Market Share | Quick budget bills are best medicine for weak EPS

Why have federal IT service stocks been so weak this summer? It's a question many investors and companies have been asking me. The federal IT service stocks we track are down by 14 percent this year, while the S&P 500 has seen a gain of 4 percent. Two broad reasons for the weakness are overall stock market concerns and lower earnings per share growth rates among public federal IT service companies.

The broader market movements strongly influence how most stocks trade, and investors are torn between subscribing to the view that the economy is going into a recession and the view that we are headed toward a "soft landing" in the economy. The uncertainty has created volatility and nervousness.

In that environment, slowing growth has hurt federal IT companies. The largest pain factor has derived from Iraq and Afghanistan operations costs, which have been much greater than budgeted and have pressured other defense and civilian agency budgets. Additionally, delays in the fiscal 2006 defense budget and the most recent defense supplemental spending bill have created more uncertainty, further slowing new programs and growth.

The decline in EPS growth has prompted some investor rotation out of the group. EPS growth in the group has slowed from 22 percent the second quarter of 2005 to 8 percent in the same quarter this year, excluding Dynamics Research Corp., which had an 87 percent drop in EPS, NCI Inc., which wasn't public a year ago and is thus not comparable, and ManTech International Inc., which is recovering from MSM losses of a year ago and thus also is not comparable. We are estimating 2 percent EPS growth in the third quarter.

A major determinant of where the stocks likely will trade over the next few quarters is passage of the fiscal 2007 defense and homeland security budgets. Because of impending elections, an on-time or nearly on-time passage is the most likely scenario. Democrats have chosen defense and homeland security as an issue to hurt Republicans, particularly as regards underfunding of deployed soldiers and their equipment. The rush by Congress to show voters its support for troops resulted in a $13 billion increase, to $50 billion, for the fiscal 2007 defense supplemental spending bill.

The combination of both the regular defense budget and the supplemental spending bill being passed on time likely will give defense personnel more confidence in their funding, freeing up additional contract awards and funding of existing task orders. This view assumes there are no new external issues, such as unexpected military actions or Katrina-like disasters, that could divert funding.

The alternative scenario is not so good for the group. If Congress cannot complete a budget before October, the defense budget will go on with a continuing resolution, probably for a few months. The supplemental spending bill likely will be delayed, and growth rates could weaken further.

For reasons more important than stock performance, I hope Congress can do its job in September and pass the Defense budget on time to support our troops overseas.

Bill Loomis is a managing director at Stifel Nicolaus, which acquired Legg Mason's Capital Markets Group in December of 2005. He can be reached at wrloomis@stifel.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: Stifel Nicolaus, 100 Light St., Baltimore, MD 21202, Attn: Research Department.