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Expect Slower Growth For Traditional IT

Bill Loomis

by Bill Loomis

Over the next month, investors will focus on second-quarter earnings reports. For information technology services firms, it was expected to be a trouble-free quarter, with business rebounding in both government and commercial traditional IT spending following year 2000 lockdowns.

As we enter the second half of 2000, the evidence indisputably shows that traditional IT spending is increasing slower than expected, following pre-announcements from Electronic Data Systems Corp., Computer Sciences Corp. and several smaller integrators, as well as other traditional tech firms such as Unisys Corp., Computer Associates International Inc. and BMC Software Inc.

The slower-than-expected ramp-up in traditional IT spending is attributable to several factors, including companies having a reduced sense of urgency vs. the past few years (when Y2K necessitated it) and the recent pace of change in both the technology and business environments. While traditional IT services companies are winning business, the negotiations are taking much longer then usual and sales cycles appear stretched.

Nevertheless, all indications show
e-business spending continuing at a healthy pace, with all the e-business solutions firms in our coverage tracking at or ahead of our estimates. E-business companies report strong demand and continued urgency from clients, though some anecdotal evidence exists that demand in certain verticals, particularly retail, is moderating more than in others.

Our index of 30 e-business solutions firms shows the stocks down, on average, 42 percent for the year to date, though up 50 percent from a year ago, despite continuing strong results. The weaker stock performance results from broad concerns about the viability of Internet-based business models, a concern that has increased as new dot-com business failures appear, seemingly every day.

While this has resulted in near-term concerns about accounts receivable risk from dot-com clients, investors appear more focused on the bigger issue of future demand and how it will trend. Sharply higher employee turnover among the e-business solutions firms expected this quarter also concerns investors, as growth in the professional services business model largely is driven by hiring new talent.

So far in 2000, revenue growth in federal IT services has been mixed, with CSC and American Management Systems Inc. showing strong growth, but others such as CACI International Inc. and BTG Inc. showing slower growth. Among the integrators that have significant federal business, the early estimate for AMS for earnings per share in the second quarter of 2000 is 39 cents, the same as a year ago. We estimate AMS' federal growth will be at least 15 percent this quarter, though the company has indicated the upper teens.

For CSC, the consensus earnings estimate for its first quarter of fiscal 2001, which ended in June, is 57 cents per share vs. 50 cents last year. Last quarter, CSC's total federal revenue grew 16 percent over a year earlier, adjusting for CSC's acquisition of Nichols Research in November. For Affiliated Computer Services, the consensus earnings estimate is 55 cents per share vs. 46 cents last year.

Analysts estimate BTG will have earnings per share of 14 cents vs. 11 cents a year ago. We expect BTG to show a 10 percent decline in total revenue this quarter from a year ago, due to a significant decrease in product sales as a percentage of revenue, but also expect a 17 percent increase in higher-margin contract revenue.

CACI is expected to report earnings of 41 cents a share this quarter vs. 36 cents a year ago. While CACI has seen federal revenue decline 3 percent from a year ago, the drop in its state and local business has particularly hurt, dropping from $11 million in the December quarter (9 percent of total revenue) to $7 million in March (6 percent). Much of the state and local business last year was Y2K remediation, which has been difficult to transition to other types of business.

At Titan, second-quarter earnings are estimated at 16 cents per share vs. 10 cents last year. Titan should benefit from its recent acquisitions of Advanced Communications Systems, AverStar Inc. and others. For PEC Solutions Inc., expect earnings per share of 7 cents vs. 6 cents a year ago, on higher shares outstanding following its initial public offering.

Overall, we expect the integrators to report as expected, with upside surprises unlikely in the face of a slower traditional IT spending environment.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker Inc., Baltimore. He can be reached at wrloomis@leggmason.com. Legg Mason Wood Walker makes a market in American Management Systems, BTG, CACI International and PEC Solutions. Within the last three years, Legg Mason has managed or co-managed a public offering of PEC Solutions. Electronic Data Systems Inc. is a Legg Mason Select List core holding. This information is based on sources believed to be reliable but is not guaranteed as to completeness or accuracy.

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