Strong growth around the bend

Bill Loomis (wrloomis@stifel.com) is a managing director at Stifel Nicolaus.

A common thread among the largest federal information technology services firms, or the IT business units of the large defense firms, that have reported first-quarter earnings has been sluggish revenue growth and mixed margins. Contract award activity in the federal IT and professional services industry is down sharply in the past year as contracts have been delayed due to the Obama administration's transition and changes in programs and policies. Just as impactful, in my view, has been the jump in contract award protests.

However, most firms remain optimistic about business later in the year as contract award activity improves, particularly in the stronger growth areas such as cybersecurity, health IT and command, control, communications, computers, intelligence, surveillance and reconnaissance (C4ISR). I also expect stronger awards in the industry later this year because the  administration has been in place for more than a year and many of its new policies and changes are better understood. Also, I do not see an acceleration in bid protests after they were up 17 percent in 2008 and 20 percent in 2009, driven partially by a change in the law in May 2008 that allowed protests on task orders of more than $10 million, in addition to stresses on the federal acquisition workforce.

Lockheed Martin Corp.’s Information Systems and Global Services (IS&GS) unit’s first-quarter 2010 revenues were up 4.0 percent over the prior year, while operating margins of 8.1 percent were down from 8.8 percent in the year-ago period. Growth in IS&GS’s defense and civilian business was partially offset by slight declines in intelligence programs, which also contributed to lower margins sequentially and from a year ago. IS&GS' backlog of $12.2 billion is down from $12.9 billion in the year-ago period.

For 2010, Lockheed Martin expects its IS&GS group to generate 6 percent to 8 percent growth, with defense (37 percent to 38 percent of unit revenues) and civilian (37 percent to 38 percent of unit revenues) generating upper-single-digit growth, approaching 10 percent, with intelligence (25 percent of unit revenues) remaining relatively flat. The lack of intelligence growth is mainly due to smaller contracts being awarded rather than to a decline in the number of awards. Lockheed Martin expects IS&GS operating margins to be around 8.4 percent for 2010, up from 8.1 percent in the first quarter.

General Dynamics Information Systems and Technology (IS&T) unit reported revenues up 0.7 percent in the quarter on slightly lower operating margins of 10.5 percent versus 10.6 percent a year ago. IS&T’s total backlog was $10.3 billion, slightly down from 2009, although the company believes it will see improvement in contract awards later this year. Despite the slow first-quarter revenue growth, General Dynamics still expects the IS&T unit to achieve 8 percent to 9 percent revenue growth for the year while maintaining its margins.

Northrop Grumman’s Information Systems (IS) unit reported that its first-quarter revenues declined 1 percent, excluding the impact from the sale of TASC, on operating profit margins of 8.9 percent, the same as a year ago. Northrop Grumman IS cited lower revenues from civil federal agencies and state and local clients, which were partially offset by growth from intelligence customers. Despite soft results, Northrop Grumman did not change the outlook for its IS unit, citing a stronger outlook through the year in its defense and intelligence business, including cybersecurity and C4ISR initiatives.

Science Applications International Corp. has yet to report its fiscal first quarter, which ended April 30, but for the quarter that ended Jan. 31, SAIC reported organic revenue growth of 4 percent and lowered its outlook for the next year from 6 percent growth to a range between 3 percent and 6 percent, citing weaker contract awards. SAIC’s backlog was $15.5 billion, down 7 percent from a year ago. SAIC noted particular weakness in its business with intelligence agencies, as contract awards have been delayed. SAIC’s operating profit margin was 8.2 percent, slightly lower than the 8.3 percent a year ago.

L-3 Communications Corp. has been among the most negative in its outlook of federal services in the past year, and it was reflected in the company's results. L-3’s Government Services revenues were down 6.3 percent from a year ago on lower profit margins of 8.2 percent versus 9.0 percent in the year-ago period. The revenue decline was due primarily to lower revenue for Army systems and software engineering and sustainment work that moved to a contract on which L-3 is not a prime contractor, and lower Iraq support revenues, including linguist and intelligence support activities. The operating margin decline was due to lower margins on certain contract renewals and higher costs under a Homeland Security Department security systems contract.

While there have been some smaller companies that have posted strong contract awards recently, such as ManTech International Corp., SRA International Inc. and Stanley Inc., the largest firms will also need to see solid improvement in awards in the next quarter or two to meet their projections of stronger growth later in the year.