Budget uncertainty puts damper on contractor stocks

CORRECTION: This story has been updated to correct the percentage the defense budget will be cut from sequestration. The cut is 10 percent. An editing error caused the wrong percentage to be published originally.

Federal IT and professional services stocks underperformed the broader market in 2011 and are doing so again so far this year. As I write this, the federal IT and professional services stocks are down 26 percent, lagging the S&P 500 and the NASDAQ, which are up 3 percent and 7 percent, respectively, and underperforming the aerospace and defense stocks which are up 1 percent for the year.

Although the fiscal 2012 budget being passed nearly five months earlier than the 2011 budget is a positive (and RFP activity is strong as a result), investors remain concerned that intense pricing pressure and continued long-term budget uncertainty increase the risk of earnings shortfalls from companies in the industry over the next couple of years.

As a result, I think the main drivers of stock performance in the group in the near term will be acquisition activity and unexpected large contract award wins. Without the help of these two events, federal IT stocks could continue to underperform over the year, at least until the elections in the fall and a resolution to sequestration, which will lower risk and improve funding visibility in the group.

The federal IT and professional services stocks are not expensive by historical measures. At about 9-times projected earnings, they are at the lowest valuation in the past decade. Also, growth expectations are modest, as I am projecting the public federal services companies will show average earnings per share decline of about 10 percent on no organic revenue growth. However, the risk of companies in the industry lowering revenue and earnings guidance increases over the next year in my view, as budget and margin pressure impacts a larger percentage of companies’ revenues through normal contract recompetition and potential budget sequestration.

Longer term, I believe IT spending will fare better than overall government spending (including defense), as government needs to do more with less and leverages technology, particularly newer technologies around cloud computer, data analytics, and mobility

The president’s fiscal 2013 federal budget request to Congress supports my view, with a request for total federal IT spending of $78.9 billion. While this is down 1.2 percent from the prior year, I think it’s not too bad considering total discretionary spending is down 1.4 percent, and down 4.3 percent excluding security agencies.

Also, there are some bright spots in the IT budget such as cyber and health care. While the government did not release a total figure on cybersecurity spending, it received much mention in the budget, and we note that the cyber funding request for the Homeland Security Department is up 67 percent to $769 million, and the Defense Department is seeking an increase to $3.4 billion, up 6 percent.

The most concerning and surprising area of the budget, in my view, is the non-military intelligence agency budgets, where the budget request is $52.6 billion, down 4 percent from the $55 billion request in 2012. The intelligence agencies are reducing the contractor workforce and freezing hiring at 2012 levels.

However, I think the biggest risk near-term for government contractors is the automatic sequestration cuts next January if Congress cannot come to an agreement with the president on spending reductions. The cuts would reduce the fiscal 2013 defense budget by 10 percent, and the non-defense discretionary budgets by 8 percent.

Few people seem to be expecting a deal in an election year (myself included). I think that sequestration cuts get deferred or reduced for a year or so, with the thought that Congress and the president (regardless of the election results) generally do not think sequestration is a good idea and there is more likelihood of a budget agreement after the elections.

However, even if deferred with legislation early next year, I think the initial damage to budgets and funding will be done, resulting in a slowing down of programs and awards later this year as government employees prepare for sequestration. Even worse, Defense Secretary Panetta has stated that if military personnel are excluded from sequestration, it would mean a 23 percent cut to the remaining budget, and in our opinion contractors would likely take more than their equal share of the reductions since they are easier to reduce in the short-term than government employees and large procurement programs.

Bill Loomis is a managing director at Stifel Nicolaus. He can be reached at wrloomis@stifel.com. 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. Stifel Nicolaus does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For additional information and current disclosures for the companies discussed herein, please go to the research page at Stifel.com.