When boring is best

Other areas may sound sexier, but Legg Mason Managing Director William Loomis says the hot action is taking place in the federal IT market.

4 min read
Information-technology spending cycles come and go--and will continue to come and go--but veterans of the industry whom I spoke with said they were generally taken by surprise by the last two cycles: Y2K and e-business.

Of course, some say in hindsight that they foresaw the Y2K boom-and-bust spending cycle. However, a check of their companies' income statements over the past few years will likely disclose a different story; very few--if any--technology firms remained immune from the negative impact of these cycles.

But guess which market has largely escaped the current slump in IT spending. Try the boring, often-loathed federal IT market. And now many of the same commercial IT companies that had not-so-nice things to say about the $44 billion federal market are scrambling to get federal contracts and form partnerships with established service companies and vendors.

Federal IT: Why the sudden interest?
Wall Street has taken notice, as federal IT companies such as CACI International and PEC Solutions have hit all-time stock-price highs recently.

While some interest will surely fade once commercial IT spending improves, the federal market enjoys many advantages--not the least being high visibility for growth in the government sector. Most government contracts tend to be multiyear. What's more, the government is less affected by short-term economic changes. Contrast that with the state of affairs in the commercial IT sector, where most companies can, at best, project only one quarter into the future.

In addition, profit margins are improving in the government sector, where procurement reforms in the past 10 years have resulted in faster procurement cycles and more emphasis on performance and quality rather than simply price.

Then there's outsourcing, which was already gaining momentum under the Clinton administration. The change in administrations should prove even more favorable for outsourcing contracts. During his tenure as governor of Texas, George Bush outsourced (or at least tried to) many functions previously handled internally. Meanwhile, several other officials in the new administration have looked positively at outsourcing as part of a philosophy embracing smaller government.

Defense spending has been under significant pressure since the mid-1980s, but a rethinking of defense spending priorities, including increased emphasis on using technology on the battlefield and in information warfare, may result in more IT spending by the Defense Department. The benefits will take some time to trickle down to federal IT contractors, but a change will likely be positive for the industry.

The federal government is also moving away from buying custom solutions in favor of more packaged commercial solutions. Over the past few years, "enterprise resource planning" systems makers such as SAP, PeopleSoft and Oracle have increased their focus on the federal government. Suppliers of customer-relationship management and supply-chain software, which have been slower to adapt to government markets (and vice versa), are starting to gain momentum. Meanwhile, other areas, such as information security and e-government, which usually account for smaller-sized contracts, also represent significant potential opportunities for commercial firms.

Lastly, the federal government's IT work force is shrinking. About one-third of the U.S. federal government work force will be eligible to retire within five years. How many of these federal employees will actually retire remains unknown, but significant numbers will surely depart and then move to the private sector. The departure of such a large number of the government's most experienced IT workers will likely lead to a higher reliance on contractors.

There are a couple of potential flies in the ointment.

Commercial companies could face disclosure rules regarding pricing and proprietary technology that they would not otherwise encounter in commercial competition. And despite recent progress, profit margins remain lower in the federal IT market than in the commercial market.

Then again, the risks are lower too.

All this is prologue to the conclusion that while the current IT spending slowdown in the commercial markets may be temporary, the renewed interest in the federal market will likely last for some time.

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