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Few Silver Linings in These Dark Clouds

Bill Loomis

Once again in-vestors are focusing on earnings, with most companies reporting second quarter results over the next couple of weeks. I don't expect many surprises this quarter. I continue to believe there will be another round of broad estimate reductions among commercial information-technology services firms.

The warnings have already begun with warnings from DiamondCluster International Inc., Sapient Corp., American Management Systems Inc., Cap Gemini and others. However, the extent of the estimate reductions will probably be less than last quarter.

While recent news suggest the economy should improve toward the end of this year and into first half of 2002, the rebound in business will probably be slower than most companies expect, hence the likely reductions to second half of 2001 or fiscal 2002 guidance.

None of the companies I have spoken with indicate business is accelerating (except Electronic Data Systems Corp., which continues to be very confident and has set high investor expectations over the next year). Many companies have had additional reductions in work force and have deferred internships or new college hires this summer. Even Accenture and IBM Global Services recently announced small layoffs.

Investors will probably once again become jumpy over the prospect of reduced second half 2001 expectations following the announcement of second quarter results, sending IT services and technology stocks lower near term. However, I do not expect most of these companies to retest their lows, given a more encouraging economic outlook vs. three months ago.

One of the companies that preannounced weaker-than-expected second quarter results was AMS. The company said second quarter earnings per share will be in the 30-cent to 34-cent range, lower than the 39 cents that analysts expected. AMS indicated revenue will be slightly lower than anticipated, in the $319 million to $325 million range, due mostly to weakness in its financial services unit and costs incurred due to the transition to its new shared-services model. Interestingly, its telecom industry unit has had stronger revenue growth than expected. Like most technology companies recently, AMS is shying away from giving full-year earnings guidance due to low visibility in its business.

Among the largest IT service companies, EDS continues to be bullish on its prospects, while competitors announce lower earnings and layoffs. Investors (and competitors) are asking: "How long can EDS ride its strong business momentum?"

Last quarter EDS showed some weakness, with revenue from its largest customer, General Motors, declining, as well as revenue from its consulting business declining. The consensus EPS estimate for EDS for the quarter is 62 cents vs. 53 cents a year ago.

Computer Sciences Corp. has been the reverse image of EDS over the past few quarters. CSC continues to struggle with slower revenue growth and much lower profit margins from a year ago. Despite 25 percent of CSC's business being federal government (and doing well), and 40 percent long-term commercial outsourcing contracts (which is having a few contract start-up issues), CSC's shorter-term commercial consulting and systems integration business has dragged down overall results and has resulted in layoffs as well. Analysts are expecting EPS of 27 cents vs. 56 cents for CSC on about 10 percent to 11 percent revenue growth.

The story with the federal government IT services firms is quite different from the commercial firms. While I continue to have some concerns about potential near-term disruptive effects of the administration change, its effect, if any, has not yet been apparent. Bid opportunities continue to be strong for these companies, and the prospects of increased outsourcing should help further.

After several tough quarters, BTG Inc. improved results last quarter sequentially, including a 50 percent increase in its bid pipeline. Analysts are looking for EPS of 12 cents for BTG, which will be equal to last quarter, but below last year's 16 cents.

Titan Corp. also is expected to report lower EPS this quarter, with consensus estimates for cash EPS (excluding goodwill) of 6 cents vs. 16 cents a year ago.

CACI International Inc. has delivered consistent financial results over the years, and investors are finally rewarding the company. Over the last few weeks, investors have bid CACI's shares to an all-time high. Analysts are expecting CACI to report another solid quarter, with EPS of 51 cents vs. 41 cents a year ago.

PEC Solutions Inc.'s stock also recently hit an all-time high as investors took notice of the company's strong earnings growth. Analysts estimate PEC will report EPS of 11 cents vs. 7 cents a year ago, up 57 percent on expected strong 45 percent revenue growth.

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. Within the last three years, Legg Mason Wood Walker has managed or co-managed an underwriting of the securities of PEC Solutions. EDS is a Legg Mason Select List core holding. Legg Mason Wood Walker makes a market in the shares of American Management Systems, BTG, CACI International, PEC Solutions and Sapient. The information contained herein has been prepared from sources believed reliable but is not guaranteed, nor is it considered an offer to buy or sell any securities referred to herein. 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. No investments or services mentioned are available in the European Economic Area to "private customers" or to anyone in Canada other than a "Designated Institution." From time to time, Legg Mason Wood Walker Inc. and/or its employees involved in the preparation or the issuance of the communication may have positions in the securities or options of the recommended issuer.

About the Author

Bill Loomis is a managing director at Stifel Nicolaus.

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