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Price Wars Prompt Firms To Abandon Service Sector

Sep. 9, 2012 - 12:26PM   |  
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Government services contracts — deals to provide technical experts and consultants to fulfill operational and planning needs — got hot starting in late 2001 after the U.S. entered Afghanistan.

As one war became two, large companies hired technical experts by the boatload to fulfill the flood of service contracts, and the Pentagon’s budget quickly shifted away from equipment. The services industry began to routinely post double-digit growth.

But during the middle of 2009, the growth stopped.

“Someone flipped the switch in 2009 and pricing changed for many,” said Martin Bollinger, senior vice president at Booz and Co.

Now, with profit margins on sales squeezed and limited prospects for substantial growth given a fierce competitive climate and flat defense budgets, a number of large defense contractors are getting out of the services business, looking to divest segments that diminish their overall margins and create potential conflicts of interest for systems deals.

So why are margins in the services business so thin, as opposed to other areas of the defense industry, such as development and production? It comes down to the limited barriers to starting up a service business: Any company that can recruit quality experts can quickly become a player, without the need to develop manufacturing capacity or expensive, unique technologies. The result is that competitors pop up constantly, and incumbents are forced into price wars to keep business.

SAIC announced that it would spin off its technical services business Aug. 31, following in the footsteps of L-3 Communications, which completed the spinoff of Engility in the summer. In recent years, Lockheed Martin and Northrop Grumman have trimmed their portfolios as well.

Analysts say more moves are likely.

“Companies look at their portfolios and say, ‘Why am I in this business if it’s going to be a drag on my earnings because [the Defense Department] under Better Buying Power is going to compete everything, every three years, and it’s just going to be a rat race to improve margins or gain any sort of market share?’” said Byron Callan, a senior defense analyst with Capital Alpha Partners.

Analysts pointed to three primary shifts in 2009 that have changed the market dynamics: Total defense spending began to plateau, and the Obama administration wanted to increased competition and prevent potential conflicts of interest.

The Pentagon got what it wanted, and competition has soared.

“The greater utilization of Lowest Price Technically Acceptable evaluation factors, particularly at DoD, meant that the competition centered on price, not on technical capability,” said Alan Chvotkin, executive vice president at the Professional Services Council. “All of those factors drove prices down, to the benefit of the Defense Department, but also changed the economics for companies.”

The Pentagon’s emphasis on competition, which kicked into high gear when President Barack Obama took office and was codified by then-defense acquisitions chief Ashton Carter in the Better Buying Power memo, has brought new providers to the table.

“It’s being dragged down by some very specific players, by the international folks entering the market and the commercial folks entering the market,” Bollinger said.

The competition mantra is still repeated routinely by administration officials.

“I think that nothing, nothing, works better than competition to drive cost down,” Frank Kendall, who inherited Carter’s position, said at a conference Sept. 5. “As long as we have competition, we will be better off.”

As profit margins on sales for services contracts have been squeezed, defense contractors have begun to face the difficult task of explaining a component of their business that does not match traditional defense equipment sales models.

“This is an industry that was raised around the production of equipment to investors,” Bollinger said. “These can be very good businesses, but they don’t always fit the traditional investor model that defense companies typically put forward. They have not been able to paint a coherent picture of their businesses, and investors don’t like incoherence.”

While margins may be decreasing, the services business still can be profitable, largely because of its limited overhead, analysts said. This allows companies to receive a profit, albeit smaller than the percentage of margins on equipment, with far less investment of capital and far less potentially risky legacy costs to confront. That return on capital can still make a company real money, even with the lower profit margins on sales.

“Because these businesses don’t have factories or laboratories where there’s a lot of fixed investment, they should be relatively easy to manage in an upturn and a downturn,” Callan said. “It’s basically you hire people or fire them.”

Even though these companies retain a strong business case — if viewed in terms of return on capital, as opposed to sales margins — investors aren’t receptive, said Loren Thompson, an industry consultant and chief operating officer of the Lexington Institute, Arlington, Va.

“Industry has been arguing for many years now that the proper metric for measuring services profits is return on invested capital, but Wall Street isn’t buying that story,” he said. “Wall Street isn’t accustomed to thinking about the defense industry in terms of return on investment.”

As a result, services segments have been viewed as a drag on overall company margins, and companies are facing increasing pressure to separate segments, Thompson said.

“Had SAIC not moved to split the company, it’s possible that activist investors would have put pressure on leadership, given their recent returns,” he said.

That doesn’t mean services businesses are unable to find investors. With profit still to be made, private equity companies have quietly moved to purchase a number of large services contractors. Cerberus Capital Management, the Carlyle Group and Veritas Capital Management all have positions in the market.

“If services is such a bad business, why are private equity companies getting into it?” Bollinger said.

There are potential problems with this new model for financing services businesses. And having private equity play a large role can be risky, Callan said.

“There’s a risk to DoD if all of a sudden a lot more of these companies are held by private equity because, at the end of the day, you’ve created a capital structure that is inherently more risky than one where these enterprises are embedded in much larger companies,” he said. “There are just a lot more suppliers who are a lot more leveraged, and if you start changing contract policy and affect cash flow negatively for these guys, you could get some of them to hit the exit door pretty quickly, and ultimately you’re going to have far less competition in this area.”

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