Are federal IT stocks already at rock-bottom?

Bill Loomis is an analysti with Stifel Nicolaus.

Federal IT and professional services stocks have underperformed the broader market for the last couple of years as investors worry about federal budget cuts and increasing pricing pressure. So far this year, federal IT stocks are nearly unchanged, below the S&P 500 which is up almost 8 percent and Nasdaq, which is up 11 percent. But with the forward price to earnings ratio of the group falling from more than 20x a few years ago to 11x, how much of this bearish outlook is already priced into the stocks?

I believe much of the lower expectations around growth are largely factored in the federal stocks’ valuations, and they are positioned to outperform the broader market over the next five to 10 years, similar to the past two post-recession periods (1990 to 2001 and 2001 to present), but not right away. There are a lack of positive catalysts for the industry in the short term (budget concerns on fiscal 2012, award delays and defense contractor reductions will likely continue to dominate the news over the next year).

I view the long-term prospects for the group positively, though, and liken the current environment to the early 1990s. The Obama administration has been emphasizing the use of IT to improve participation, collaboration, transparency, and efficiency, and we expect federal IT budgets to show better growth than overall defense spending over the next cycle.

In the last defense cycle spending downturn, federal IT stocks outperformed the broader market by a wide margin until the rise of the Internet bubble in 1997, but then resumed outperformance following the 2000 recession and accelerating after the Sept. 11, 2001, terrorist attacks. Federal IT stocks, recovering from their early 1990s lows, significantly outperformed the S&P 500 and large defense stocks in both of the last two decades. Past performance is not always indicative of future performance, but I believe the next decade could present similar general patterns to the last two, as the current insourcing trend swings the other way back to outsourcing as the federal government seeks to reduce cost and headcount, and there is better visibility on budgets and policy.

While growth rates have slowed, business still remains relatively healthy in the industry. The September quarter federal contract awards were solid for most of the publicly traded companies, as it usually is due to the end of the government fiscal year. Also, I believe industry consolidation will pick up over the next year, attracting investors seeking the next buyout. However, there are several issues that will continue to weigh on the federal IT group into next year and likely keep most new investors away in the near term, particularly what the outlook for the fiscal 2012 budget is for IT, defense and discretionary spending, more details around Defense Secretary Robert Gates’ call for cutting service support contractor funding by 10 percent each year for the next three years, and more details around cutting funding for defense intelligence advisory and assistance contractors by 10 percent.

Also, with the Republicans controlling the House of Representatives starting next year, we will likely see near-term pressure on the fiscal 2011 budget if an omnibus funding bill is not passed by year end. Newly reenergized Republican leadership will probably focus on fiscal discipline, potentially starting with the yet-to-be-passed fiscal 2011 budget if no omnibus bill is passed this year. By next spring we should have answers for many of these issues, and therefore less uncertainty impacting the group. Later in 2011, I believe the combination of conservative earnings expectations, a more stable government contracting environment (less “change” confusing people, better idea of budget directions), and IT generally gaining budget share over the next several years will allow the better performing companies to have better-than-expected performance, driving earnings expectations higher in a less uncertain environment, and adding to earnings through acquisitions. I think that only until earnings estimates generally begin to be revised higher all but the most patient growth stock investors will choose more economically sensitive investments.