4 questions raised by General Dynamics' deal for CSRA

Why go where defense primes have left before?

The struggles in recent years of large defense contractors in federal IT are well-documented.

Lockheed Martin had the most notable exit in mid-2016 amid margin pressures due to customers focused on lowest-price contracting. But that was preceded earlier that year by L3 Technologies’ divestiture of its IT business, then last year Harris Corp. joined that group when it sold its IT business, now known as Peraton.

General Dynamics’ IT services and mission systems product segment -- formally called information systems and technology -- showed no top-line growth last year and showed year-over-year declines in the first three quarters before a bounce-back in the fourth quarter.

As I wrote earlier this month, legacy defense primes like General Dynamics have taken different approaches to the IT market and sought to recast those businesses amid disruption by new entrants including those from the commercial arena.

But with the Monday news of its deal to acquire CSRA, General Dynamics is breaking ranks with its defense peers and is doubling down on its IT business. CSRA brings to General Dynamics more intelligence community work on the customer front, plus new and emerging technology services on the offering front, for example.

“While GDIT has taken steps to integrate analytics, automation and cloud-based delivery tools into legacy services such as contact center operations, acquiring CSRA will accelerate these efforts,” Technology Business Research public sector IT analysts Joey Cresta and Sebastian Lagana wrote in a note to clients Monday.

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“General Dynamics will benefit from gaining access to CSRA programs such as MilCloud 2.0 and the National Security Agency’s Greenway contracts, which are areas where CSRA has the opportunity to build the platforms that will enable the government’s transition toward managed services,” they added.

Post-close, General Dynamics will separate the combined GDIT services-CSRA business into its own reportable segment. The mission systems hardware business will also be its own segment.

Will this spur even more market consolidation?

As General Dynamics executives put it Monday, the government IT and professional services market is still largely fragmented with many players and not dominated by any one company even as it seems the big are getting bigger.

It was only a few years ago that no government services company seemed to want to exceed $5 billion-$6 billion in revenue, then Leidos of course changed the equation in its bulk up to $10 billion through the Lockheed IT merger.

Now with General Dynamics IT catching up to near $10 billion, it leads to the inevitable and natural speculation over whether others will follow. The bankers I spoke to did not discount the possibility of more large deals and more bulking up.

As Raymond James’ government services practice lead John Hagan told me yesterday, services companies look at scale as a way to not only diversify but spread costs around their revenue base.

“Scale and diversification are valuable in today’s market,” said Kevin DeSanto, managing director of Tysons, Virginia-based investment bank Kipps DeSanto. “I would not be surprised to see large deals continue to occur.”

Credit ratings agency Moody’s Investor Service largely concurs with the notion of scale as a help, according to a Monday note. Analysts there see “expanded scale and scope of services” as helping General Dynamics “more effectively compete across U.S. government departments, both military and civilian, as these organizations sustain and modernize their IT infrastructures in upcoming years.”

How does one now handicap the $3.5 billion Navy NGEN IT services recompete?

One of this year’s defining government IT contracting opportunities is shaping up as a three-way showdown between teams led by incumbent DXC Technologies, and challengers CSRA and Leidos.

The combination of General Dynamics IT with CSRA presents “a compelling contender” for NGEN, Cresta and Lagana wrote in their note.

DXC’s team so far includes AT&T, while Leidos has brought IBM, Unisys and Verizon into the fold. Prior to the GDIT-CSRA deal, a spokesperson for CSRA told us they will announce their team as the NGEN acquisition moves further along.

“(General Dynamics) has significant expertise providing enterprise support to maritime and shore operations worldwide, with globally dispersed resources and a differentiated relationship with the Navy,” Cresta subsequently told me.

“Consider General Dynamics’ broader business model and level of engagement with the Navy. Its shipbuilding business and capabilities in tactical mission systems give it unrivaled depth within the Navy market.”

How does General Dynamics make it all work?

CEO Phebe Novakovic has been frank and honest in investor presentations during her tenure about what she saw as wrong acquisitions for General Dynamics’ IS&T business and even halted them entirely when she became chief executive in 2013. The company also entered a $2 billion write-down on the business for 2012 that resulted in a loss of $322 million for the year.

“Our M&A process was broken in that we bought some businesses that were somewhat problematic. We’re past that,” Novakovic told investors Monday. That three-year spree prior to her start as CEO she referenced cost the company $2.6 billion, including the $920 million deal in 2011 for health care IT outfit Vangent.

“Let’s remember… particularly on the IS&T side… the modern GD was built on a series of successful integrations of big- and medium-size companies. We’re good at that. This team knows how to do that,” she said.

CSRA is different this time around in that its portfolio match is “fundamentally enterprise IT services… right in (General Dynamics IT’s) wheelhouse,” Cresta told me. “Moves like Vangent aimed a bit too high and were outside GD’s comfort zone.

“GD has been far more cautious” with Novakovic at the helm, which Cresta told me is “one of the reasons this deal is such as a surprise. But it also tells me that leadership is extremely comfortable with the company’s ability to make this acquisition a success.”

There is “significant risk” in the deal given how cultural integration of both sides could play out, Cresta and Lagana wrote. There is General Dynamics’ business profile of enterprise IT programs and contact support services with CSRA’s next-generation IT focus and willingness to engage in self-disruption, they wrote.

Also consider General Dynamics’ image as a legacy defense contractor with that of CSRA’s push to advance modern IT in government through partnerships with commercial vendors like Amazon Web Services, Microsoft and more recently Google.

“It is possible that CSRA’s fresh perspectives will breathe new life into General Dynamics’ IT business,” Cresta and Lagana wrote. “This outcome will need to be heavily promoted to prevent legacy mindsets from suppressing the new perspectives that could potentially be brought to the table.”