Market disruption presents silver lining

One comment I often hear lately about the financialmarkets is that their volatility has increased. Theincreased volatility is an indicator of uncertainty, causinginvestors to react quickly to each piece of financial,economic or political news.We have seen this volatility in the bigswings of the broader stock index averages,commodity and currency prices, andspreads of debt instruments, and we havealso seen it in the stocks of the public federalinformation technology services firms.Even some of the companies thatreported results in line with expectationswere punished by declines of 10 percent ormore in their stock prices as investorsworried about future results. Federal ITservices stocks are down 10 percent year-to-date, about the same as the S&P 500,as the broader market benefited recentlyfrom a rebound in financials.Some of investors' skeptical views havedeveloped after three years of disappointingfederal budget news, including budgetpassage delays and diversions to war funding,which have slowed growth in thegroup and resulted in several companieslowering earnings expectations the pastfew years. At this point, investors and analystsare trying to figure out what nextyear's changes in Congress and the administrationwill mean for the group. Manyheadlines about the group have not builtinvestor confidence. The political environmentseems to be more hostile now thanin some time.Congress has bolstered oversight hearingsand is pushing for less outsourcing ofessential or critical government services.One of the more publicized examples isthe call by Sen. Hillary Clinton (D-N.Y.) toeliminate 500,000contractor positions.The DefenseDepartment hasbeen pushing toreduce time-and-materialcontracts,which generallycarry better margins than cost-type contracts? assuming good contract management.Although contract protests and theresulting longer sales cycles have slowedbusiness for many companies, the situationlikely will get worse. A change includedin the fiscal 2008 Defense Authorizationbill, which becomes effective at theend of May, will allow protests on taskorders of more than $10 million. Taskorders previously could not be protested.Changes in small-business rules and contractconsolidation also have had somenegative impact on midsize firms.Despite some of the headwinds in theindustry, I remind investors that this is alarge and fragmented marketplace, allowingwell-managed firms the opportunityto gain market share and show strongdouble-digit earnings growth. We seemany examples of that happening today.The disruption caused by changes inthe industry usually also offers anopportunity.Also, the federal IT and professionalservices industry has good financialcharacteristics: There is little capitalexpenditure required, and it has solidfree cash flow that is near net incomelevels, strong return on capital potentialand relatively moderate risk. If youdo the work right and bill properly, theclient will pay, and the client is notgoing away anytime soon.There will continueto be budget delays andchanges. For example,we might see the fiscal2009 budgets delayeduntil early next year.But the better companieswill be able toadapt and take advantageof the changes. And although federalIT and services budget growth has slowed,it is still huge and still growing.