The popular stereotype of the defense industry is big industrial companies making billion-dollar weapon systems. Over the last dozen years, though, it is the Pentagon’s providers of technical services who have seen the greatest growth. The defense department spends over $100 billion annually on services ranging from systems engineering to equipment maintenance to cybersecurity. Going to war in two different countries at the same time — and overextending the military’s in-house logistics capacity — generated a great deal of new business in a market segment that hadn’t seen a single provider break into the ranks of top Pentagon contractors until just before 9-11.
But the bloom is now off that rose. Overseas contingencies are winding down, information services are becoming commoditized, and even support of black (secret) programs is proving to be no sure path to profits. The big system integrators like Lockheed Martin and Northrop Grumman are pulling back from services, convinced they can never generate the kind of margins realized in military hardware and worried that organizational conflict-of-interest provisions in the Federal Acquisition Regulation will damage core franchises. Raytheon recently wrapped its technical-services unit into another division and General Dynamics sounds like it wishes it never had gotten into some of its service lines.
It’s not that GD hates all defense services. It would love to continue supplying the Army with support for the armored vehicles that the company makes. But healthcare IT? That’s another story — one that investors don’t quite get. Even the hardware companies that seem committed to high-end technical services like Exelis (nee ITT Defense) seem to have some reason other than profits for staying in; in the case of Exelis, it got saddled with pension obligations in the breakup of its former parent that require a lot of cashflow to cover.
But for the service providers that don’t have a major stake in building military hardware, the future looks unsettling. There seem to be way too many suppliers in most market segments to sustain the number of companies currently chasing contracts. So margins are compressing and shares are being shorted in a way that signals sector consolidation lies right around the corner. Market leader SAIC decided to split up its business so remove potential conflicts of interest, in the process increasing the parent’s addressable markets by tens of billions of dollars. L3 spinoff Engility is working hard to become the lowest-cost provider of technical services to its defense customers. And ManTech will probably follow the same path it did in previous slowdowns, taking advantage of falling valuations to buy niche players.
However, when you get past all the reorganization and rationalization, it’s not so clear that respectable profits lie in the service sector’s future — at least, not until some new threat materializes to stimulate Pentagon demand. Service companies have been trying to convince Wall Street for years that their high return on investment is as important as more traditional performance metrics like return on sales, but investors don’t seem to be buying that story. Which means more and more of the players are eyeing private equity as a way out. Whether private equity understands what it’s buying is another matter.
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