An uncertain refrain rings familiar in the New Year

Early into the new year, the business outlook in the federal IT services market is looking a lot like it did last year. I was encouraged that the on-time fiscal 2007 Defense and Homeland Security departments, and the upsized $70 billion defense supplemental spending bills, would boost prospects for IT program growth.

We saw a surge in contract awards last fall and generally good earnings reports from public companies in the industry. However, the president's increase in troop levels for Iraq has pushed up costs for the war and upset the new Democratic Congress. While the Democratic leaders support the troops and largely promise no funding cuts to the warfighter, additional legislation for the upcoming defense supplemental spending bill and increased debate could delay passage of that important funding.

Facing higher costs and more uncertain funding, I believe it's unlikely we will see a significant increase in defense IT spending this year. Also, the continuing resolution for non-DHS civilian agencies through the government fiscal year will hurt new program starts and growth in civilian agencies. CACI International Inc.'s disappointing financial outlook, which sent its stock down 15 percent in a day, was largely due to these industry issues, in addition to a couple of company-specific issues. Even giant General Dynamics Corp., which acquired Anteon International Corp. last year, indicated organic growth in its IT services group slowed to 2 percent in the quarter, with higher war costs helping some aspects of its business (particularly warfighter equipment) and hurting the IT side as defense agencies prioritize their limited funds. In contrast, Northrop Grumman Corp. and Lockheed Martin Corp. reported strong growth and are, respectively, predicting high single- and double-digit organic growth in their IT units for the year.

Federal IT services stocks are trading at 18 times my 2007 earnings-per-share estimates, a valuation that implies investors expect improved results over the next year. I estimate EPS growth was the lowest in 2006 (based on my estimates, 4 percent growth vs. 23 percent in 2005) than it has been since the early 1990s and will continue to be soft in the first half of 2007. For 2007 in total, I expect the group to have EPS growth of 8 percent, rising to 14 percent in 2008. I expect that EPS growth for the federal government IT services group overall will bottom out for 2006 in the fourth quarter, with EPS growth of minus 3 percent for public companies.

I still expect improvement in results through the year, but now expect 9 percent organic revenue growth for public companies in fourth quarter 2007, up from 5 percent in fourth quarter 2006, and 13 percent EPS growth in the fourth quarter. I estimate EPS will grow faster than revenue as profit margins increase somewhat following an improvement in revenue growth later in the year. My forecast assumes an on-time fiscal 2008 budget and no further escalation in war costs.

Short-term funding uncertainties have hurt federal IT service companies' awards and growth rates, but over the next few years we expect average organic revenue growth rates for public companies to settle out at between 8 percent and 11 percent, down from 15 percent and higher over the last several years, and EPS growth rates to be between 10 percent and 15 percent, including acquisitions. With the slowdown in budget growth rates, we likely will see a pickup in industry consolidation as companies try to satisfy shareholders' growth requirements. l

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.

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