Market Share: Federal IT service stocks a bright spot in glum market

Bill Loomis

After investors sold them off in the beginning of the year over concerns about lower defense spending, federal IT service stocks have roared back, with many reaching all-time highs in recent weeks.

Investors also have been attracted to the group amid continued concerns about the economy and rising oil prices, which have resulted in the commercial IT service stocks that I track being down 17 percent year-to-date, while the federal IT service stocks are up 5 percent. The broader stock market, as measured by the S&P 500, is down 1 percent year-to-date.

The federal IT service stocks tend to be indifferent to economic news but highly sensitive to news about defense spending, budget trends and contract award activity. This point was demonstrated last month when CACI International Inc. gave its fiscal 2006 earnings guidance to investors.

CACI's issuing September quarter revenue guidance modestly below investor expectations and its statement that new contract awards remain slow prompted investors to sell CACI shares. Although the selling in CACI shares, as well as in some competitors' shares, was brief, it was quite telling how high investor expectations are for the public federal IT service firms.

Although CACI indicated that new contract award activity was slow, CACI as well as others are experiencing good award activity under existing contracts; some expansion of scope of some contracts also has happened to accommodate new services for government clients.

There likely was some impact on defense award activity with the delay of the fiscal 2005 defense supplemental budget, signed May 11. At this point, the fiscal 2006 budget process seems to be on track, although Congress could become distracted by issues such as judicial nominations or balanced budget battles.

We expect new contract award activity to pick up before the end of the fiscal year Sept. 30. Most companies indicate they have record levels of bids submitted, and there does not appear to be any material budget or legislative issues hanging over the awards process.

In fact, the move by the General Services Administration as a part of its "Get It Right" program to discourage "parking" obligated but unspent IT funds in the Federal Technology Service IT Fund could add to the pace of year-end contract awards.

But it also could result in some older funds' obligations being reprogrammed, possibly impacting funded backlogs by a modest amount.

I anticipate the federal IT companies generally will report as expected or better than expected results for second quarter 2005 (similar to first quarter 2005), and have favorable comments on their outlooks.

Also, new contract award activity should pick up, and there should be continued merger and acquisition activity.

As a result, I believe the stocks will generally move higher to the end of the year. Beyond that, we could see nervous investors focus on what the president's fiscal 2007 budget request will be, with a particular eye on defense spending.

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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