Federal contractors need the right stuff for success

Strategic development for federal contractors is more important than ever given the economic and market environments that have unfolded during the past year. Both thoughtful internal development and highly targeted mergers and acquisitions will be essential to achieve double digit top-line growth in the years ahead. Successful contractors will need to be better structured and managed to compete effectively.

Certain emerging factors will support an active transaction environment, including greater government attention to organizational conflicts of interest and portfolio repositioning for changing customer priorities. Availability of capital to support transactions will increase. At the same time, a significant slowdown in the growth rate of discretionary spending will reduce organic growth opportunities, particularly for unprepared contractors.

The future trajectory of discretionary federal spending has flattened, as reflected in budget projections recently released by the Office of Management and Budget. Compounded annual growth rates in federal discretionary spending, including national security and civilian agencies, are projected to drop by nearly 80 percent; that is, the CAGR for federal discretionary spending in the 2008 to 2016 period is less than 2.0 percent, compared to a rate of about 8 percent during 2000 to 2008.

Contractors also should consider the stated intention of the new administration to insource more and outsource less. Accordingly, the ability of contractors to achieve meaningful organic growth is now more directly dependent on their ability to squarely align their capabilities and depth with federal spending priorities than in previous times. Excluding preference programs, commodity businesses will generate less value and attract fewer interested buyers.

OMB projections include assumptions about future growth in gross domestic product, federal deficits and spending for mandatory programs. Along with estimates of total federal debt and the prospective interest rate environment, how these factors actually turn out will directly affect the pace of discretionary spending that the government can finance. Importantly, discretionary spending provides the energy to fuel contractor growth and prosperity.

The magnitude of projected federal budget deficits is huge, as are the total federal borrowing levels necessary to finance those deficits. Measured as a proportion of the U.S. GDP, the federal deficit will reach 12.3 percent in 2009 and average 6.5 percent during the five fiscal years ending in 2013. That proportion has averaged 3.6 percent during the past 10 years and 4.5 percent during the past 30 years. At the end of fiscal 2008, total federal debt stood at about $10 trillion, up from $5.5 trillion since 1998, an increase of 82 percent.

Looking forward 10 years, the federal debt is projected to reach $22 trillion in 2018, an increase of 120 percent. In fiscal 2009, discretionary outlays — excluding Troubled Asset Relief Program spending — approximate 38 percent of the budget. In 2018, discretionary outlays are forecasted to drop to about 30 percent of the total budget. Additional threats to discretionary spending exist. Slower GDP growth could reduce tax receipts. From 2004 to 2009, GDP grew 22 percent. The OMB forecast reflects 29 percent GDP growth during the next five years. Should the growth remain at recent levels, the government would lose about $250 billion in tax collections.

Federal borrowing rates equal to historic averages of around 4 percent would increase interest costs by more than $700 billion over five years. Expansion of federal health care spending through the addition of a public option, coupled with burgeoning bailout costs, would further challenge federal resources, raising taxation levels, federal borrowing, or both. Accordingly, the discretionary spending component of the budget, already declining as a proportion of the total, might be squeezed further by wrong estimates or additional government spending mandates.

Taken together, these factors suggest a much more competitive environment for the government technology services market, favoring companies with discriminating attributes, such as creativity, technology tools, strong management and domain-specific solutions.