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Big IT Services Firms Survive Shaky Economy

Bill Loomis

Stocks of companies in the federal information technology market continued to show strength following the Sept. 11 terrorist attacks, with CACI International Inc., PEC Solutions Inc., Titan Corp. and Dynamics Research Corp. all having strong performance in the past two weeks.

As I discussed in my last column, I am quite positive about the outlook for the federal IT services sector, though investors have largely discounted this outlook by quickly bidding these shares higher.

Another group of IT service stocks hitting new price highs (or close to it) are the IT services industry giants, such as Electronic Data Systems Corp., Accenture and Affiliated Computer Services Inc.

As the 2001 third quarter reporting season winds down, there are a few clear conclusions.

First, demand for systems integration and consulting services in the commercial IT service markets continues to be weak, and likely will be weaker next quarter. Unfortunately, this could result in another round of layoffs in the sector at year's end, as companies attempt to bring their cost structure in line with declining revenue.

I continue to believe that business expansion ? a growing economy ? will have to lead to a meaningful turn in IT spending. There is no powerful catalyst to cause corporations to spend on IT: No big technology cycle, regulatory requirement or other event, such as the year 2000 crisis.

There are some pockets of spending, such as consulting and integration around Health Insurance Portability and Accountability Act requirements in the health care field, but not enough to drive top-line growth of the smaller IT service firms. Based on most integrators' business pipelines, I do not expect a turn in IT spending until next summer.

Second, the big companies are taking market share from the small companies. Most of the large players in the industry, including EDS, IBM Global Services, Accenture and ACS, reported solid third quarter results. These four companies make up about 17 percent of the worldwide IT service marketplace, and each showed double-digit revenue growth, adjusting for currency impact and not including acquisitions.

Third quarter results of some of the smaller public IT service firms, such as American Management Systems Inc. (revenue down 13 percent year-over-year), Keane Inc. (revenue down 10 percent year-over-year), Sapient (revenue down 49 percent) and others, suggest that clients are favoring the larger IT service vendors in this uncertain time.

Smaller firms seem to be hurt even more, such as the former e-business IT service leader Scient Corp., which reported a third quarter revenue drop of 89 percent year-over-year.

Another observation is that companies with mostly long-term contracts are faring better. This point is obvious, but it applies to a wide range of industries and types of work, whether it is data center outsourcing with EDS, state and local business process outsourcing with Maximus Inc. or federal IT services with CACI International.

Even payroll and transaction processors, such as ADP, and credit card processors, such as First Data Corp., are doing well despite economic concerns.

Even larger companies are experiencing weakness in their business with short-term contracts. For example, IBM Global Services' outsourcing business (about 40 percent of its revenue) was up 13 percent, while its systems integration and consulting was up only 6 percent, down from double-digit growth in the first half of 2001.

The impact of Sept. 11 on the non-law enforcement civilian agencies also is a bit cloudy at this point. Nevertheless, federal IT service firms' employees and investors are smiling after seeing their stocks outperforming their commercial counterparts over the past couple of years, following a decade of underperformance.

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 and Maximus. EDS is a Legg Mason Select List core holding. Legg Mason Wood Walker makes a market in the shares of American Management Systems, CACI International, PEC Solutions and Sapient. The information contained herein has been prepared from sources believed reliable, but is not guaranteed by Legg Mason and is not a complete summary or statement of all available data, 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. From time to time, Legg Mason Wood Walker. 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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