Are performance drivers shifting in the GovCon market?

After several years of cash-focused strategies emphasizing overhead efficiencies, increasing margins, and returning cash to shareholders, investors are once again demonstrating serious interest in the growth strategies of companies that do business with the U.S. government.

Their renewed interest is spurred by the projected growth in spending by many large agencies, such as the Department of Defense, which has seen its budget grow to $716 billion in fiscal 2019. This increased investor attention has executives searching for ways to improve their firm’s overall performance characteristics.

To do so, these firms face significant strategic choices: Should they focus on improving the scale of their government business? Should they concentrate in their core market areas or diversify to new customers?

A recent study in the Journal of Marketing, Uncle Sam Rising, provides important insights for managers as they decide on strategic activities to improve their outlook to Wall Street.

The research study investigated the stock returns of over 1,300 public companies between 2000 and 2016 that did business with the government and measured the impact of revenue received from the federal government on firm value (magnitude of return) and firm risk (variability of return). The results of this work are informative for executives doing government business in terms of a) should you strive to scale and b) how do you manage your customer portfolios. In terms of drivers of firm value, investors appear to offer greater financial incentives to “purist” companies whose government work is 30% or greater of their book of business when compared to “tourist” firms that have lower levels of government business, illustrating the value of scale. The benefits of scale are enhanced when the firm focuses on a small set of important customer groups. Investors value concentrated customer portfolios over customer diversification, at least in terms of firm value.

However, there is a dark side of striving for scale for government contractors, often referred to as GovCon companies. The study found that firm risk (projected variability of firm cash flows) increases the more they focus on government customers.

In other words, investors become worried when companies become too dependent on the government as its major source of revenue. Managers can mitigate this concern with two types of customer management strategies: building a diversified portfolio of government customers and building deep relationships with its key government customer accounts.

While the findings of this study are not specific to mergers and acquisitions, the recent frenzy of M&A activity by government contractors might offer evidence that executives agree with the studies core findings.

From Northrop Grumman’s purchase of Orbital ATK to SAIC’s plan to acquire Engility to L-3’s announced merger with Harris, companies are clearly looking to M&A to help them grow their businesses and generate additional value. Generalizing the core findings of the study’s findings further, firms apparently need to consider how a target firm’s portfolio of government agencies matches with that of the acquirer in addition to any scale benefits. When SAIC CEO Tony Moraco announced the acquisition of Engility, for example, he noted the “highly complementary portfolios, combined with our similar cultures, operating models and histories,” as a central part of his rationale for the transaction.

Another trend that appears in line with these findings is that platform-focused purists are focusing on transactions that enhance their depth in the GovCon market. Moves by Lockheed Martin, Northrop Grumman, and L-3, for example, have varied in size and scope but all have focused on growing their core defense portfolios.

Additional analysis is needed to fully explore the impact of these and other transactions on long-term company value. Nonetheless, these trends appear to align with the principal conclusions of the focal academic study that it is critical to be a purist rather than a tourist in the GovCon market and that the combination of scale and, in particular, customer depth and breadth are important determining factors of financial performance, both in terms of firm value and firm risk, in the GovCon space.

About the Authors

Dr. Jerry McGinn is the Executive Director of the Center for Government Contracting in the School of Business at George Mason University (GMU). In this role, he has established and is leading the first-of-its-kind university center for research, education and training, and collaboration on issues facing the $500B+ government contracting industry. He has an active Top Secret clearance and has recently been nominated for restoring his access to Sensitive Compartmentalized Information.

Jerry is also a trusted strategic advisor sought after for his expertise in U.S. industrial policy, supply chain, industrial security, export control, foreign military sales, and industrial base policies and he currently serves on the Economic Security Subcommittee of the Homeland Security Advisory Council. Prior to joining GMU, Jerry served as the senior career official in the Office of Manufacturing and Industrial Base Policy in the Department of Defense, leading efforts to analyze the capabilities and overall health of the defense industrial base, including the Presidentially-directed 2017-2018 interagency review of the manufacturing and defense industrial base. He also directed hundreds of reviews of high-profile mergers and acquisitions as well as transactions before the Committee on Foreign Investment in the United States.

Previous to DoD, Dr. McGinn spent a decade in senior defense industry roles at McGinn Defense Consulting LLC, Deloitte Consulting LLP, QinetiQ North America, and Northrop Grumman. Before industry, Dr. McGinn served in DoD as Special Assistant to the Principal Deputy Undersecretary (Policy) and as a political scientist at RAND.

Dr. McGinn is also a widely acclaimed thought leader, author, and sought-after speaker. He has published numerous influential RAND monographs and articles in The Hill, Business Insider, Defense News, Washington Technology, War on the Rocks, and Joint Force Quarterly. He has also testified before the U.S. Congress and the UK House of Commons and he is regularly interviewed and cited in outlets such as USA Today, The Financial Times, The Los Angeles Times, Politico, Government Matters, Federal News Network, and Time. He has led advisory studies for and held leadership roles in the NATO Industrial Advisory Group, the Defense Science Board, the Aerospace Industries Association, and the Professional Services Council.

Dr. McGinn was commissioned into the U.S. Army and served with distinction as an infantry officer and is a graduate of Ranger and Airborne Schools. He has received numerous civilian and military awards and has earned a Ph.D., M.S., and M.A. from Georgetown University as well as a B.S. from the United States Military Academy.

Brett Josephson is assistant professor of marketing in the George Mason University School of Business and was the lead author for the Uncle Same Rising study.

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