Market Watch: Recovery in commercial IT market slower than expected

Bill Loomis

While the federal information technology service firms continue to do well, both in business and share price, the commercial companies are struggling to recover. Earlier this year, I expected an improving economy to increase consumer and corporate confidence, resulting in higher capital spending for IT. That seemed to be the case until late March, when a flurry of software company pre-announcements made it clear that IT spending recovery would not be quick.

Since then, investor, consumer and corporate confidence has declined because of corporate scandals, accounting restatements and a weak stock market. While the economy is expected to continue to show good growth, economists seem more guarded about growth for the remainder of the year given declining consumer confidence and other factors. Also, the cautionary language many companies are using ? no one seems to be saying that business is materially better in commercial IT services ? as well as the relatively weak results we have seen from IT companies so far this quarter, causes me to believe the turn in IT spending will likely occur next year, instead of the second half of this year.

Several issues causing concern in the commercial IT segment seem to be less concerning to investors in the federal IT sector, and for good reasons. Demand and visibility on future business seem good in the federal sector. Also, accounting tends to be simpler in the federal IT services sector, with fixed-price contract revenue usually representing about 20 percent or less of the typical public federal IT revenue mix.

Cost-reimbursable and time-and-material contract accounting, particularly with the Defense Contract Audit Agency and other government auditors looking over most companies' shoulders, require less "guesstimates" than the percentage of completion accounting used in fixed-price projects. Federal IT services companies also enjoy strong balance sheets and good cash flow.

Most of the publicly traded federal IT firms have little to no debt and sizable cash balances. Capital expenditures are relatively low in the sector as well, and companies that manage their working capital needs, particularly accounts receivables, should enjoy good, free cash flow.

The federal sector is not without risks, however, which generally come as unexpected budget changes or legislated rules changes. For example, the last-minute addition to Section 803 of the fiscal 2001 defense authorization bill requires defense IT service buys to be in fixed-price contracts. While this is certainly not a show stopper, it could cause some disruption should the rule be implemented.

This change seemed be added largely to encourage performance-based contracting. While more performance-based contracting could be both beneficial for industry and government, there are instances when agencies need time and material IT service contracts. The government rulemakers need to look at the commercial IT services project world, where most IT and consulting projects seem to be time- and material-based, and not fixed price.

Commercial companies are free to choose either fixed-price or time-and-materials. Forcing agencies to use fixed-price only contracts does not seem efficient and is not what occurs in the commercial world.

Bill Loomis is managing director of the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at wrloomis@leggmason.com. 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.

About the Author

Bill Loomis is a managing director at Stifel Nicolaus.

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