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Upswing Forecast for Federal IT Stocks

Bill Loomis

By Bill Loomis

While federal IT companies have not been hurt significantly by year 2000-related project deferrals, many commercial IT companies have not been so lucky.

Unfortunately for the federal IT companies, some of investors' dampened enthusiasm for commercial IT stocks has hurt federal IT stocks as well.

Negative pre-announcements from traditional information technology services companies have prompted a massive shift in investors' money into the new Web-solutions IT services companies and partially out of traditional IT services stocks.

IT services companies making the transition away from Y2K business are continuing to see non-Y2K business slow down, with every month since June being weaker. This weakness is a reflection of the Y2K lockdowns that corporations are implementing so they do not disrupt existing, tested systems and likely will continue through the fourth quarter and January 2000.

Demand for e-commerce and other Internet-related development is very strong and is one of the few IT services areas that shows no impact from Y2K lockdowns. Momentum investors are bidding shares up in this sector to market-capitalization-to-revenue ratios of 10 times to 20 times revenues (yes?revenue, not earnings!) for most companies.

Ken Bajaj, former chief executive of the federal IT company I-Net (sold to Wang), has profited from this wave by rolling up 12 small commercial IT firms to form AppNet last year. AppNet currently has a market capitalization of 9 times estimated 1999 revenues, vs. the typical 0.7 times revenue for federal IT companies.

While I believe investors should have some exposure to quality names in the Web solutions group, I also believe there is an opportunity for patient, more value-oriented investors in the more mature IT services companies. Although these firms face business transition issues, they are not sitting idly by and letting the Web startups enjoy a monopoly on the strong growth rates in Internet-related IT services.

More mature IT services firms are leveraging their extensive customer lists and strong back-office integration skills to target complex e-business solutions.

My view has remained the same since last March?that the IT services sector will likely underperform the broader market until the end of the third quarter, at which time the full impact of the Y2K transition/lockdown will be known and priced into the stocks.

My long-term investment thesis on the group continues to revolve around the Internet's extensive impact on business and the resulting need for a wide range of IT services over the next several years. These needs are not only for front-end electronic commerce projects but also for infrastructure and back-end integration efforts, and apply to both federal and commercial customers.

We see some events that suggest sentiment is quite low in the sector, such as negative pre-announcements for the first time this year of IT services companies that are working through Y2K transitions but have not guided down expectations, leading to some analyst downgrades.

Even American Management Systems Inc. of Fairfax, Va., was downgraded due to Y2K-deferral concerns. An encouraging indicator of low investor sentiment for the mature IT services companies was the fact that the shares of most of the downgraded stocks hardly budged.

Although we may not be at the bottom of IT stock prices yet, I believe we are close. Clearly, the fourth quarter will be difficult for those IT service firms feeling the impact of the Y2K lockdown, but I believe investors' expectations are quite low.

As third-quarter results are announced over the next month, companies should have good visibility on the fourth quarter and the final round of lower earnings expectations should occur. The federal IT companies should benefit as well, as investor enthusiasm returns to the sector over the next few quarters.


Bill Loomis is managing director of the Technology Research Group at Legg Mason Inc., Baltimore. He can be reached at wrloomis@leggmason.com. This information is based on sources believed reliable but is not guaranteed as to completeness or accuracy and is not intended to be an offer to buy or sell any security.

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