LOGISTICS AND MAINTENANCE
Market for Service Contracts Shrinking, and So Is the Number of Competitors
Facing a steep decline in government spending on support contractors, companies in this sector are rushing to consolidate and cut expense as price-based competitions become the norm in service contracts.
The recent acquisition of longtime government services contractor Dynamics Research Corp. by major competitor Engility underscores the changing environment of the industry.
Engiliy, a company that was spun off by defense contractor L-3 as a pure-play government services contractor, completed the $120 million acquisition of DRC Jan. 31. Executives touted the deal as an early jump ahead of the next wave of industry consolidation.
"There are too many competitors chasing too few opportunities," said Engility CEO Tony Smeraglinolo.
The market for defense and intelligence contract services exploded from 2001 to 2011, peaking at about $200 billion, while the number of contractors in the sector soared from 45,000 to 130,000. With the business now headed for a sharp decline, the industry will shrink but there will still be lucrative opportunities, Smeraglinolo said in an interview.
"When we formed Engility in 2012, we knew this market space was going to get more constrained," he said. The company, based in Chantilly, Va., has 7,000 employees and 2012 revenue of $1.6 billion. With the acquisition of DRC, Engility expects to gain up to $5 billion worth of contracting opportunities in professional services for the Air Force, intelligence agencies, military healthcare programs and Veterans Affairs. It expects to absorb most of DRC's 1,100 employees, he said.
"This opens up some new markets," said Smeraglinolo. In today's climate of reduced government spending, there has to be consolidation and mergers, he said. "This will continue. We wanted to be a first mover."
The key to survival in this sector is to offer the lowest possible price, said Smeraglinolo. “We created a company for this particular market, with cost in mind.” Government missions are not changing but agencies now demand lower cost, he said.
Although some analysts and investors have predicted gloom and doom in the government services sector, the reality is more nuanced, Smeraglinolo said. The Defense Department, for instance, is cutting back on service contracts but also forgoing acquisitions of new weapons, logistics systems and information networks. As a result, there should be greater demand for maintenance and support of existing systems, he said. “There will always be a need to have readiness and training.”
Another consideration is the demographics of the government workforce. By some estimates, about a third of the current civilian cadre will be eligible to retire by 2017. “If the government still has to operate, there may be a greater need for service providers to fill that gap.”
Smeraglinolo said his company welcomes Defense Department contracting policies that put cost above all other criteria. Under the contractor evaluation method known as “lowest cost, technically acceptable,” the government defines what is technically acceptable and it is up to the contractor to figure out how to deliver it at the lowest possible cost. “We embrace these initiatives,” said Smeraglinolo. “We're competing on efficiency.”