Some Integrators End on High Note

As we close in on the end of the year, public federal integrators, such as CACI International Inc. and PEC Solutions Inc., are continuing to hit new stock price highs. The government integrator stocks we have tracked have done very well in the past year, up 170 percent vs. the S&P 500, down 14 percent.

Many investors and companies are asking how long this strong stock performance will continue. There has been no acceleration of earnings growth of the federal integrators, though we believe there will be some in a couple of quarters, as the increased federal spending following the Sept. 11 terrorist attacks works through to actual task orders next year.

We are not looking for profit margin expansion or contraction among the federal integrators. However, the federal integrators are benefiting from investors' attraction to long-term contracts and the good business visibility the contracts give in these uncertain times.

Demand for commercial IT services continues to be weak, with many companies expecting sequentially down business in the current quarter. Assuming the economy stops shrinking by the second quarter of 2002, we believe commercial IT spending will begin to pick up in the second half of 2002. Investors tend to look ahead and will likely anticipate the rise, bidding commercial IT services stocks higher next year.

As investors begin investing in commercial systems integrators, will they pull money out of federal integrators or even the commercial outsourcing companies' shares, such as Affiliated Computer Services Inc. or Electronic Data Systems Corp.?

There may be some impact on the federal integrators' stock valuation from increased investment in commercial IT services, but unless the fundamentals turn sour, such as what happened to many of the dot-com integrators ? which we do not expect ? investors will likely continue to support the group.

Given the strong stock performance and valuation (for example, CACI's shares are trading at 27 times, PEC Solutions' shares are trading at 56 times, and Titan Corp.'s are shares trading at 47 times consensus calendar 2002 earnings estimates), future price appreciation probably will be closer to the companies' earnings growth rate, rather than continued price per earnings expansion.

One longer-term concern I have is the federal budget deficit. As candidates position themselves for the next presidential election, the deficit should be a very hot topic, assuming there is no further crisis which diverts the citizens' and politicians' attention.

As a result, we could see some pressure on budgets in a couple of years. Well-run federal contractors will be able to get through this potentially tough time, as they have for the past decade, by strengthening their positions and knowledge of growing agencies and their critical programs.

It is difficult for smaller companies to diversify among the agencies and maintain very deep relationships with those clients, making it even more important for smaller federal integrators to make the right choices while times are good.

As a result, we do not expect the strong stock performance of the federal integrators to repeat itself next year.

However, we do believe that this new level of valuation could hold, as investors have come to appreciate the positive characteristics of well-run federal integrators: relative stability, visibility in business, 15 percent or higher earnings per share growth, and strong cash flow.

Bill Loomis is managing director of the technology research group at Legg Mason Wood Walker Inc., Baltimore. He can be reached at rloomis@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 Inc. makes a market in the shares of CACI and PEC Solutions. 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 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. Additional information available upon request.