Market Watch: Procurement policy changes could sink industry profits

Jerry Grossman

The government services and defense industry is basking in the glow of positive investor sentiment. Growth in government spending, ongoing needs for technology infusion and refreshment, along with more rational, commercial-like procurement processes provide a sound basis for revenue growth and earnings visibility going forward.

Increased investor interest has resulted from the improved business environment during the past decade. So it is critical that policymakers understand the links between the health and prosperity of the industry and the cost-efficiency and effectiveness of federal procurement policies.

But proposed legislation, such as the TRAC Act and the Abercrombie amendment, which would limit outsourcing, promote neither cost efficiency nor effectiveness. Section 803 of the 2002 Defense Authorization Act contains provisions that could reduce the flexibility of buyers using General Services Administration schedules and multiple-award contracts. These provisions could add expense and time to the procurement process.

Another troublesome development is the emerging change in criteria and magnitude of small business and 8(a) set-asides. Historically, these programs benefited both the government and industry wherein the selection of those functions which could be effectively set aside, and the overall set-aside target in the range of 20 percent to 23 percent were consistent with government efficiency and contractor capabilities.

The stated intent of some government agencies to arbitrarily increase small and 8(a) business award targets to a level of 50 percent or more runs counter to getting the government's business done productively.

While this may be practical for some "commodity-type" service functions, it is not feasible in areas requiring extensive domain knowledge and experience, without loss of efficiency or increased cost.

Many companies that no longer qualify as small businesses for set-aside purposes are, nonetheless, small firms relative to most investor standards. Many of these have invested years developing the expertise and experience needed by the government to function well. Arbitrarily removing work from these long-standing, high-performance contractors to meet set-aside goals benefits no one.

Government decisions relative to these trends will be significant determinants of industry health and prosperity. The links between government effectiveness and industry health are:

  • Good industry performance attracts investors and supports higher valuations, improving access to capital;

  • Ready access to capital for growth and liquidity purposes provides a sound basis for developing strong businesses;

  • Stronger businesses attract the best people and the capital needed for investment in better service for the customer through higher commitment and creative ideas.

The performance of government services companies reflects meaningful improvement relative to the early 1990s, before procurement reforms. A comparison of industry performance in the 12-month period ending in March with the 1992-1995 period demonstrates the point. Profit margins of public companies have improved substantially: Earnings before interest and taxes and sales have increased from almost 5 percent to about 7 percent, while earnings before interest, taxes, depreciation and amortization returns have grown from just under 7 percent to above 9 percent. Coupling this 30 percent to 40 percent jump in profitability with better asset use has resulted in a doubling of the return on invested capital.

Some of the more positive aspects of industry and investor expectations could be compromised by wrong-headed changes to the federal procurement environment. As the saying goes, if it ain't broke, don't fix it.

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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