Budget priorities play to services companies’ strengths

With the economy continuing to slide and most companies outside the government market reporting weak financial results, the stock market continues to fall. The S&P 500 has declined 15 percent so far this year to reach decade lows.

Investors’ concerns about the Obama administration’s review of big defense programs and the slowdown in commercial aerospace-related businesses have hurt the tier-one defense companies’ shares, which are also down about 15 percent year-to-date. The bright spot are federal information technology and professional services stocks, which are down 7 percent this year and up 9 percent over the previous 12-month period. That group of companies is generally reporting good results and raising its future financial guidance.

The outlook for the federal IT and professional services companies looks bright for the next couple of years as well, particularly with strong growth in cybersecurity and the expansion in civilian agency programs, intelligence agency support, military intelligence, and surveillance and reconnaissance systems support. There are also logistics and modernization efforts. President Barack Obama’s fiscal 2010 budget outline released Feb. 26 points to continued growth opportunities for the next several years, despite a $1 trillion-plus budget deficit.

The federal IT budgets have not yet been announced, but I was surprised by the stronger-than-expected overall discretionary spending in the budget request. The president is asking for a 4 percent increase in the defense base budget and $130 billion for war costs, which would increase the combined defense spending (base and supplemental) by 1.4 percent — better than I would have thought. More surprising was the budget request for overall civilian agency discretionary spending: It was up 9 percent in fiscal 2010 from former President George W. Bush’s fiscal 2009 request.

At this point, the House has passed its version of the fiscal 2009 omnibus spending bill for the remainder of the civilian agencies that were operating under a continuing resolution. The bill is an increase of about $30 billion, or 8 percent, over the White House’s request for the same agencies. Should that omnibus bill pass and the enacted fiscal 2009 spending therefore be higher than expected, the fiscal 2010 civilian agency request would be an increase of about 4 percent on the higher fiscal 2009 base. Any way you cut it, it is a strong increase in federal discretionary spending in fiscal 2009 and 2010.

Despite the record deficit projections, the outlook beyond fiscal 2010 is attractive, with growth each year in defense base spending and overall civilian agency discretionary spending. However, there were some unexpected budget declines. The president is requesting only a 1.2 percent increase in fiscal 2010 for overall Homeland Security Department spending and is projecting a decline of 0.7 percent in fiscal 2011 and a decline of 1.2 percent in fiscal 2012. The Justice and Health and Human Services departments face budget declines in fiscal 2010, although those two departments benefit much more from the stimulus bill than DHS does, according to budget documents.

Although the budget does not indicate a specific amount for cybersecurity, it does say cybersecurity will receive substantial funding. There were also a couple of pages on strengthening the intelligence agencies, but no numbers were disclosed. The president’s full budget will be released in April. The initial budget outline gave high-level numbers but did not indicate specific program funding changes, particularly on the defense side. However, increasing spending — particularly in this tough economy — should result in continued strong contracting opportunities for the next year or two.

Bill Loomis is a managing director at Stifel Nicolaus. 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 go to the research page at Stifel.com.