Market Share: Good times roll on for federal IT companies

Bill Loomis

As the reporting season for second quarter earnings comes to an end, it looks like it's been another good one for the publicly traded federal IT service companies.

So far, these companies have reported organic revenue growth, which excludes the impact of acquisitions, of 15 percent in the second quarter, up from 14.5 percent in the first quarter. Revenue and earnings per share generally have exceeded investors' expectations.

Defense services were particularly strong, with revenue growth from civilian agencies generally lagging because of the delay in the fiscal 2003 civilian-spending bill. But most companies see plenty of bidding opportunities with civilian agencies, and contract awards should increase in the next couple of quarters.

MTC Technologies Inc. showed the highest organic revenue growth at 42 percent, as it benefits from growing defense contracts, particularly its Air Force FAST sustainment and modernization contract.

PEC Solutions Inc.'s organic and total revenue growth slowed dramatically to 4 percent in the quarter, reflecting the delay in the civilian spending bill, and additional delays in the Department of Homeland Security contract awards. However, PEC continues to show outstanding profit margins; its operating margin reached 17 percent in the quarter. PEC is projecting very strong sequential revenue growth in the fourth quarter as it wins new contracts, and the recently won $60 million, five-year US-VISIT program management support contract ramps up.

Anteon International Corp., ManTech International Inc., SI International Inc., Titan Corp. and SRA International Inc. posted results that met or exceeded investor expectations and gave favorable outlooks.

In an unusual step, we actually saw a company sell its federal IT services unit. Affiliated Computer Services Inc. announced a definitive agreement to sell most of its federal business to Lockheed Martin Corp. This unit had $685 million in revenue in fiscal 2003, representing about 18 percent of ACS' revenue. The sale excludes the Education Department loan processing business, which is ACS' biggest contract, and the Hanscom Air Force Base ITSP contracts.

ACS will get $658 million before taxes and transaction costs, or 0.96 times trailing revenue. I consider this a good price for ACS, given the unit's low growth rate -- and for Lockheed Martin, if it can accelerate growth in the unit.

In a concurrent transaction, ACS will purchase Lockheed Martin's commercial IT outsourcing business, about $240 million of recurring revenue, for $107 million before transaction costs, or about 0.45 times trailing revenue, also a good price for ACS, in my view.

ACS' federal business has been underperforming, with revenue last quarter down 1 percent internally vs. its overall internal growth of 14 percent, and with margins roughly half those of the commercial and state and local units.

Lockheed Martin's appetite for federal IT service firms seems to have picked up recently. While General Dynamics likely will have its plate full as it integrates Veridian Corp., which is expected to have $1.4 billion in revenue next year, Lockheed Martin and Northrop Grumman could continue to be active, as well as smaller players.

With a limited number of federal IT service firms around with $500 million or greater in revenue, the urgency for the giants to acquire could increase with each announced transaction. *

Bill Loomis is a 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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