Market Share: Power shift in Congress won't hurt federal IT spending

Public federal IT services stocks plunged by almost 20 percent between the beginning of the year and mid-August. During that same time, the Standard and Poor's 500 index rose by 3 percent.

But the decline of the federal stocks is hardly unpredictable, following as it does several quarters of downward revisions to 2006 estimates.

I cut my own 2006 earnings per share estimates for the group by 17 percent, and organic revenue growth estimates from 11 percent to 4 percent over the past year. These cuts reflect the difficult budget environment following late passage of the fiscal 2006 defense bill and funding pressures from the global war on terror.

Since August, we have had an upsized fiscal 2007 defense supplemental bill, an on-time fiscal 2007 Defense and Homeland Security bill passed, and we've have had a significant pick up in award decisions.

As a result, investors have moved back into the group, though the sector is still underperforming the broader stock market. Year-to-date, the federal IT stocks are flat (0 percent) while the S&P 500 is up 12 percent.

Wall Street has had mixed reactions on the changes in Congress. As I wrote in my last column, I do not believe the change in control of Congress will have a significant influence on federal IT spending, but certainly the 2008 presidential elections could, starting with the fiscal 2009 budget.

Both the new House and Senate's Armed Services committee chairmen ? Rep. Ike Skelton, D-Mo., and Sen. Carl Levin, D-Mich., respectively ? have been against the president's Iraq policy and have supported withdrawals. But both also agree the Army is overstretched and underfunded for its mission.

The House Government Reform committee also will likely step up its investigations of contractors, with Rep. Henry Waxman, D-Calif., now in the chairman role.

The Democrats are promising change, but no calls have yet been made for defense and homeland security cuts. These changes, as well as others in the appropriations, budget and small-business committees, will have some effect on federal IT spending and procurement rule legislation, though probably not much until fiscal 2008.

The president's change in leadership at the Pentagon, as well as the Iraq Study Group's findings and pressure from the new congressional leadership, could result in a change in the administration's policy toward Iraq.

In general, I believe a reduction in activity in Iraq and the Middle East would be positive for the federal IT services companies, as spending on the war is putting pressure on IT and other discretionary budgets.

I still expect defense budgets to rise under Democratic congressional leadership.
However, priorities may shift from large platform and weapon systems to readiness and troop support, particularly if the United States accelerates its Middle East operational tempo in an effort to stabilize before redeploying.

Given the large ? up to $160 billion, twice what was expected ? proposed spring 2007 defense supplemental spending bill, and rumbles of higher troop and equipment needs coming from military officials, we could see stepped-up activity in Iraq over the next couple of years, with transition to local forces following stabilization.

A reduction in overseas troop deployment could result in a better funding environment for IT-related businesses that are not directly supporting warfighting missions, as these services take a back seat to warfighting budget items.

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.