10 Industry Trends in Government Contracting
Government Contracting: Top 10 Industry Trends
With the United States economy remaining in the doldrums and the prospect of sustained economic growth low over the near-term, the federal government continues to accelerate growth in spending. For the fiscal year ended September 2009, U.S. government spending was approximately $540 billion on contracts to buy goods and services. This level of activity represented growth of 12% over 2008 activity according to Grant Thornton. In the late stages of 2009 and the first nine months of 2010, government contracting activity has also increased significantly.
According to the official budget of the United States Government, total cash outlays are expected to increase 15.0% from 2010 to 2011 and an additional 6.0% from 2011 to 2012. This represents an overall slowing of the growth rate in federal spending. Over the longer term, government purchases of goods and services (excluding employee compensation), a major indicator for government contractors, are forecast to grow at an annual compounded rate of 3 percent between 2010 and 2015 according to First Research. These increases do not take into account possible additions to federal expenditures resulting from incremental stimulus currently under consideration by the Federal Reserve and Obama administration.
Approximately $370 billion of the $540 billion of 2009 spending, or 68.5% was for defense-related items, from about 260,000 companies, according to First Research Corporation. The industry is heavily concentrated with the 100 largest federal contractors accounting for more than 70% of contract spending. While a myriad of contracting types exist, nearly half of all federal contract spending is on fixed-price contracts and a quarter of the money is spent on cost reimbursement contracts. Generally, production contracts are fixed-price, while development contracts are cost-reimbursement. Research and defense-related spending are the biggest contracting sectors; services are the largest federal spending category.
Industry Trends
Uncertainty of Government Spending
The federal government as an entity does not guarantee its overall spending level. However, the rate of growth and the application of spending is highly uncertain during recessionary times. This issue generates significant concern from government contractors relative to the uncertainty of future growth, rendering long and short term planning extremely difficult. As an example of this uncertainty, The Washington Post reported that defense contractors are wary of a federal plan to cut spending at the Pentagon, which includes a lower reliance on private contracts. Defense Secretary Robert Gates has been quoted as saying that he would slash thousands of jobs and reduce spending on contracts by 10 percent over three years. Concerns related to reduced tax revenues from the ongoing recessionary climate; the potential of cutbacks in defense spending relating to the Iraq and Afghanistan wars; and the ongoing debate over the national deficit, all combine to create uncertainty for government contractors.
A Time of Economic Uncertainty
Government spending is tied to tax receipts, which boomed in the mid- and late-1990s, and in the mid-2000s, as the economy expanded rapidly, but fell during the challenging economic environment of the late 2000s recession. Federal individual income tax receipts rose 47 percent from 2003 to 2007, but quickly fell back 21 percent between 2007 and 2009 as the recession deepened. Corporate income taxes, another major revenue source, dropped over 50 percent between 2008 and 2009. These statistics are provided by First Research.
Compliance, Compliance and more Compliance
Industry experts are unanimous in their view that there has been a significant increase in the complexity and depth of compliance for government contractors. Grant Thornton contends that the government has expanded requirements for compliance systems which are applicable to most government contractors. The federal Costs Accounting Standards (CAS), overseen by the Cost Accounting Standards Board (CASB), now requires contractors to operate a more detailed set of accounting books. Defense contractors are audited by the Defense Contract Audit Agency (DCAA) while non defense contractors are audited by other agencies. Compliance with these increased regulations is, of course, mandatory, with the increased costs placing pressure on the bottom line of already cost conscious contractors.
Sagging Profitability
While there has been much hyperbole in the popular press over profitability levels in corporate America, a survey by Grant Thornton suggested that 45% of the leading government contractors, up 8% over prior year, had either no profit or profit rates between 1-5%. Even more alarming, 85% of the companies surveyed had either no profit or profit rates ranging from 1% - 10%. That compares to 76% in the prior year. The number of surveyed companies with profit rates above 10% shrank from 24% last year to 15% this year. As evident from the above, profit rates are not only low, but they are shrinking. This is particularly true when considering the performance and financial risks inherent in government contracting along with the potential risk to corporate reputations from being unfairly targeted for public criticism.
