Market Share: IT spending uncertainties mean rough ride ahead

Publicly traded government IT companies have suffered this year because of tighter budgets and delays in approvals of the fiscal 2006 budget. Organic growth has slowed, dropping from 13 percent in the second quarter a year ago to 6 percent in this year's second quarter.

For the quarter that just ended Sept. 30, we estimate no growth.
Earnings per share growth in the group slowed from 22 percent in second quarter 2005 to 8 percent in the second quarter 2006, excluding Dynamics Research Corp. (87 percent drop in EPS), NCI Information Systems Inc. (not public a year-ago, so not comparable) and ManTech International Corp. (recovering from MSM losses a year-ago, so not comparable). EPS in the third quarter 2006 likely will be even slower. We are estimating 2 percent EPS growth for the same group in third quarter.

I believe the September quarter will be the bottom for the group for internal revenue growth and EPS growth, with both expected to rise to double-digit growth next year.

We have seen a pick-up in contract awards and task orders over the past few months, particularly with Defense Department agencies, following the June passage of fiscal 2006 defense supplemental spending bill. I expect to see a further acceleration of awards and task orders in coming months now that the president has signed fiscal 2007 Defense Department and Homeland Security Department appropriations bills. The upsized $70 billion fiscal 2007 defense supplemental spending bill attached to the regular budget likely will help even further.

Defense budgets remain tight in the face of higher than expected costs in Iraq and Afghanistan, but on-time funding of both the regular and supplemental spending bills likely will give better funding visibility for defense agencies over the next few quarters. This will break some funding logjams, at least until next spring when the president likely will request the next supplemental spending bill.

Another positive indication is the signing of DHS' budget, as this is one of the largest and fastest growing IT budgets over the next year. While most of the remaining civilian agencies likely will not have a fiscal 2007 budget passed until December, on average, 70 percent or more of the revenue from the public companies come from the departments of Defense and Homeland Security, making these budgets relatively more important for the public companies.

Even if there is a change in the control of Congress this November, I do not believe the change would have a significant impact on federal IT spending, but certainly the 2008 presidential elections could, starting with the fiscal 2009 budget. If we continue on the path of foreign policy, IT spending will likely continue to be under pressure. This has been the situation since the global war on terror began in 2001, when overall defense spending began outpacing IT spending, which is expected to be flat next year.

Should the next president begin scaling down Middle East operations, and in the absence of another U.S. terrorist attack, we could see a repeat of the 1990s, with IT spending outpacing overall defense spending each year. There are too many uncertainties and variables to know the direction of policy and spending beyond the presidential election, but I believe change of some sort is inevitable.

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.