Firms Brace for Softened Market

By Griff Witte and Kim Hart
Washington Post Staff Writers
Monday, September 11, 2006

Government contractors, which have been riding a wave of unprecedented growth since the Sept. 11 attacks, are starting to feel the effects of an industry-wide slowdown as the government tightens its technology spending, according to company officials and industry observers.

The effects have so far been mild. Companies that in the past five years had experienced booming demand and grown accustomed to record profits nearly every quarter and double-digit annual growth are having to settle this year for numbers that are closer to still-robust historical averages. Stock prices have come off their peaks but remain above where they were a year or two ago. Few, if any, companies are considering significant layoffs.

But the slowdown reflects a significant shift in an industry that since 2001 has led an expansion of the Washington area economy, as companies swooped in to fill the government's appetite for technology that could help ward off another attack. Many firms boosted their bottom lines in the process and added thousands of jobs. They are now having to rein in their ambitions and look beyond the federal government as information technology budgets flatten.

The federal government is budgeted to spend $63.5 billion on information technology this year, which is only a little over a billion more than was spent in 2005, according to the Office of Management and Budget. The administration has requested $63.8 billion for 2007, compared with a request for $40 billion back in 2001.

"I don't think anyone's in a panic zone yet. People realize that homeland security and defense will get attention when they need it," said James M. Krouse, director of market analysis for Input, a market research firm that specializes in government technology spending. "But there's a recalibration of expectations for the next few years."

There is disagreement over just how long the slowdown will last, but the underlying reason does not seem to be going away: Spending to fight the wars in Iraq and Afghanistan is eating up such a large portion of the budget that the government has had to postpone or cut back many planned technology upgrades.

Civil programs have been especially hard hit, but military and homeland security technology modernizations have also been shelved.

"A lot of the budgetary dollars focused on the digitization of the battlefield have been reprogrammed into Iraq," said Rick Knop, managing director of BB&T/Windsor Group. Before the Iraq invasion, the Pentagon was focused on redefining how the military operates by incorporating so-called net-centric warfare technology, an initiative that has slowed.

The softening of the market has come at an especially bad time for San Diego-based contractor Science Applications International Corp. The company, which has been employee-owned since its founding in 1969, had considered going public last year but was forced to postpone those plans because of a problem with a contract.

Now the firm is contemplating the idea again, but it would be entering a less friendly market. Chief executive Ken C. Dahlberg warned in a letter to stockholders last month that "our current and projected performance . . . reflects a slow down in growth from our historical performance due to the increasing challenges of our business environment. Given this environment, the IPO price of the new shares plus the dividend may be less than our June stock price."

SAIC, which has 16,000 employees in the Washington area and nearly $8 billion in revenue, is expected to decide whether to pursue an IPO by the end of the month. Some in the industry want it to wait until conditions improve, but there's a risk there, as well.

"Six months from now, it could be worse," said Jon B. Kutler, chief executive of Admiralty Partners, an investment firm focused on government contractors.

Kutler said that concern is also limiting mergers and acquisitions. "Few people want to make a huge bet at what could still be near the top of the market," Kutler said.

Venture capitalists, meanwhile, are still investing in contractors but have to be choosier about where they put their money. Jack Biddle, a partner in the Novak Biddle Venture Partners, said venture capital spending may decline a bit in the next few years, "but the fact that there's a war going on means that the government is very aggressive in looking at technologies and products that can help the country in the war. And a lot of these products have potential commercial value."

The contractors themselves are jockeying hard for deals that are considered immune from cutbacks. Contracts that affect national security are deemed safest, but any work that can save the government significant sums in the near term is also a good bet. "If you're not targeting specific, high-priority areas, you probably are having a problem," said Larry Schlang, chief executive of Tysons Corner-based IT provider Bantu Inc.

Companies are also looking beyond the federal government for business. "If federal dips, we have strength in state and local," said David Hadsell, who leads government sales efforts at EDS Corp. "Many of the state budgets are in better shape. And they're obviously not funding the war effort."

One variable that everyone in the industry will be watching closely over the next several months is how the elections turn out. If Democrats win the Congress in 2006, or the White House in 2008, the business climate could change quickly. "If there's any uncertainty on the horizon, it comes from the election. That could create a new direction," said Robert Lohfeld, president of Lohfeld Consulting Group.

But he and others doubt that the Sept. 11-fueled boom is really near its end, even if power changes hands in Washington, because so much work remains undone.

"It's not like there's a peace dividend to be harvested," said Mike Gaffney, president of business development for the federal sector of Computer Sciences Corp. "I think everyone recognizes we're still in the middle of this."

© 2006 The Washington Post Company