House and Senate, evidence of defense spending's strong momentum. Civilian spending bills appear likely to be rolled into another omnibus bill. Although some investors are nervous about what a change in the administration could mean to defense and federal IT spending, the biggest risk I see for federal IT service stocks over the next year is a potential delay in the supplemental budget request to fund Iraq and Afghanistan military operations. Congress has approved $25 billion, but at least $50 billion more will be needed over the next few quarters. Any delay in these supplemental bills could mean money would be pulled out of non-warfighting programs. The Iraq and Afghanistan operations also have drawn a spotlight to the use of contracts, including General Services Administration contracts, for out-of-scope work. CACI International Inc. and Titan Corp. have been getting most of the press on this issue -- CACI for its GSA IT blanket purchasing agreement through which interrogation services were contracted, and Titan, for a GSA contract it used for counseling services.But a June 2004 Government Accountability Office report found other contractors and government agencies that put out-of-scope work on contracts to perform work overseas. Changes as a result of these investigations could be disruptive in near term, but they probably will not be significant factors for most companies, particularly those that have a wide range of contract vehicles. With mixed economic news and many earnings preannouncements in the commercial world, we could see investors rotate back into federal IT service firms in the near term, assuming second-quarter results for federal IT firms come in as strong as expected. 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.