Still sunny in the services sector

Despite facing tighter budgets,
tougher competition, and heavier
oversight and regulation burdens,
the federal information technology
and professional services industry is a
relatively bright spot on Wall Street.

Federal services stocks are down almost
11 percent for the year, which is better
than the 41 percent decline in the S&P
500, the 43 percent decline in the
Nasdaq, and the 19 percent decline in
aerospace and defense stocks. Given the
relative stability and visibility of the federal
market, the group will likely
continue to outperform other sectors
until the economy begins to
turn around.

The third quarter of 2008 generally
went as expected for the
group. Trends in the federal IT
and professional services industry are
healthy and quite strong relative to the
commercial sector. The common themes
for the quarter were strong contract
awards, solid contract funding, on-target
organic revenue growth, generally on-target
earnings per share, and companies
maintaining or slightly raising their
financial projections.

However, profit margins were mixed,
with the average operating profit margin
at 7.3 percent ? less than the 7.6 percent
of a year ago. Operating margins
fell in the third quarter at CACI
International Inc., DynCorp
International, Dynamics Research
Corp., ICF International Inc., SRA
International Inc. and SI International
Inc. They were better than expected at
ManTech International Corp., NCI
Information Systems Inc. and Stanley
Inc.

Internal revenue growth for the public
companies was 11 percent, down from 14
percent a year ago but still healthy. The
growth in earnings per share was 10 percent,
down from 17 percent a year ago as
margins contracted modestly on average.

The funding visibility for the next year
is strong, with the fiscal 2009 Defense,
Homeland Security and Veterans Affairs
departments' budgets having been
passed and the remaining civilian agency
bills likely to be included in an omnibus
spending package. All eyes will be on
President-elect Barack Obama's fiscal
2010 budget submission to Congress in
February, even though that is not
enough time to effect major policy or
spending changes.

Despite the fiscal pressures facing the
United States, the House and Senate are
unlikely to take a hard line on spending
in their versions of the fiscal 2010 budget,
which means we can expect modest
budget growth. Fiscal 2011 might be
quite different if the economy does not
improve, the Troubled Assets Relief
Program does not work as envisioned
and other outlays continue to grow. TARP is already having an impact on the
fiscal 2009 deficit, and talk of a trillion-dollar
deficit in fiscal 2009 does not
seem unrealistic given the deficit in just
the first month of the fiscal year.

In October, the government invested
$115 billion in preferred stock at eight
banks under TARP. The Congressional
Budget Office used a present-value
method to come up with $17 billion as
the cost of the investments, while the
Treasury Department used a cash-basis
method and deducted the full
$115 billion from the deficit.

As a result, for the month of October,
CBO estimated the federal budget
deficit at $134 billion, compared with
$57 billion a year ago, and Treasury
estimated it at $232 billion.

With government receipts falling, the
deficit exploding and defense spending
outpacing other expenditures, we will
likely start seeing significant pressures
on defense budgets in fiscal 2011,
assuming no large new deployments are
required.

Bill Loomis (wrloomis@stifel.com) is a managing
director at Stifel Nicolaus. 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,
go to the research page at www.stifel.com.