IT services sector holds steady in soft economy

Although the economy remains soft, firmer corporate earnings outlooks and some signs of economic stabilization have resulted in the market moving higher since early March, with technology stocks driving most of the performance.

The technology-heavy Nasdaq stock index is up 21 percent this year, better than the 5 percent increase in the S&P 500, which has a larger weighting of underperforming financial and industrial companies. Stocks of federal information technology and professional services companies are holding their own, up 7 percent and outperforming aerospace and defense stocks, which are down 4 percent.

It is not unexpected to have federal IT services stocks underperform in the initial stages of an economic recovery, or at least investors’ anticipation of it. That’s because there is less economic exposure in the group, which is driven primarily by government spending. Also, concerns about long-term government spending pressures, given the ballooning deficit, and insourcing issues are worrying investors.

Contract awards have been sparse this year as the new administration transitions, reviews programs and moves forward with its agenda. But contract activity is expected to pick up sharply in September because the fiscal 2009 budgets have long since passed. Awards from the stimulus package should pick up later this year, too.

Although fiscal 2010 budgets will be late, based on President Barack Obama’s request to Congress, they will show strong growth, with 7 percent higher overall discretionary spending — 4 percent by defense agencies and 9 percent by civilian agencies — and 4 percent higher IT spending. The 4 percent increase in fiscal 2010 might not excite investors, but it comes on top of a large 8 percent jump in fiscal 2009 spending. That was driven by the omnibus spending bill earlier this year, which boosted civilian agencies’ spending 8 percent over former President George W. Bush’s request.

Public federal IT services firms are expected to show earnings growth of about 13 percent per share in the second quarter, and 14 percent during the next year, which is below the 19 percent level seen in 2008. Organic revenue growth for public companies is expected to be 6 percent on average in the second quarter, growing to 11 percent during the next couple of quarters as the strong awards of 2008 continue to ramp up and year-over-year comparisons become easier.

Even though the trends for federal IT and professional services firms look positive for the next few years, the biggest concern is insourcing. Although the focus now seems principally on acquisition functions, Defense Secretary Robert Gates and others have made it clear that the push for insourcing is not limited to procurement and acquisition support areas. As the economy improves, general employment rises and fewer worried workers seek a “flight to safety,” the government likely will have a difficult time hiring qualified workers and shifting a significant amount of work back to government. Most companies have seen the government hire more of their workers, but it has not been a big increase.

A trend that concerns me less is the government’s move away from time-and-material contracts. Although that trend should lead to more fixed-price programs, work seems to be shifting to more cost-type contracts, which can be easier and quicker to structure for the government and have lower risk to contractors. However, they generally do lead to lower margins, too.