Time is now for a 'Last Supper' for government services

In 1993, former Defense Sec. Les Aspin and senior Department of Defense officials met for dinner with more than a dozen CEO’s of the major defense companies in what is now labeled “The Last Supper.”

Aspin’s message, according to those present, was clear – the defense industrial base was facing federal spending reductions and there would not be enough money for everyone. Thus, began a series of mergers and acquisitions that largely yielded the platform defense industry we have today.

More recently, driven by tight federal budgets and drawdowns in the Iraq and Afghanistan Wars, the government services industry has experienced strategic mergers and acquisitions over the last five years as business leaders seek to expand capabilities, add scale and broaden their customer base.

But compared to the blockbuster deals that have characterized M&A activity in the defense industrial base, transactions in the government services sector have been small.

Today’s government services industry has an annual market of more than $250 billion and some 135,000 companies competing for federal contracts. No company has more than 4 percent of the government services market or possesses a competitive advantage market share. To put this into perspective, the auto and smart phone industries each represent similar sized $250 billion annual markets.

The auto industry has only 30 global competitors with the top 10 capturing more than 95 percent of the market, according to Edmunds. Moreover, according to comScore, there are also about 30 manufacturers of smartphones and the top 5 accounts for more than 90 percent of sales.

Fragmented industries typically have the following characteristics: low barrier of entry; absence of economy of scale; lack of innovation and the ability to differentiate; and, fierce competition that minimizes profitability. As a result, competitors in this kind of market are faced with excessive infrastructure, low and continually suppressed margins, lack of competitive advantage with customers and suppliers and ultimately, a high failure rate.

By this definition, the government services industry is fragmented and ultimately at risk for maintaining business viability. There continues to be too many companies chasing too few new opportunities.

Just as the U.S. government told the defense industrial base in 1993 that it did not have the budget or capacity to keep everyone in business, it may be time for the government to take a sharp look at today’s government services industry.

For the short term, government agencies are rightfully taking advantage of the low prices that are available, however, it is on the longer term that we should focus our attention.

While there is currently a strong willingness from financial institutions and private equity firms to invest both debt and equity in this market (an indication that this market is considered healthy for now) this support can dry up quickly.

Over the last 18 months the Federal Reserve has increased interest rates three times by a quarter of a percent. Further increases are anticipated over the next 12 to 24 months as our economy improves.

Rising interest rates combined with flat and even shrinking margins created by overheated competition for limited dollars will cause this willingness to invest to subside. Yet, this institutional involvement is critical for the long-term health of the industry given these investments provide the financial fuel for the consolidation that must occur.

With consolidation, margins will increase as excess infrastructure is reduced and synergies turn into profit. While some of these savings will be priced in over the longer term (benefitting the government), the reduction of infrastructure cost, the added scale and the lessening of unhealthy competition will allow “normal” pricing and ensure an ongoing healthy industry – which the government must have.

A viable industry benefits all of us and by healthy competition our government customers will get better innovation and even more creative solutions. This is a win-win for all our gederal agencies and the men and women in the contracting services industry that are proud to serve and support them.

The time for the government services “Last Supper” is now!

About the Author

Tony Smeraglinolo is a veteran GovCon executive and most recently was the CEO of Engility Corp.

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