Market Share: Strong performance doesn't lift federal IT stocks

Despite two quarters of mostly good earnings reports from federal IT service firms, these companies continue to underperform in the S&P 500. The federal IT stocks are down 16 percent so far this year, while for the same period, the S&P 500 index is down 3 percent, and commercial IT service companies are down 7 percent. Investors worry about the elections, slowing budget growth rates and the potential for defense spending disruptions because of higher-than-expected costs of operations in Iraq and Afghanistan. The decline in federal IT stocks has driven down the price-to-earnings (P/E) ratio for the group to 16, down from 27 two years ago and 22 at the beginning of this year. Despite the valuations drop, business continues to be good at most of these companies. Organic revenue growth in the second quarter publicly traded federal IT service firms was about the same as it was in the first quarter, 13 percent. Anteon International Corp. reported strong earnings per share (EPS) growth, up 36 percent, with total revenue growth of 20 percent. Although organic growth was only 10 percent, Anteon had another strong quarter of contract wins with $465 million, and I estimate organic growth will improve over the next year.DigitalNet Holdings Inc. reported much better than expected EPS growth of 25 percent, with EPS coming in at 35 cents, well above analyst consensus projections of 31 cents. DigitalNet showed strong organic revenue growth of 15 percent, but contract awards in the quarter were down from the first quarter. MTC Technologies Inc. reported strong revenue growth of 47 percent (organic growth was 22 percent), but EPS growth of 23 percent was hurt by a 19 percent increase in shares outstanding from a recent stock offering.SI International Inc. reported very strong EPS growth of 58 percent on revenue growth of 57 percent. Organic revenue growth was 14 percent, the strongest over the past year.SRA International Inc. reported 23 percent EPS growth, despite having a 14 percent increase in shares outstanding from a stock offering last year. SRA continues to grab market share, evidenced by a 33 percent organic revenue growth rate and yet another strong quarter of contract wins. Among larger commercial IT service companies, BearingPoint Inc.'s federal unit, which represents 33 percent of BearingPoint's total revenue, had organic revenue growth of more than 40 percent, and Perot Systems Corp.'s federal government unit, which represents 16 percent of its total revenue, was up 17 percent. Not all public federal companies had a good quarter, however. Dynamics Research Corp. reported 4 percent growth in its revenue and EPS; it also lowered its EPS guidance for the rest of the year, despite its acquisition of the government unit of Impact Innovations Group LLC, which bring new intelligence community and other government clients. PEC Solutions Inc. reported lower year-over-year organic revenue growth and lower EPS. That investors seem to be ignoring the good results for many federal IT service companies is probably more a function of uncertainty and bearish investor sentiment than a response to the federal IT market. 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.