Market Share: Outlook for contractors is strong, despite deficit

It appears that business is continuing at a strong pace for the industry. The positive business trends I have seen at companies over the past several quarters remain intact, with most firms indicating continued strong bid opportunities and no significant disruptions from the Iraq war or the administration personnel changes.Most of the business companies have done with the Homeland Security Department continues to be with its underlying 22 agencies, as there have been few departmentwide initiatives. Additionally, there has been little impact from past DHS executive departures, and the same is expected when Tom Ridge leaves. However, most companies -- the exception being PEC Solutions Inc. -- are not seeing a pickup in DHS activity, but rather more of a steady state of activity. Although in Washington there seems to be more concern about the growing deficit and its impact on agency budgets, companies have not seen a slowdown in business opportunities. However, there are fewer new initiatives coming from civilian agencies, requiring companies instead to win more business from competitors to boost revenue from that sector. On the defense side, companies continue to be optimistic about the number of business opportunities they are seeing and that they expect to see over the next few quarters. The overall defense budget growth rates have slowed over the past two years, but the military seems to be outsourcing more business. Driving the trend is the military's workforce shortage and its need to move more uniformed personnel from back-office and support functions to warfighting functions. Although these opportunities tend to be relatively small in size, ranging from a few people to several dozen, they seem to be widespread and growing more numerous. One trend that a few companies discussed was an expressed preference by some defense clients to favor Defense Department indefinite-delivery, indefinite-quantity contracts or other contract vehicles over General Services Administration contracts as a way to better control and track spending and reduce costs. The jury is out on how significant this trend might be, as several companies have not seen a push away from GSA contracts by defense clients at this point. Merger and acquisition activity remains high and characterized by a wide range of acquisition candidates and reasonable prices, though the average size of the companies available to acquire has declined as the large enterprises snap up the largest private firms. All of the public companies and most of the private companies we spoke with are eager to make acquisitions but seem to be disciplined on pricing. As a result, most of the deals closing are in the eight times to 10 times earnings before interest, taxes, depreciation and amortization range for a company with average growth and margins. Companies outside the averages can have much different valuations, with higher margin, intelligence-agency-focused companies often above the typical valuation range. Although defense and civilian budget growth rates and the group's public stock valuations peaked in 2003 (at 27 times forward earnings rather than the current 20 times forward earnings), there continues to be a steady stream of opportunities for the public federal IT services firms, particularly on the defense side, which likely are driving the strong average of 20 percent and higher earnings per share growth for the group. 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.