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Third-Quarter Outlook Looks Brighter

Bill Loomis

by Bill Loomis

Over the past month, most information technology services companies have reported second-quarter results generally in line with expectations. For the traditional IT services companies, however, these expectations had been guided lower in June or earlier in the quarter, when most of the traditional IT companies we track, including Electronic Data Systems Corp., Computer Sciences Corp., Unisys Corp. and smaller integrators, all indicated that revenue appeared to be below analysts' estimates.

After analyzing second-quarter earnings reports and interviewing management teams, we continue to believe that we are seeing the effects of the year 2000 problem.

Y2K was a huge event, much bigger than generally believed, in our opinion. It affected corporate budgets, not just corporate IT budgets, more than people think. It accelerated IT spending in commercial and government organizations, and greatly disrupted traditional IT budget cycles over the past three years.

It probably will continue to do so until new budget cycles begin Oct. 1 for the federal government and Jan. 1, 2001, for most commercial companies.

The federal and state governments have been strafed by the Y2K hangover the same way that commercial markets have been hurt. Two government e-business solutions companies, National Information Consortium Inc. and PEC Solutions Inc., indicated that revenue in the second half of the year could be below analysts' estimates because of longer procurement cycles and other delays.

National Information Consortium is a leading government e-portal developer and PEC Solutions Inc. is a leading e-government systems developer and integrator. Both companies report strong pipelines and said the delays seem only temporary. Also, despite the slowdown, both of these companies continue to show very strong growth.

The growing business pipeline and backlog is a message consistent with what we are hearing on the commercial side. All three of the large outsourcing companies, EDS, CSC and IBM Corp., exceeded analyst estimates on contract wins in the second quarter.

This is particularly surprising, because these companies compete mostly against each other. Even smaller integrators, such as Keane Inc. and American Management Systems Inc., report that contract activity is high, pointing to the potential for stronger results later in the year.

In contrast to the traditional commercial and government IT companies, the commercial e-business IT services companies have reported stronger-than-expected results in both revenue and earnings per share. The key trends in second-quarter, commercial e-business, IT services companies' results were the following:

? Demand in the second quarter was very strong and the business momentum is carrying into the third quarter.

? The percentage of employee turnover is climbing from the mid-teens to the 20s for the group as these companies' growth exceeds that of the Internet-skills labor pool.

? Many e-business companies have indicated that sales cycles are growing as large clients become more thoughtful in their e-business initiatives in light of the weakness in many of their dot-com competitors.

? Projects continue to get larger and longer term.

? Bill rate increases continue, as do gross profit margin increases.

With second-quarter earnings reports out, I believe investors likely will wait to see how third-quarter reports develop before bidding traditional IT stocks higher, seeking stronger evidence that the expected acceleration in IT spending is indeed happening. This could result in traditional IT stocks trading sideways until visibility becomes very clear on the quarter, probably in late September.

Trading in the IT services group, both traditional and e-business, will be heavily influenced by investors' appetite for technology stocks overall, which is currently weak.

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. This information is based on sources believed to be reliable but is not guaranteed as to completeness or accuracy and is not intended to be an offer to buy or sell any security. Opinions expressed are subject to change. Additional information available on request.

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