Exelis boosts services business, lowering margins but maintaining sales

April 8, 2012

Preparing for government spending cuts, contractors have been trying to maneuver into growth areas and programs with appropriated funding to preserve their revenue.

In some cases, contractors even are shifting their mix of work between products and services to maintain sales. McLean-based ITT Exelis, for instance, over the past year has seen its mix shift from the majority of its revenue coming from products to a nearly 50-50 split between products and services.

For contractors looking for solid programs, it’s not always clear which area is best. In 2009, as the first round of Pentagon spending cuts began, products looked like the riskier business. The Defense Department focused on cutting some key programs, including big chunks of an Army effort to modernize its weaponry.

But more recently, the services business has come to look more vulnerable. The Defense Department has made a point of moving some previously contracted work in-house, while the Office of Management and Budget has called for trimming contracts involving management support services.

“There has been a reality that set in on services,” said Byron Callan, a director at Washington-based investment research firm Capital Alpha Partners, noting that some of the worst-performing stocks recently have been those of services companies, such as Reston-based NCI.

Over the past year, NCI, which provides information technology-related services, has seen its stock fall from over $24 a share to under $7. While other government services firms, including McLean-based Booz Allen Hamilton and Arlington-based CACI International, have seen stumbles in their stock prices, they have not suffered the same kinds of losses.

Generally speaking, services work has lower margins but also requires a lower level of investment, Callan said. Companies don’t have to build factories or buy parts but simply hire employees and give them administrative and IT support.

Contractors have taken different approaches. New York-based defense contractor L-3 Communications, on the one hand, is spinning off its locally-based government services business into a new public company because it said services work had become a lower-margin, price-focused business, while Herndon-based GTSI, known as a reseller, has focused on building up its professional services work to improve the company’s profit.

In the case of Exelis, a growth in services business helped offset some of the decline in product sales, Callan said.

In 2010, the company’s revenue was 60 percent products and 40 percent services, but in 2011, the mix was about 50-50. While revenue stayed stable from 2010 to 2011 — dropping slightly from $5.89 billion to $5.84 billion — the company’s profit declined from $587 million in 2010 to $326 million in 2011, though the company attributed about $50 million of the decline to the cost of spinning off the business from its then-parent company. Additionally, Exelis said it received a $139 million boost in income in 2010 from selling off a unit.

“In this unpredictable budget environment, it makes sense to have a diverse mix of businesses; however, that’s not the way Wall Street will see it,” said Loren Thompson, a defense industry consultant. “What Wall Street will care about is what the margins look like and how durable those margins are likely to be. From that perspective, it’s still better to be in products than in services.”

Exelis officials — who declined to speak for this article — are touting the company’s shift. Well known for building products like radios and night vision goggles, Exelis recently won several big services contracts, including several to support operations in Kuwait and in Afghanistan.

At the same time, some of its traditionally large products programs, including a radio program, jammers meant to stop explosives and night vision goggles, are winding down, said David F. Melcher, chief executive and president of Exelis, in a conference call with investors last month.

“While these service contracts dampened the overall operating margins in 2011, they are lower risk and provide high returns on invested capital,” said Peter J. Milligan, chief financial officer at Exelis, on the same call. “We expect our product to services sales mix to roughly stabilize in 2012.”

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