Market watch | Budget forecast calls for scattered funding

Results in the federal IT industry have been dampened by the late passage of the fiscal 2006 defense bill, and more recently have taken a hit from the delay in the defense supplemental spending bill.

First quarter 2006 financial results for federal IT companies generally were modestly below my expectations, with organic revenue growth, which excludes the impact of recent acquisitions, and in line with my estimate: up 7 percent over the prior year, while earnings per share growth of 10 percent was below my 12 percent estimate.Results in the federal IT industry have been dampened by the late passage of the fiscal 2006 defense bill, and more recently have taken a hit from the delay in the defense supplemental spending bill.With the Army specifically citing the delay in the supplemental spending bill as its reason for cutting certain operations and maintenance spending, look for a negative impact on contract funding and growth to increase as long as the supplemental spending bill is delayed.The generally slowing growth in the federal IT service companies, coupled with a weaker overall stock market, has resulted in a pullback in federal stocks over recent months. Year-to-date, the federal IT service stocks that I track are up 5 percent, better than the Standard and Poor 500's 3 percent gain, though lagging the commercial IT service stocks, which are up 9 percent this year.The valuation on federal stocks continues to be higher than that of the commercial IT service companies we follow. Federal IT service stocks are trading at an average of 17.6 times our 2007 EPS estimate, vs. commercial IT service companies at 14.1 times our estimates and the S&P 500 trading at 14.7 times the consensus 2007 EPS estimate.A month or two after the fiscal 2006 supplemental spending bill is passed, I expect to see evidence of accelerating growth, likely making for good results in the third and fourth quarters from most federal IT service companies.Following passage of the fiscal 2006 supplemental spending bill, investors next will focus on the progress of the fiscal 2007 spending bills. With the congressional elections coming this year, we likely will see either nearly on-time passage of spending bills, or longer-than-usual delays, as was the case with many of the civilian spending bills during elections two years ago.As the year progresses, we likely will get more insight into fiscal 2008 budgets, particularly for defense. With many in Congress appearing to tire over continued large supplemental spending bills, it will be interesting to see how the fiscal 2008 defense budget shapes up, possibly taking some of the budget requirements that have previously been pushed through supplemental spending bills.Federal IT service stocks continue to be moved by takeover speculation. Arlington, Va.-based CACI International Inc.'s stock went up 10 percent in a day last month amidst press reports of a possible takeover of the company by BAE Systems plc, only to sink again after CACI dispelled the rumors. We have seen one or two public companies acquired in the space over the last few years. The current tougher budget environment, good results from IT service companies and the need to satisfy public shareholders' need for EPS growth likely will mean that the trend will continue.Despite budget uncertainties, most federal IT services companies still are posting good consistent earnings and cash flow growth relative to the overall market, supporting their above-market-average valuation.

Bill Loomis

Bill Loomis is a managing director at Stifel Nicolaus, which acquired Legg Mason's Capital Markets Group in December of 2005. 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., Baltimore, MD 21202, Attn: Research Department.