Market Share: Fall in share prices may equal good purchase opportunities

Despite positive earnings reports from federal IT services providers throughout 2004, the group's stock performance was mired for most of the year by the uncertainty of political elections and potential budget slowdowns. Federal IT services stocks, along with the overall market, rallied strongly in the last few months. For 2004, our federal IT services index return was 25 percent, in contrast to the 13.8 percent annual return from our commercial IT services, and beat the S&P 500 Index by 16 percentage points.Internal revenue growth accelerated throughout the first three quarters of 2004, but I project a modest pullback in internal growth during the fourth quarter. As of press time, those results are not yet out. Over the next year, I expect internal growth to average between 13 percent and 15 percent. After showing sharp expansion -- from 6 percent to 9 percent -- in the last few years, operating margins in the industry continue to expand, though at a slower rate. Although some companies will enjoy expanding earnings before interest and taxes (EBIT) margins, I believe that, in general, the pace of EBIT expansion will moderate, and meaningful upside potential will be more difficult for the industry as a whole. At 22 percent, earnings per share growth has been greater than internal revenue growth , reflecting the high level of acquisitions by public federal IT services companies over the past year as well as stable-to-improving margins.Although investors drove up the shares of public federal IT service companies in the fourth quarter of 2004, 2005's first quarter is off to a difficult start. Last year's optimism is tempered by investors' concerns about defense cuts, following the leak of the Defense Department's Program Budget Decision 753, which outlines a proposed $30 billion in cuts to the defense budget over six years, starting with $6 billion in the fiscal 2006 budget. Although the proposed cuts are relatively small, representing less than 1 percent of the likely total defense budget, the fact that Pentagon officials are seriously discussing cuts has raised fears that they're just the tip of the iceberg and that more cuts are coming. Speculation has it that in an effort to save big money programs, primarily weapon systems, the Pentagon will try to reduce contractor support. I think this would be difficult, given how thinly stretched uniformed warfighters are, the increased operational tempo (with no sign of a slowdown), sharp increase in depreciation of assets because of greater use, and the increasingly difficult hiring environment. (I'm seeing employee turnover increase in both federal and commercial IT sectors, an indicator of a tougher hiring environment.) To the contrary, we have seen the Defense Department's outsourcing increase, as small pieces of work previously done by warfighters are outsourced to contractors to free up personnel. Also, "contractor support" is a broad term, and could mean supporting weapon systems, developing software, providing facility management or any number of possibilities. In 2002 and 2003, a pullback among public federal IT companies during the first half of the year proved to be a good buying opportunity for investors. We could see the same this year. 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.