Market Share: Politics aside, 2006 looks good for fed IT market

Bill Loomis

Public federal IT service companies in general reported third quarter 2005 results in line with their guidance ranges, but fourth quarter 2005 revenue guidance for most of those companies was lighter than most investors expected. The unexpected delay of the fiscal 2006 defense spending bills, as well as continued delays on several key civilian spending bills, has resulted in lighter than expected contract award activity this quarter. And that means that most of the companies probably will announce fourth quarter results closer to the low end of their guidance and give first quarter 2006 guidance with modest growth.

I would expect to see robust contract awards in the March and June quarters as a result of the delays. It will be a couple of months yet until the fiscal 2006 federal IT budgets are final and the Office of Management and Budget reports the actual amounts for those budgets. But the president's request was for a seven percent increase in federal IT spending in fiscal 2006, well above the fiscal 2005 federal IT budget growth of less than one percent.

With awards slipping to the right and the budget growing, we will likely see strong contract award activity next year. However, much of this new business probably will not have much of an impact on the March or June quarter results, as it will take some time to win and ramp up new business. That, I expect, will make the second half of the year much stronger on revenues and earnings per share for most companies.

Revenue from Defense Department agencies is an average of 75 percent of the revenues of public federal IT services, making investors and companies sensitive to defense spending news. A few months ago, I thought the fiscal 2006 defense spending bill would be one of the first major spending bills to pass, in October or sooner. Now it seems likely to be the last one passed and signed by the president.

The stock market tends to be fast to price in developing news. Because of these budget delays, the federal IT service stocks have underperformed the broader stock market. Year to date, the federal IT service stocks are up by 3.4 percent, slightly below the S&P 500's 4.7 percent return, but well ahead of the commercial IT service stocks' decline of 18.6 percent. The commercial IT service stocks have been hurt by concerns of a slowing economy, therefore, slowing IT spending by commercial clients.

Over the next few months, investors will focus on completing the fiscal 2006 spending bills and how the fiscal 2007 budget request shapes up. We're likely to hear about proposed cuts to some defense programs ? as with the Program Budget Decision 753 memo that created a stir last December ? which investors will study carefully. Despite the moving budgets, business opportunities seem likely to remain strong for federal IT companies over the next few quarters. Industry participants are not likely to be unduly surprised or discomfited by Washington politics that have caused budgets and awards to be only delayed and not cut. Investors are less patient.

Bill Loomis is a managing director at Stifel Nicolaus & Company Inc., which recently acquired Legg Mason's Capital Markets Group. 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: Stifel Nicolaus, 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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