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Tech Industry

Sparking interest in IT

Investors in information technology services are throwing long-held assumptions out the door, and selling off IT stocks in the process.

Investors in information technology services are throwing long-held assumptions out the door, and selling off IT stocks in the process. Yet in the selling frenzy, IT services stocks have become attractive buys at their current levels, with the sector expected to see greater demand after Year 2000.

Let's talk about this sell-off and whether it's warranted.

For many years, IT stocks were considered recession-proof. Many held the assumption that since corporate executives knew technology was changing fast, to defer or eliminate projects in an economic downturn would be a major strategic mistake.

Since September, however, there has been a real shift in investors' thinking about the IT group, in part due to the market's increased sensitivity to risk.

Also, two major uncertainties loom over the group--and we all know how the market handles uncertainties! These major uncertainties are the economy, and the impact of Y2K compliance spending.

Investors' concerns come despite an industry momentum that continues to be strong, with dozens of IT services companies reporting better-than-expected earnings, with only a few missing their numbers. Employee turnover--a big concern in any service-based industry--has also been stable in the third quarter. And profit margins continue to be stable or are expanding.

However, although I believe the industry will continue to show double-digit growth during a recession, it will undoubtedly slow from its breakneck pace over the last few years, if faced with an economic slowdown.

When CEOs see their core businesses slowing and profits (read: bonuses) drying up, they will order cost reductions, even in IT spending.

While this in itself may only have a dampening effect on the growth of the IT industry, the Y2K impact could make the slowdown in non-Y2K spending even more severe.

Corporations' Y2K spending estimates seem to be increasing month-to-month, and large Y2K service providers such as Keane are continuing to book new customers daily! As result, probably in mid-1999, we may see many overwhelmed companies put their non-Y2K projects on hold.

These potential deferrals, combined with an economic slowdown, may result in losses for some IT services companies for a quarter or two.

Shares in IT services companies have been hit hard since reaching a peak in early July. Year-to-date, the average IT services stock is down 38 percent from high levels, and valuations have returned to 1995-96 levels.

The group is currently trading at 28 times their 1998 earnings per share estimates, and 22 times their 1999 earnings per share estimates--almost half the valuation the group had claimed while trading near 52-week highs.

Although valuations are still far below their July levels, over the past month the group has rebounded by 15 percent in tandem with the broader market.

I continue to be bullish on the IT services sector and believe most stocks are attractive at current levels, although there are real uncertainties that the sector faces over the next two years.

So why am I so positive on the group?

The market usually does a good job of anticipating slowdowns--it tends to predict more recessions then actually occur!

In fact, during the recession of 1990-91, most of the IT services stocks had sold off prior to the actual recession, and during the downturn enjoyed strong stock price appreciation.

Of course, no one is really sure how the Y2K problem will impact the broader economy. But given the amount of time and money being spent on compliance and the high level of awareness, I think January 1, 2000 will be disappointing to many of the media and doom-and-gloom folks.

IT has become a more integral part of business strategy, with the Internet accelerating the merger. While there may be a temporary slowdown in IT spending, I believe demand for IT services will accelerate after the Year 2000. Lower stock prices, and reduced valuations make the industry very attractive for investors over the next several years.

We are quite positive on two stocks in particular, Keane and Complete Business Solutions*. Both of these companies do some Y2K services, though they have shifted their focus slightly, to now sell their Y2K customers non-Y2K projects, in particular, application maintenance or application outsourcing projects.

While both of these companies offer client/server and Internet application development services, it will be their strong application maintenance, outsourcing, and migration services that will benefit the companies in a slower-growth environment, as these services will stretch tighter IT budgets.

*Legg Mason co-managed Complete Business Solutions 's August 1997 follow-on offering and makes a market in the security.

William R. Loomis is a managing director covering the information technology services industry at Legg Mason's equity research department. He also is a chartered financial analyst, and is a member of both the Baltimore Security Analyst Society and the Association for Investment Management Research.