Market Share: Government IT outlook remains strong despite EDS bombshell

Bill Loomis

As we near the end of the third quarter, it appears there will be more
good news from federal information technology services firms and not-so-good news from
commercial IT service firms.

A very negative preannouncement from
Electronic Data Systems Corp. and disappointing earnings from Oracle Corp. seem to signal
that no turn is in sight for commercial IT spending. With the Dow below 8,000 again, and
NASDAQ hitting levels last seen in 1996, it is a difficult time for most industries, not
just IT services.

I believe the catalyst for higher IT spending
will be business expansion and increased business investment, as opposed to a new
technology cycle, regulatory requirements or unusual events such as Y2K. Early indicators
for a turn in commercial IT spending are improving corporate revenue and earnings
performance and better outlooks at larger companies, with the view that this will lead to
increasing capital expenditures, including IT.

However, as the
performance of the stock market suggests, we are not yet seeing such expansion and
probably will not for at least a few quarters.

The EDS miss was a
big surprise to investors, given the magnitude, the amount of long-term contracts the
company holds and the fact that EDS reported results and backed guidance just two months
ago. The shortfall was a result of one-time events, such as losses from USAirways, which
filed for bankruptcy; weakness in Europe, which Oracle also cited as one of the reasons
for its disappointing earnings; weakness in EDS software business; and a general reduction
in follow-on business from outsourcing clients.

One bright spot:
EDS' Navy-Marine Corps Intranet contract is running at a greater pace than anticipated,
helping revenue but not profits.

At the annual Legg Mason IT
Services conference in September, commercial systems integrators said their clients
continue to delay decisions because of economic uncertainty. The systems integrators are
managing their businesses to preserve cash and managing their costs with expectations of
flat-to-down revenue.

Even the outsourcing companies are citing
lengthening sales cycles because of client uncertainly over the economy's direction.

One area that continues to surprise me is the state and local market, in
which IT service firms continue to win new business despite staggering budget deficits.
While some areas in the state and local IT market are being cut, projects that help
governments perform their essential missions or that have alternative funding sources
(federal, fee-based or sources other than taxes) are continuing to be awarded.

SIZE="2">In an effort to reduce costs, commercial and state clients increasingly are
shifting software development and outsourcing offshore, primarily to India.

SIZE="2">The federal IT service firms at the conference maintained their upbeat outlook,
despite budget delays.

Direct or indirect spending for homeland
security is driving the growth of many of the companies' businesses. As for defense
spending, most of the participants thought defense spending will continue to grow over the
next several years, though a potential war with Iraq could cause some near-term disruption
to programs not directly supporting the effort. Investors clearly have recognized the
differences in market outlook between federal and commercial companies, with the former
trading at their highest valuations in over a decade, and the latter trading at their
lowest valuations in a decade.

Bill Loomis is managing director of
the Technology Research Group at Legg Mason Wood Walker Inc. He can be reached at 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. For additional information and current disclosures for the companies
discussed herein, please write to: Legg Mason Wood Walker, Inc., 100 Light St., P.O. Box
1476, Baltimore, Md., 21203, Attn: Research Department.

About the Author

Bill Loomis is a managing director at Stifel Nicolaus.

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