As wars wind down, will defense revenues follow?

Bill Loomis is a managing director at Stifel Nicolaus.

One question I am often asked by investors is which federal information technology and professional services firms have the most war-related exposure in the Middle East. With President Barack Obama keeping his campaign promise of withdrawing our troops from Iraq, though at a pace slower than his pre-election promise, and his desire to start withdrawing from Afghanistan next year, investors want to understand how much revenue companies have in the area.

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With some companies, the answer is clear. For example, DynCorp has more than 14,000 employees in the Middle East — and growing quickly — to assist the State Department in police training and counternarcotics operations, provide translators to the Army, and support logistics and base camps, among other services. The company can easily give a revenue amount for services in the area. For its fiscal 2010, DynCorp expects to generate about 61 percent of its revenues from Iraq and Afghanistan, and another 11 percent from work in other Middle East countries. ManTech International Corp. is another firm that breaks out its largest contracts in the Middle East. ManTech’s primary work in the area is supporting various types of mine-resistant ambush protected vehicles used to transport troops to protect them from roadside bombs. Those contracts accounted for 32 percent of ManTech’s total revenues in the latest fourth quarter.

However, the more difficult part is assessing how much work is being performed to support the war effort through work done in the United States. For example, the $19 billion Army Strategic Services Sourcing contract provides a broad range of services, from engineering to test and evaluation and even IT services, for a wide variety of Army customers. ManTech expects to generate about $450 million in revenues this year — 16 percent of its total revenue — from the Army S3 contract, which it acquired early this year through the acquisition of Sensor Technologies.

CACI International Inc. is also one of the holders of the S3 contract, and government records show it generated about $560 million in revenue in fiscal 2009, or 20 percent of its total revenues, from this contract. What is not clear is how much of the revenues from this contract would decline if we were to leave Iraq and Afghanistan.

Investors have been concerned about declining revenues from companies supporting the war efforts. However, both base defense spending and war supplemental spending have climbed rapidly since then. From fiscal 2001 to 2010, the supplemental spending has jumped from $19 billion to $163 billion, totaling $1.1 trillion for the period. Obama’s DOD budget request for fiscal 2011 is a base increase of 3.4 percent and $159 billion in war costs, resulting in total defense spending in fiscal 2011 that is up 2 percent. For fiscal 2009 supplemental funding, 14 percent was for military personnel, 24 percent was procurement spending (new and replacement systems and equipment that benefit the defense primes primarily), 60 percent was operations and maintenance, and 2 percent went to other areas. It is difficult to say how much of the operations and maintenance spending is for contractor support, but given the number of contractors in the Middle East, it is likely substantial. As of Dec. 31, 2009, DOD indicated that there were 239,451 DOD contractors in the Middle East, with 107,292 of those in Afghanistan and 100,035 in Iraq. That compares to about 185,000 total troops in Iraq and Afghanistan.

Supporting defense efforts overseas has clearly been a winning business strategy in the past decade. The question is will it continue to be during the next decade. Even in the face of continuing threats, defense spending is cyclical as other national priorities replace national security and complacency sets in like it did before the 2001 terrorist attacks. Although history shows this cycle many times and the resulting drop in defense spending, based on President Obama’s fiscal 2011 defense budget request, it will not happen for a couple more years at the earliest. Will this time be different, with defense spending continuing to rise with no downturn in the cycle? Some companies, such as ManTech, have been right and show strong earnings growth during the past few years to prove it.