IT services sector shows lackluster performance

Investor interest expected to increase in 2010

After two years of outperforming the broader stock market, federal information technology and professional services company stocks have underperformed in 2009 as investors sought more economically sensitive companies to benefit from an improving economy. The increasingly adverse business environment for government contractors during this Congress and under the Obama administration has also had a negative effect on investor interest in the space.

At this time, the federal IT services stocks are up 3 percent, lagging behind the S&P 500’s 23 percent gain, Nasdaq’s 40 percent gain, and even the aerospace and defense firms’ 7 percent gain. The stocks of the commercial IT services firms have fared much better, going up 58 percent this year. I expect investor interest in the group to improve in 2010 as we see an increase in mergers and acquisitions in the space, experience an improvement in contract award activity and receive some clarity on the fiscal 2011 budget.

Budget growth has not been the issue this year, and the fiscal 2009 and fiscal 2010 budgets show strong total discretionary, defense and IT funding growth. However, award activity has been sluggish and extensions frequent in 2009 as government managers figured out how to implement new requirements from the administration and improve the procurement process to reduce protests — for example, by using peer reviews. The early news about the fiscal 2011 defense budget suggests the president will ask Congress for a 3 percent to 4 percent increase in defense spending, far from the cut I would have expected a year ago.

Despite a lackluster stock performance from federal IT and professional services firms, most of the public companies reported third-quarter results in line with or ahead of expectations. Although contract awards were much higher than expected for a few of the public companies, such as ICF International Inc. and NCI Information Systems Inc., overall cumulative contract awards among the public companies in the past year were flat as procurement delays pushed award decisions into later quarters, dampening the surge that typically happens at the end of the government’s fiscal year. Bid pipelines and outstanding bids continued to show solid growth at most companies, partially due to award delays.

Among the public federal IT and professional services firms, DynCorp International LLC had the strongest earnings-per-share (EPS) growth. It was up 61 percent on 5 percent organic revenue growth as it continued to ramp up recent contract wins to support U.S. efforts in the Middle East. DynCorp maintained its fiscal 2010 outlook for EPS growth of 20 percent to 30 percent and revenue growth of 6 percent to 13 percent.

Dynamics Research Corp. had 34 percent EPS growth and 2 percent organic revenue growth, and raised its 2009 EPS guidance to 23 percent to 26 percent growth. Stanley Inc. had 33 percent EPS growth on continued strong improvements to its profit margin and organic revenue growth of 11 percent. The company raised its fiscal 2010 EPS guidance to 18 percent to 20 percent, reflecting better-than-expected margins.

NCI continued strong with 28 percent EPS growth and 26 percent organic revenue growth, and it raised its EPS guidance for this year to 22 percent to 24 percent growth. Rebounding from a tough year, SRA International Inc. had 24 percent EPS growth on 5 percent organic revenue growth, both of which were above expectations as federal business strength offset losses in its commercial businesses. SRA maintained its fiscal 2010 guidance at 14 percent to 24 percent EPS growth.

ManTech International Corp. had EPS growth of 21 percent on 4 percent organic revenue growth, driven by its Mine Resistant Ambush Protected support contracts in Iraq and Afghanistan. But the rest of its business was flat to slightly down. ManTech boosted its 2009 EPS guidance to 21 percent to 22 percent growth. CACI International Inc. reported 13 percent EPS growth on 12 percent organic revenue growth and gave fiscal 2010 EPS guidance of 10 percent to 17 percent growth. ICF had 28 percent lower EPS because its large Road Home program contract with Louisiana ended in the second quarter. Excluding that contract, ICF showed 14 percent organic revenue growth.

Among the largest firms, Science Applications International Corp. had 17 percent EPS growth, with higher-than-expected profit margins more than offsetting a lower-than-expected organic revenue growth of 1 percent. SAIC maintained its fiscal 2010 revenue and EPS guidance. However, due to slower award activity and slower federal budget growth, fiscal 2011 guidance is at the low end of its normal target ranges, with 6 percent to 9 percent organic revenue growth and 11 percent to 18 percent EPS growth.

Lockheed Martin Corp.’s Information Systems and Global Services’ third-quarter 2009 revenue growth of 0.9 percent was down from 5.6 percent in the second quarter and 10.3 percent in the first quarter. IS&GS’ operating margin of 8.2 percent was unchanged sequentially but down from 9.1 percent a year ago. Northrop Grumman’s Information Systems group had 4.3 percent revenue growth in the third quarter, up from 2.9 percent in the previous quarter. The company also has an 8.2 percent operating margin, up from 6.5 percent in the year-ago period due to less drag from troubled state and local government programs. General Dynamics’ Information Systems & Technology unit’s third-quarter revenues were up 8.8 percent year-over-year, with 6 percent organic growth, while its operating margin was 10.8 percent, up slightly from 10.7 percent in the year-ago period and the previous quarter.

Despite a tough business environment and slowing budget growth, most of the public firms are still showing healthy double-digit earnings growth and are projecting the same for next year.

About the Author

Bill Loomis is a managing director at Stifel Nicolaus.

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