Uncertainty stalks defense and IT services sectors

Investors are feeling more upbeat after seeing indications that the economy might be stabilizing, or at least that the pace of the decline might be slowing. The broader stock market began to rally in March as a result of this shift, with financial services stocks showing particular strength. Since federal information technology and professional services firms generally do not benefit directly from an improving economy, investors tend to be less enthusiastic about owning government services when the economy is improving and seek more cyclical investments.

As a result, the S&P 500 is down 8 percent so far this year, while federal IT and professional services stocks are down 11 percent, under-performing the broader market after two years of out-performance.

The federal services stocks also have been hurt by uncertainty around President Barack Obama’s executive orders issued earlier this year, a potential strengthening of union representation among contractors, and potential insourcing trends. Defense Secretary Robert Gates’ plan to move 30,000 contractor positions to government positions could be the first significant step toward less outsourcing. At this point, however, Obama’s focus appears to be on acquisition-related positions and not areas such as IT services. Although the government seems to be stepping up its hiring in the acquisition area, a broader move to insource various areas would likely prove difficult as the government would be competing even more with the private sector for top talent.

Despite those uncertainties, the outlook for federal IT and professional services companies is good during the next couple of years given the contract opportunities generated by the strong budget increases in fiscal 2009 and 2010, based on Obama’s fiscal 2010 request, coupled with spending on stimulus-related programs. Areas of particular growth in IT and program support include cybersecurity; intelligence, surveillance and reconnaissance; and logistics and modernization efforts. Other opportunities will involve civilian-agency programs designed to address the administration’s policy initiatives in areas such as energy, environmental protection, health care and government transparency.

Contract award activity was relatively light in the first quarter for publicly traded federal IT and professional services companies. I expect awards to pick up through fiscal 2009 and be particularly strong in the September quarter.

Although none of the midtier federal IT services firms has reported first quarter results at press time, I estimate that internal revenue growth — growth without the impact of recent acquisitions — for the group was about 7 percent in the first quarter, down from 9 percent in the fourth quarter and 16 percent a year ago as some companies compare against large wins in 2007 — such as ManTech International Corp., NCI Information Systems Inc. and Stanley Inc. — or lost a large contract last year, as did SRA International Inc. I do estimate that revenue growth will improve for the companies through the year as the improving contract awards convert into revenues. As earnings and revenue growth improve and contract awards pick up in the second half of the year, we will probably see a pickup in investor interest in the group even in an improving economy. With the federal IT services firms trading at 14 times our 2009 earnings estimates, the group’s valuation is now where it was in the mid-to-late 1990s, a multiple similar to our expected earnings growth in the group.