Increased Customer Concentration
Investor and lender appetite for government contracting firms can be negatively impacted by the fact that many government contractors rely on the federal government for virtually all of their revenue. This means that the loss of contracts or the inability to get new ones is a major threat in today’s economic climate. According to Market Connections, a research firm specializing in government contractors, the success rate in pursuing new government contracts is 40 to 75 percent. Larger, more diversified firms are able to withstand the vagaries of contracts of different lengths, but the issue of customer concentration is one that continues to have a major impact on the profitability and viability of many government contracting companies.
M&A Activity on the Rebound
Studies show that changes in the profile of U.S. troops in Iraq and Afghanistan combined with a cutback in traditional weapons have sparked a wave of deal-making among defense contractors rushing to get deeper into the fast-growing world of cyber warfare. Thomson Reuters reported on October 12, 2010, that deal volumes in the global aerospace and defense industry are up 87% in 2010, from $3.1 billion in 2009 to $5.8 billion in 2010. BAE Systems has outwardly stated its interest in utilizing external growth to create shareholder value. Companies like ManTech International is an example of a high-end technical defense services firm with cyber warfare capabilities that has become more attractive to potential buyers, driven in part by the declining budgets for tanks, planes and other hardware in the United States. Buyers are looking for cyber-security companies as well as those active in command, controls and communications; intelligence, surveillance and reconnaissance.
Need for Advanced Technological Expertise
According to Melissa Hathaway, President of Hathaway Global Strategies, LLC and Senior Advisor at Harvard Kennedy School's Belfer Center, "The need for partnership between industry and government will increase over the next decade especially as our enterprises become further interconnected due to our dependence on information technology. The seams between private networks and government networks will continue to blur and it will be harder to know where one ends and the other begins." Data from First Research indicates that over the past decade, a greater percentage of spending by the Department of Defense and some other departments has been for goods and services that require high levels of technological or scientific expertise. As government programs have also become more technologically demanding, contractors have increasingly joined forces to bid on contracts, or have used a larger number of subcontractors with special expertise.
Changing Nature of Government Contracting
In an effort to increase the number of small businesses that participate in government contract work and also to reduce expenses, the Obama administration recently implemented a series of new initiatives that impact government contracting. New rules were recently initiated to increase competition for new government contracts, in an obvious effort to allow competitive bidding to reduce costs. A second initiative – something that the government calls "insourcing" - would result in less work for external government contractors. According to First Research, insourcing received a major boost when the Obama administration declared it part of a new suite of priorities for reining in government contractor spending. These initiatives collectively shift the playing field for external government contracting firms. "Industry continues to face a move toward fixed price development contracts, long procurement cycles, and insourcing," according to Linda Mills, Corporate Vice President and President, Northrop Grumman Information Systems.
Growth of Homeland Security
The Obama administration has allocated a majority of the Department of Defense Homeland security budget to security, enforcement and investigations mission area, according to Frost & Sullivan. The overall budget grew in 2010 by 6.2% from 2009 as the country continues to act on the both the real and perceived threat of terrorism. In addition to core Homeland Security spending, the federal Department of Homeland Security is spending large amounts of money to integrate the many agencies that are now part of the agency. According to First Research, defense industry analysts expect homeland security funds to reach companies beyond the traditional, well known military defense contractors.
Demand for Highly Skilled Sub-Contractors
The demand for highly skilled subcontractors with the necessary security clearances has increased dramatically over the past five years. With the increased focus on advanced technological expertise as a requirement for government work, a skill set not always found in the government, outside contractors face increased needs to find highly skilled direct or indirect employees to meet the complex demands of governmental agencies.