In an effort to accelerate growth in the future, some companies in the IT and professional services market are increasing their investments in this difficult period at the expense of earnings, writes Bill Loomis of Stifel Nicolaus.
Bill Loomis (firstname.lastname@example.org) 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.
After starting 2010 underperforming compared to the broader stock market indexes, the federal information technology and professional services firms’ stocks are now outperforming for the year, albeit only slightly. Federal IT stocks are up slightly for the year, above the S&P 500 and Nasdaq, which are both down more than 3 percent, and above the performance of the aerospace and defense stocks, which are down 11 percent. Concerns about the global economic rebound have pressured the broader stock market indexes.
Although the federal IT and professional services market has its share of headwinds, the relative stability of the federal services business, in addition to two publicly traded services companies, Stanley Inc. and DynCorp, being acquired this year, has brought some investor interest to the market segment. However, concerns about federal budget pressures, insourcing and margin pressure have pushed stock valuations down to levels last seen in the mid-1990s.
Industry is actively addressing the budget pressures, from the smaller companies to giants such as BAE Systems and Lockheed Martin Corp., which have announced cost reductions and reorganizations. But some companies are taking a different view and increasing their investments in this difficult period at the expense of earnings in an effort to accelerate growth in the future.
One such middle-market firm is NCI Inc. The company has enjoyed a strong reputation in the marketplace and with investors, based on solid contract performance and business development efforts, which have resulted in double-digit organic revenue growth during the past several years.
But just five years ago, NCI had less than $200 million in revenue and was not seen as big enough to compete for larger IT contracts with companies that have more than $1 billion revenue. Now, with revenues of nearly $500 million in the past year and an even broader portfolio of contract performance experience, NCI has decided to increase its investments in hiring and business development, at the expense of earnings growth during the next year or two, in an effort to win larger contracts, particularly key indefinite-delivery, indefinite-quantity contracts that are being recompeted soon.
With the announcement earlier this year of this new strategy and negative impact on near-term earnings, investors reacted by selling NCI shares down 23 percent that day. The magnitude of NCI’s stock decline is not too surprising given the change from expectations of double-digit earnings growth to flatter earnings growth.
Investors reacted similarly when another middle-market federal services firm, ICF International Inc., announced it filed a shelf offering, which signals an intent to sell stock at some point, to issue new stock in fall 2009. That resulted in dilution to earnings, with an 18 percent decline in ICF’s share price from the time of the shelf offering announcement to the pricing of the stock offering in December 2009. ICF used the offering proceeds to pay down debt, with the intent of taking advantage of attractive business valuations to make acquisitions.
Unfortunately, many institutional investors will not wait patiently for 12 to 24 months until those investments start paying off in the form of strong, above-average earnings growth. They need stocks that can perform now because many of their own investors will not be patient and leave money in mutual funds that are underperforming compared to the S&P 500 or other broader market indexes for a year or two. Nevertheless, history has shown that there can be a large payoff when a company wins those larger IDIQ contracts, which significantly drive earnings and stock prices higher. Patient investors with a vision tend to make the bigger returns over time.