Market Share

Fed market spurs enthusiasm while commercial side struggles

Bill Loomis

As we approach the first quarter's end, investors face mixed indicators as to whether commercial information technology spending is improving.

The shares of companies such as KPMG Consulting Inc. and Computer Sciences Corp. have been moving higher in recent weeks as investors believe the improving economic news should translate to higher systems integration and application development business.

Although we haven't yet seen a turn in commercial systems integration, I think spending will likely pick up with an improvement in the economy and in the confidence of companies that buy IT products and services.

However, there are indicators the industry will not rebound quickly, as evidenced by Oracle Corp.'s negative pre-announcement and one-time systems integrator leader Sapient's pre-announcement.

Oracle's notice of a 27 percent decline in software license revenue in the quarter surprised most analysts. However, the shares of competitors SAP and PeopleSoft did not follow Oracle's decline, and investors believe Oracle's problems are more company-specific, though obviously we continue to be in a tough IT spending environment.

Sapient pre-announced likely lower-than-expected results for the first quarter (low end to below prior guidance). The shortfall primarily is due to continued weak demand. The company announced its third staff reduction since the beginning of 2001, reducing billable head count by 22 percent, or about 415 people, and nonbillable or administrative head count by 24 percent, or about 130 people.

I do not believe investors are expecting IT companies to report that demand for services is accelerating since last quarter, but news that business is worsening will likely be met with selling pressure, unless companies indicate strong visibility of revenue growth in the second quarter.

Among the federal IT service companies, business remains strong.

With Congress finally approving fiscal 2002 appropriations, contracting opportunities should begin to flow. However, to date, most of the companies I speak with are seeing increased activity under existing contract vehicles, rather than new contract opportunities.

The federal sector has Wall Street's full interest, and the initial public offerings have begun in the space.

ManTech International Corp. was the first to come public this year, selling 7.2 million shares at $16 per share. In following the industry in the last 10 years, I have never seen such investor enthusiasm over the federal IT and engineering services firms.

Yes, I did write "engineering services." Investors seem to be less focused on particular types of services and more interested in profitability, earnings growth, cash flow and visibility, though higher-margin IT services should continue to deserve a higher valuation.

With almost daily talk in the press of growing defense, homeland security and IT budgets, investors are following the money.

With the larger companies having greater access to equity capital and eager to make acquisitions, we likely will see continued, and perhaps accelerated, consolidation in the industry over the next couple of years.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker Inc. 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 ManTech International Corp. Legg Mason Wood Walker makes a market in the shares of KPMG Consulting and ManTech. 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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