For contractors that specialize in manning and supporting government operations — commonly referred to as the services industry — the decade following the terrorist attacks of Sept. 11, 2001, was one of spectacular growth.
These businesses, such as Fairfax-based ManTech International and Arlington-based CACI International, made millions helping the military manage two wars and handle an even broader range of chores at federal agencies.
CACI sales hit $3.6 billion in 2011, up from $558 million a decade earlier. By 2011, the Pentagon was spending nearly $200 billion on services, more than double what it spent in 2000, in constant 2011 dollars.
These companies became the bright stars of contracting. Unlike those that produce weapons, services businesses required relatively small investments to get off the ground and could quickly ramp up as demand grew. But as the government winds down its wars and takes a harder look at what it’s spending, their shine seems to be dimming.
The larger defense contractors such as Northrop Grumman and L-3 Communications have spun off their services businesses, which they say no longer fit with their strategy of pursuing higher-margin work, while companies that only offer services face new questions from Wall Street about the impact of federal budget cuts.
Many businesses in the sector are now finding themselves at an inflection point, revamping to win work in a competitive environment characterized by fewer opportunities and a more cost-conscious customer.
“Government services companies have to update their strategy to be successful,” said Bob Kipps, managing director of the McLean-based investment firm KippsDeSanto. “The strategy of the last 15 years is not going to be the strategy of the next five years.”
Falls Church-based Northrop Grumman was the first prominent defense contractor to rid itself of its services business in 2009, when it divested Tasc. A private-equity firm bought the unit, which operates out of Chantilly.
The spinoff came at a time when the government was promising to take a harder look at the potential conflicts of interest created when, for instance, a company’s services unit ended up testing a piece of equipment built by the same company’s manufacturing arm. For Northrop, it no longer made sense to put its products business — of drones and sophisticated military equipment — at risk.
Lockheed Martin followed suit in 2010, selling off its advisory services unit EIG. When L-3 Communications announced in 2011 it would spin off its services business, a company official said the lower-margin business didn’t fit with L-3’s focus on high-tech — which generally means high-margin — sectors.
“You have those growing concerns with government regulations, you have less prospects in terms of growth, a lot of the business that these companies used to do is drying up as overseas deployments are reduced,” said Philip Finnegan, director of corporate analysis at the Teal Group. “The growth that was part of the attraction in the past isn’t there anymore.”
Engility, as the L-3 spin-off is called, has said it will cut its workforce and consolidate in order to bring down its costs and improve its ability to compete on price.
McLean-based Science Applications International Corp. became the latest in this trend, announcing earlier this year it would separate its government services business from its solutions business, which is expected to include growing sectors, such as cybersecurity and health technology.
Much of the company’s current leadership, including chief executive John P. Jumper, will stay with the solutions business.
At the same time, companies that provide only services — and not products — have faced significant pressure.
Incumbency no longer provides protection against losing a contract. Reston-based NCI has become something of a poster child as its revenue and profit declines.
The IT company has blamed the slide on a government move to place more emphasis on price in contract competitions. In contracting circles, this is known as a shift to “lowest price, technically acceptable,” meaning the government isn’t seeking the best value but instead the cheapest bid that meets the requirements of the solicitation.
“Lately, we have been providing outstanding proposals in both technical as well as management approach, but we have lost those proposals mainly because of pricing structure — which means 25 percent, 20 percent below what we normally would have bid on those programs,” said Charles K. Narang, NCI’s chairman and chief executive, earlier this year.
NCI has reorganized and is conducting a strategic review that will be evaluated by its board next month, said Brian J. Clark, the company’s president.
At the same time the government is pushing for lower prices, the Obama administration has pursued in-sourcing, an effort to hire civil servants to replace contractors in cases in which a job was “inherently governmental,” or a function that should be done by federal employees. The initiative has drawn contractor ire, though some officials indicate the government has pulled back its efforts.
Seeking work has also gotten more expensive as competition builds and award protests rise.
“You have to be very selective ... on what you bid and what you go after,” said Mitchell Martin, a principal with the investment firm McLean Group. There are “more companies going after smaller opportunities and lower-level work. You’re competing with Lockheed Martin now where you didn’t have to before.”
The pressure has led some services firms to diversify. Fairfax-based ManTech International, for instance, gave up commercial work a decade ago, but recently announced it would be returning to that market. The company acquired a cybersecurity company meant to help it sell work to customers beyond government agencies.
Kevin M. Phillips, the company’s chief financial officer, said ManTech has also entered the health care technology market.
“ManTech has been around for a while, and we’ve done this before,” he said. “We have a process that we’ve used in the past to decide when and where to diversify and to do it smartly.”
Despite the challenges, analysts say there’s little chance these kinds of businesses are going away.
“What’s happening now is they’re no longer the darlings of the industry the way they used to be,” said Finnegan. “Contractors are viewing these business differently.”
Services firms are having to take a hard look in the mirror to decide what kind of business they want to be, Kipps said. Companies that want higher-margin work need to be very innovative and perform more technical work; simpler, more straightforward chores demand a lower price.
“You either have to be thin and commodity-like — which is an increasing proportion of the market — or be on the innovative side” and focus only on higher-end work, Kipps said.
NCI, for instance, has boosted its health-related work, including making an acquisition last year.
“We’re really focusing on the priorities ... that will have long-term, visible funding streams associated with them,” said Clark, the company’s president. NCI is “not really looking for flash-in-the-pan stuff.”
Still, there’s not one set strategy, said Guy Ben-Ari, deputy director of the Center for Strategic and International Studies’ defense-industrial initiatives group. The market can vary dramatically, depending on what kinds of services a company provides.
For instance, nearly half of the dollars the Pentagon spends on research and development services go uncompeted, meaning the work is given to a single contractor who brings unique capabilities to the job. For companies that have invested in building up research facilities and know that the barriers to entry are daunting, the market should remain appealing.
But in the Pentagon’s facilities services and maintenance market, almost three-quarters of the work is competed with multiple offerors. Companies that mow government lawns and paint federal buildings should brace for competition, Ben-Ari warned.
The difficult environment may make the industry ripe for consolidation. “There’s been some speculation too that it might be prime for private equity to do sort of a roll-up of different [services] businesses,” Finnegan said. “But it’s also a very uncertain time in terms of defense spending, so that could really impede that.”
Indeed, William Loomis, managing director at Stifel Nicolaus, said consolidation has been slowed by concerns about sequestration.
“I think there will be some consolidation for sure as bigger companies look to add capabilities,” he said. “A year from now, we’ll see [merger and acquisition] activity much higher.”