We take a dive into the defense IT business of the three of the largest contractors in the market and explore their challenges and opportunities.
Second quarter earnings season proved to be a mixed bag for the technology services business segments housed within three of the market's largest government contractors.
As reported here Wednesday, General Dynamics lowered revenue expectations for its IT product and services segment to flat year-over-year after a 6.4 percent-decline over the first six months to $4.25 billion, which CEO Phebe Novakovic told investors was in part due to the change in administration and extended continuing resolution that slowed down contracting activity.
Raytheon gave Wall Street a more upbeat outlook for its services segment in its second quarter earnings call Thursday as it boosted full-year sales guidance from $5.9 billion-$6.1 billion to $6 billion-$6.2 billion. CEO Tom Kennedy cited the win of the Homeland Security Department’s “Domino” cyber services contract to investors Thursday as key in that guidance lift.
Northrop Grumman’s technology services segment saw sales fall 2.4 percent in this year’s first half but increased its operating margin from 10.6 percent to 11.2 percent for that six-month period. Outperforming internal expectations, Northrop is shifting the business largely away from enterprise IT and other similar commoditized, lower-margin work.
A look under the hood at General Dynamics’ information systems and technology segment shows a shifting dynamic between its two divisions: IT services, and military and space hardware.
First half sales were split even between both General Dynamics IS&T divisions, the company said in regulatory filings. IT services’ first half sales fell 5.8 percent to $2.11 billion and hardware showed a 6.9-percent decline to $2.14 billion.
The historical norm and more ideal sales ratio for General Dynamics is IS&T tilted in favor of hardware, according to Joey Cresta, public sector analyst at Technology Business Research Inc. Even with first half order delays in procurement uncertainties, Cresta told Washington Technology the product side of IS&T tends to be the segment’s “more lumpy” component and has a history of picking up later in the year.
For example, hardware represented 47 percent of IS&T sales in the 2016 first half, then ended the year at 52 percent for the full 12-month period, Cresta said. “It will be significant to watch if it picks back up suddenly and if that same trend happens,” he added.
General Dynamics’ IS&T mix is also a significantly more complex portfolio compared to its defense peers with both services and hardware involved. Raytheon largely stayed away from enterprise IT and Northrop is shifting its services business increasingly toward higher-margin services on military hardware and the cyber domain.
“Maintaining a favorable balance in the business mix across these two divisions is an important consideration for IS&T, and a complicating factor that (Raytheon) and (Northrop) do not have to factor in because of their more targeted approaches,” Cresta said.
Raytheon lifted its intelligence, information and services segment expectations on three key contract awards in the second quarter: Domino, a potential $375 million Air Force space software contract and a potential $575 million Army software sustainment task order.
The company also got an added boost from its Army Warfighter FOCUS training services contract due to be broken up in separate follow-on competitions next year. Raytheon captured $35 million in higher revenue year-over-year from FOCUS, which analysts expected to be a drag on the company.
FOCUS is an example of “military readiness priorities driving strong demand for training services in the U.S. and internationally,” Cresta said. “Recent work won under FOCUS will continue into 2018, providing a bit more revenue upside to IIS in the near term.”
And as Raytheon stayed away from commoditized IT, the company can stay on the higher end of work that requires a technology differentiation that includes much of its cyber portfolio.
For Raytheon, “it’s cyber and the utilization of concepts such as analytics and machine learning to support emerging mission priorities of defense and intelligence clients,” Cresta said.
In the case of Northrop, CEO Wes Bush has described to investors in several earnings calls the company’s strategy shift for its technology services segment. This “portfolio tuning” as he said in a January 2016 call has seen the contractor exit enterprise IT and state and local work and replace it with high-end engineering of technology componentry.
In Wednesday’s second quarter call, Northrop Chief Financial Officer Ken Bedingfield acknowledged the year-over-year sales decline to its “shorter cycle” services business in part on the CR extension but also touted the segment’s performance as “very well relative to its peer group.”
That fall on the top-line is in part by design, Cresta said, as letting some lower-margin contracts run off inevitably creates revenue headwinds.
“The business unit has become much more focused on smart captures where it can offer a superior technological solution. This inherently means a more expensive solution, which precludes it from participating in some lower-end or more commoditized areas of the market,” Cresta said.