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Is this the bottom for IT spending?

Legg Mason managing director Bill Loomis looks into his crystal ball for an answer to the $64,000 question on the minds of many tech investors.

The stock market, particularly technology stocks, has had quite a rally since the market plunged after the Sept. 11 terrorist attacks. Does this mean the storm is behind us and IT spending is ready to resume its strong growth?

Many stocks may already have seen their lows, but IT spending will likely be weaker in the fourth quarter of this year and will not begin to show growth until mid-2002. Analyzing IT services companies can help gauge spending trends, since these companies support the development and integration of information systems, using a wide range of hardware and software products.

There are two conflicting answers.

The midsized and smaller IT services companies have had a particularly tough time. Midsized companies such as American Management Systems, Keane and KPMG Consulting have seen revenue decline by more than 10 percent in the third quarter of the year and expect even steeper declines in the fourth quarter. Many smaller companies, such as Sapient, with revenue falling 49 percent, have fared even worse.

Some of the midtier and smaller IT services companies also are losing market share to bigger competitors. Large IT services companies, such as IBM Global Services, Electronic Data Systems and Accenture, experienced double-digit growth last quarter, driven largely by strength in Europe. What's more, each is on track for a positive fourth quarter as clients seem to be favoring the larger IT services companies in this uncertain time.

Which industries are still faring well? The list includes health care and the federal government, neither of which has been significantly affected by the slowing economy. Despite pockets of strength, financial services, telecommunications and manufacturing remain weaker. Demand for systems integration and consulting services in the commercial IT services markets continues to be soft (including enterprise resource planning, customer relationship management and supply-chain implementations) and will likely be weaker next quarter.

However, outsourcing contracts are in strong demand because clients are attempting to cut costs. The strength in outsourcing applies to a wide range of industries and types of work, including data center outsourcing, business process outsourcing and application outsourcing. Even payroll and transaction processors such as ADP and credit card processors such as First Data are doing well despite the larger economic concerns.

Although long-term contracts give companies some cushion in a slowing economy, they also will result in slower earnings acceleration when the economy and IT spending pick up. That's important to factor into any stock-picking scenarios because investors like earnings acceleration.

Confusing IT outlook
Given the soft economic indicators, poor consumer confidence and weak earnings outlook for most companies, many market strategists and investors are confused by this rally.

Just looking at the IT services stocks, the issues are the same. Many of the companies have reported poor third-quarter results and expect even lower results for the fourth quarter. But consider the aforementioned performances of KPMG Consulting and American Management Systems: Both stocks are up over 50 percent from their post-Sept. 11 lows.

At this point it appears the stocks bottomed soon after the Sept. 11 terrorist attacks, when the days appeared darkest, confidence was at its nadir, and pessimistic investors discounted the likely weak results for the second half of this year, and possibly for the first quarter of 2002.

The first quarter of the new year will be particularly telling for the IT industry, since it is the start of a new budget year. It should be seasonally stronger than the fourth quarter due to fewer holidays. However, fundamentals continue to be weak, and this could result in another round of layoffs in the sector at year-end as companies attempt to bring their cost structures in line with declining revenue.

Business expansion will have to lead to a meaningful turn in IT spending. Currently, there is no powerful catalyst to cause corporations to spend on IT; there is no big technology cycle, regulatory requirement or other event such as Y2K. Based on most integrators' business plans, I do not expect a meaningful turn in IT spending until next summer. Now we just need IT spending to catch up to stock prices.

EDS is a Legg Mason Select List core holding. Legg Mason Wood Walker, Inc., makes a market in the shares of American Management Systems, KPMG Consulting and Sapient. The information contained herein has been prepared from sources believed reliable but is not guaranteed by Legg Mason and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. 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. From time to time, Legg Mason Wood Walker, Inc., and/or its employees involved in the preparation or the issuance of the communication may have positions in the securities or options of the recommended issuer. Additional information available upon request. Copyright 2001 Legg Mason Wood Walker, Inc.