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February 2008

Federal Contractors Set Sights On Health Care Business

By Chad Crank

Information technology spending on defense, intelligence and homeland security continues its upward trajectory, but contractors are setting their sights on potentially even more lucrative opportunities in health care information technology.

From 2005 to 2007, homeland security IT spending rose from $1.9 billion to $2.7 billion. Intelligence IT spending is expected to increase at a compound growth rate of 8.4 percent during the next five years, according to INPUT market research.

Government contractors, meanwhile, are adjusting their business models in anticipation of rising government IT spending on health care during the next five to 10 years.

Health care IT spending by the government is expected to increase from $5.3 billion in 2007 to $8.7 billion in 2012, for a compound annual growth rate of 10.7 percent, predicts INPUT.

To capitalize on this growth potential, federal contractors have engaged in a number of industry acquisitions. Corporate mergers and acquisitions will likely occur among middle-market players looking for “tuck-in” acquisitions to complement current IT structures, while building a presence in health care IT.

The lure of booming government IT spending, particularly after 9/11, attracted substantial attention among firms focused on defense, intelligence and homeland security. The U.S. government further fostered a fragmented market through its congressionally-mandated small business contracting target levels. Over time, this increased spending led to impressive revenue growth with tighter margins.

Many public companies have become accustomed to the substantial revenue growth in the industry, but as the industry matures, these growth expectations may become more difficult to meet over the long-term. As a result, managers are looking at their long term business mix and evaluating whether they can sustain the levels of growth to which they and their shareholders have become accustomed.

Many companies that led the security and defense IT boom are seeking complementary product lines to bolster their business models. Health care IT offers an ideal fit.

The U.S. government controls the nation’s largest health care systems — Medicare and Medicaid. There appears to be broad bipartisan support for leveraging technology to reduce costs and improve the delivery of health care. Government officials are demanding technologies to build nationwide databases and to track medical outbreaks.

The decision to automate health care information can’t come soon enough. Within two years, baby boomers will begin retiring and will be taking advantage of entitlement programs such as Medicare, Medicaid and Social Security. Overall, health spending in the United States is expected to double to $4.1 trillion by 2016, which will consume 20 percent of the nation’s gross domestic product — up from the current 16 percent.

By then, the government will be paying 48.7 percent of the nation’s health care bill, up from 38 percent in 1970 and 40 percent in 1990. Military spending, on the other hand, is in the “discretionary” part of the federal budget.

Industry’s expansion into health care IT through acquisitions appears to be accelerating. In March 2005, Northrop Grumman acquired Integic Corp, which specializes in enterprise health and business process management. In the ensuing months, Northrop won a share of the National Health Information Network contract — which will be used to develop prototypes for a nationwide health information network.

Now, numerous mid-tier IT contractors are following suit.

In August 2007, SRA International acquired health consulting services provider Constella Group. Constella designs international public health programs and provides health and bio-medical research primarily to government customers. Constella will spearhead SRA’s health services practice. In that same month, SRA won a contract from the U.S. Health Resources and Services Administration to operate the agency’s national practitioner data bank.

In June 2007, NCI Inc., a provider of information technology services and solutions to U.S. federal government agencies, announced the acquisition of Karta Technologies Inc. Karta offers engineering, training, medical transformation and information technology services. Terry W. Glasgow, president and chief operating officer of NCI, said that the acquisition of Karta meets “strategic acquisition objectives, including … expanding NCI’s service offerings to healthcare IT, Defense Department medical transformation, high-end training solutions and distance learning.”

In the same month, ICF International, which delivers consulting services and technology solutions in various sectors including defense and emergency management markets, purchased Z-Tech Corp., a firm that provides software engineering, web design and development, and scientific computing services in support of federal health agencies. The acquisition of Z-Tech positions ICF as a leader in the health information technology market.

While spending in defense, intelligence and homeland security IT remains strong and continues to expand in many areas, long term risks remain for the industry. Although health care IT spending may have some short term uncertainty, there appears to be little doubt it offers substantial long term growth potential.

Chad Crank is a senior vice president at Stephens Inc., an investment banking firm in Little Rock, Ark. He can be contacted at ccrank@stephens.com.

This article is not a solicitation, or an offer, to buy or sell any security. It does not purport to be a complete description of the securities, markets or developments referred to in the material.

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