The Drive Down Commercial Lane
By Bill Loomis
We hear it less today than several years ago, but many federal IT companies still feel they must increase their commercial work to add value for shareholders.
While a well-run commercial IT company is expected to deliver higher risk-adjusted returns to shareholders compared with a well-run federal IT company, most federal companies fail in their commercial ventures.
In fact, other than Computer Sciences Corp., I have a hard time thinking of any federal IT companies that have grown commercial business to a significant amount of total revenue and have maintained profitability for many years. There have been some larger companies that have gone the other way, starting out in the commercial world and then entering the federal sector, such as American Management Systems and Affiliated Computer Services.
The differences between federal IT and commercial IT are not so much in the actual project side, but more on the sales, marketing and finance sides. Developing a Web site or managing a network for Kodak would involve the same technical people and project management expertise as doing it for the Internal Revenue Service.
Interestingly, the federal and commercial worlds seem to be coming together in terms of finance, with the federal sector moving away from cost-plus and toward time-and-materials contracts, and the commercial sector moving from fixed price to time and materials.
Adding services to the General Services Administration schedule and the move to indefinite delivery, indefinite quantity contracts have resulted in more time-and-materials contracts on the federal side. Many companies are seeing improved profit margins because of their ability to maintain more labor categories and re-price labor rates more frequently.
On the commercial side, the Internet has resulted in more companies shying away from fixed price. Companies are developing and adjusting their e-business strategies in real time.
On the project side, the federal sector is following many of the same trends as commercial, including moving toward packaged software solutions (such as enterprise resource planning) and away from large custom applications. The federal government is expanding aggressively its Web presence in terms of information dissemination, e-commerce and other processes.
As commercial and federal markets continue to converge, federal IT companies should determine if they have any competitive advantages that will allow them to excel in a particular commercial market. Many federal IT companies are not defining their target customer list tightly enough and not understanding or communicating to that customer base their competitive advantages over the legions of commercial IT companies in the marketplace.
Often, the shotgun approach is used in marketing and business development, with sales people hired in several cities to drum up general IT services business. The end result is often poor revenue generation, acceptance of low-margin business or under utilization of professionals.
Also, the emerging commercial units of many federal IT companies often take a disproportionate amount of senior management's attention and incremental resources of the firm, potentially resulting in missed opportunities in the core federal business.
Financially, the average public federal IT company we track has a return on invested capital of about 12 percent, greater than its average cost of capital of about 11 percent. This compares with a return on invested capital of about 16 percent-plus for commercial IT companies and an average cost of capital of about 14 percent.
While profit margins and growth rates in the federal IT market are about half those of the commercial market, well-run federal IT companies have generated returns on capital higher than their cost of capital, making them value-added enterprises in which investments should be considered.
Unless you can define a clear, focused strategy that will allow you significant advantages over existing commercial IT companies and that requires limited investment, you are probably better off focusing on improving your federal business.
Success is more likely if you acquire a small commercial company with a good management team that wants to stay and can leverage your company's strengths. Of course, this is easier said than done.
Bill Loomis is managing director of the Technology Research Group at Legg Mason Inc., Baltimore. He can be reached at firstname.lastname@example.org. This information should not be construed as advice designed to meet the investment needs of any investor.