What tax reform means for federal IT contractors

The much-anticipated tax reform is becoming a reality and government IT contractors are due for a huge cut. So what will they do with all that extra cash?

The much-anticipated tax reform package is moving through Congress with the Senate voting just after midnight Wednesday and the House planning to re-vote Wednesday morning before the bill heads to President Donald Trump for his signature.

Three mistakes were found in the bill after the initial House vote on Tuesday, triggering the need for the House to vote a second time after the Senate vote. 

Two fundemental components in the reconciled Tax Cuts and Jobs Act of 2017 are a significant reduction in the corporate tax rate from 35 percent to 21 percent, plus a change for the U.S. to a territorial tax system from a global model.

Both the rate cut and tax system model change figure to bode well for federal contractors and especially the large, publicly traded government IT and professional services firms.

As investment bank Drexel Hamilton noted in a Dec. 4 report for investors, nearly all pure-play government services companies north of $1 billion in annual revenue except for Engility Corp. pay among the highest effective tax rates at 37.5 percent.

That would make this group one of the largest beneficiaries of a rate cut and seemingly give them more cash to make investments amid wide anticipation for higher defense spending, which would give them a double-billing of good news.

“Most of these companies are thinking there’s going to be growth in the defense area after a five-to-six year down trend,” Drexel Hamilton’s government services analyst Brian Ruttenbur told me. “Growth is happening on the top line and additional cash is coming in to help invest.”

Some government services companies have already publicly welcomed the reduction and also given hints on what they might allocate the added windfall from a tax cut toward.

During the Nov. 30 Credit Suisse Industrials Conference, Leidos Chief Financial Officer Jim Reagan said what they “think about is an ability to put some of that into (research-and-development), market growth (and) business development initiatives.”

At that same event, Booz Allen CFO Lloyd Howell said he expects the firm to “channel a portion of that gain into our people, the development of them, sourcing and recruitment of them.”

“We’re likely to look for what are those future capabilities on the horizon we can accelerate or maybe be more aggressive with,” Howell said.

The defense industry’s leading trade group Aerospace Industries Association also has welcomed the cut. At the AIA’s annual year-end luncheon Thursday, its outgoing President and CEO David Melcher backed the tax reform package’s move to “transition to a territorial tax system” and facilitate the “repatriation of overseas revenues.”

Many of the prime defense hardware makers derive large portions of their revenue overseas through foreign military sales, which helps bring down their effective tax rates. Lockheed Martin for example had an effective tax rate of 23.2 percent last year, while General Dynamics reported 27.6 percent and Northrop Grumman stated 29.5 percent.

Many government IT and services contractors by comparison derive at least 90 percent of sales from U.S. federal agencies.

Corporate tax rate cuts could also inject more energy into an already hectic merger-and-acquisition environment in the contracting market said Greg Nossaman, managing director at investment bank The McLean Group.

Buyer demand is pretty strong in this market and valuations are being pushed up as result of that,” Nossaman said. “This is a legitimate means to support higher valuations on companies without the rationale of overpaying.”

Several government services companies have noted during recent earnings calls that they have observed inflation in the market for acquisition prices. Maximus CEO Richard Montoni said Nov. 9 they “have resisted paying what we view to be inflated prices.”

CACI International CEO Ken Asbury went a step further in their third quarter call Oct. 30 to say that “people believe they’re worth more than they are.” And Science Applications International Corp. CEO Tony Moraco said in their third quarter call Dec. 8 “some of the multiples are pretty high” in capability areas they want to grow in.

During the Credit Suisse event, Leidos’ Reagan did not discount the possibility of the company pursuing bolt-on acquisitions with higher cash flow. He said that could give the company “more latitude, more nimbleness to pursue growth initiatives that are inorganic.”

With all that said about what companies could do with increases in cash, there is also the fiduciary duties that all public companies have to act in the best interest of their shareholders.

This could translate into some primarily keeping to their model of returning excess cash generated by tax cuts to their shareholders through dividends and share repurchases.

Many defense companies opted for share repurchases instead of investments in research-and-development or acquisitions during the post-2010 defense spending downturn “because there wasn’t an alternative,” as outgoing L3 Technologies CEO Michael Strianese put it to Defense News in a recent interview.

SAIC signaled shareholder return would be its approach during a third quarter call Dec. 7.

“We’re very comfortable with our capital deployment structure, and we have a target of cash we need; excess cash, we’ll always return to our shareholders,” CFO Charles Mathis said.

Joey Cresta, public sector IT market analyst at Technology Business Research, told me via email he expects that cash deployment approach to be the general point-of-view.

“It (the tax cut) certainly will provide more flexibility to invest in the business,” Cresta said. “But based on comments made during recent earnings calls it seems to not be a huge game changer from an investment perspective.”

The comments from Booz Allen’s Howell to the Credit Suisse audience further highlight the choices government services companies will have at their disposal with a 14-percent corporate tax rate cut.

“With such a windfall from a tax reduction, we will ask ourselves ‘Hey are there other strategic uses of this money than automatically dropping it to the bottom line?’” Howell said.

“It’s also fair to say ‘of course that is going to drop to the bottom line,’ but we reserve the right to see what else we need to be investing in,” he said.