Threats loom for government contractors

By nearly any measure, the government services market has been on a roll for the past decade.

The explosive growth was fueled first by the uptick in homeland security spending and the global war on terrorism after the 2001 terrorist attacks, and then by the rise in the outsourcing of government work to contractors.

The charts that accompany this feature tell the financial side of that story and how publicly traded companies – arguably the barometer for the industry as a whole – have posted strong results as they’ve taken advantage of growing markets.

There are three points you should take away from this feature. One, the government services industry has probably completed a run of success unmatched in its history. Second, today’s numbers remain strong but are returning to more traditional levels.

And, third, tough times lie ahead as the government attempts to deal with rising deficits.

First, the good news.

Growth rates among the publicly traded government IT services company have slowed, but not because of a poor economy or underlying weaknesses in the market, said Larry Davis, managing partner with the investment bank Aronson Capital Partners. Aronson did the analysis that is the basis of the charts featured in this story.

"Growth has reverted back to the normal growth in the federal sector after several years of outsized growth," he said.

From 2005 to 2008, annual growth rates among the public companies topped 20 percent, including organic growth and growth from acquisitions, according to Aronson’s data. The rate has returned to the 10 to 15 percent range for 2010 before dropping to just over 5 percent in 2011.

Another bright spot have been margins, which have held steady at over 8 percent over the last five years and have not eroded significantly in recent quarters.

“The common thinking is that margins will come down, but we haven’t seen that in the numbers yet,” Davis said.

The availability of credit and the ability to raise capital also remain strong for government contractors. In 2002, the publicly traded contractors raised over $1 billion. So far in 2010, the figure stands at over $4.5 billion, according to Aronson’s data.

“There has been a real flight to quality,” said Jean Stack, director of the aerospace, defense and government group at the investment bank Houlihan Lokey.

She expects to see more government contractors file for initial public offerings of stock, bringing even more capital into the government market. Booz Allen Hamilton filed in mid-June, but “others are lined up behind them,” she said.

The influx will help fuel another bright spot in the market: mergers and acquisitions.

More deals are getting done, but valuations have come down to the levels of four or five years ago and there are fewer blockbuster deals, Davis said.

Companies are not so much interested in acquiring bulk as they are in trying to acquire technical skills or customer sets. “There is a lot of portfolio shaping going on right now,” he said.

Most of the higher-priced deals are coming in the market segments that are seen as high government priorities: cybersecurity, intelligence, command and control, training, energy, and health care.

These are the markets where the government is expected to increase spending, so these areas likely will be protected from budget cuts.

But beyond those hot markets, tough times are ahead for government contractors.

“I have serious concerns about the viability of the government services market outside of those four or five areas,” said Bob Kipps of the investment bank KippsDeSanto.

Kipps can recite a litany of complaints he hears from companies: The government is moving slower. Procurement shops are broken. Insourcing is rising. There is more oversight.

“There is a lot of volatility in the market right now,” he said.

The big concern is the deficit and the actions that the government will have to take to get it under control.

“You’ve got pressure on the amount of dollars that these agencies can spend, so you’ll have less growth and more competition for fewer dollars,” Davis said. “The federal deficit has been looming for years, but it looks like policies are starting to develop to cut budgets so it is going to get tighter.”

Revenue growth and profit margins likely will be the first metrics where you’ll see the impact of tighter spending, he said.

According to Aronson’s analysis, growth rates among the publicly traded companies are expected to remain in the single digits for several years to come.

Although the economy may bounce back in a year or two, the “deficit is not a short-term issue. It is going to take years,” Kipps said.

For companies that want to weather these times, Kipps said the focus needs to be on factors such as being selective of the kind of business they pursue, staying in the upper end of the food chain, having strong customer relationships and a strong management team, and picking market areas that are sustainable.

Differentiating your company from its competitors is crucial. “That can be from a specialized tool you are providing your customer, or a proprietary technology or something else, because this is a hugely competitive market,” Stack said.

She also recommended picking customers carefully, not just those in the hot growth markets, but “customers that value your differentiation and ascribe to the concept of best value not just lowest cost."

Davis is careful not to focus on too much gloom in the market. “It’s been a healthy market for a long time and you’ll always see cycles,” he said.

Growth is moderating, but “you still have some fast currents underneath this broad ocean where you will see above-average growth,” he said. “And there are some areas where you won’t see eye-popping growth but are fairly well protected. IT systems will still need to be maintained.”