Third-quarter awards feed a hungry sector

Public companies that provide federal informationtechnology services have continuedto see their stock prices rise since mid-August, when most of the companies reportedsecond-quarter results and issued outlooksthat excited investors.So far this year, federal ITservices company stocks are up25 percent. In comparison, theaerospace and defense companiesare up 30 percent ?excluding recently acquiredEDO Corp. ? and the overallstock market is up 6 percent asmeasured by the S&P 500.Growth in the industry hasbeen slowing during the pastthree years, with organic revenuegrowth rates ? that is,revenue growth from internaloperations, not recent acquisitions? for the public federalIT services companies fallingfrom 20 percent soon after thestart of the Iraq war to 5 percentearly this year. However,organic revenue growth pickedup to 12 percent in the secondquarter of 2007 following anincrease in contract awardsand backlog in 2006. The averagegrowth for contract awardsand backlog has been under pressurethis year, but third-quarter awardshave been strong and should helpmove the average backlog growthhigher, driving growth in the 5 percentto 10 percent range next year.Progress on the fiscal 2008 spendingbills has been slower than Iexpected. At press time, it appearedthat most of the civilian spendingbills would be rolled into an omnibusspending bill in the next month ortwo, with the defense spending billalso passing. The key issue for thefederal IT services companies will bethe amount of the defense supplementalbridge funding because theDemocratic leadership has said it willnot consider the $196 billion defense supplemental spending bill until nextyear.A bridge supplemental will buysome time, but if Congress takes thesupplemental spending bill down thesame path as the one earlier this year,we could see reprogramming of fundsand delays to pay war costs. This typeof action last year led to weakerresults and underperformance in thestocks in the first half of 2007, and itis looking like 2008 could be a repeat.Overall, we expect the businessenvironment for the federal IT companiesto remain challenging duringthe next couple of years, though withless contention between Congressand the next president. Moreover, areduction in war spending shouldhelp reduce funding delays anduncertainty that have hurt the federalIT budgets during the past fouryears. The Government Electronicsand Information Association recentlyissued its forecast on federal ITspending, which indicated that itexpected total federal IT spending togrow at a 1.4 percent compoundannual growth rate during the nextfive years. GEIA expects federal ITspending to be flat during the nexttwo years and then rise on highercivilian-agency IT spending after thenew administration formulates its fiscal2011 budget.The profit margins of federal ITcompanies also have been underpressure during the past few years asbudget growth rates slow down,slowing growth while companiescontinue to increase their investmentsin new solutions and businessdevelopment.With organic growth stabilizingand companies having adjusted theirorganizationsthrough cost cuttingor efficiencies, Iexpect profit marginsto stabilize andinch higher duringthe next year toabout 8 percent forthe industry.Despite modestbudget growth andmargin pressures, with more than$100 billion in annual spending inthe federal IT and professionalservices market, I believe well-run,agile companies can show stronggrowth and produce strong returnsfor shareholders..