Member Spotlight: NT Concepts

September 2017

Our largest, most transformative contract supports a body of work with foundational impacts to National Security. 

On award, we found the effort severely understaffed and with significant business process inefficiencies causing production delays. Employees were working excessive overtime, felt undervalued, and morale was low; these conditions had measurable negative impacts on our customer’s mission achievement. We needed to build a better workforce and provide the leadership, culture, training, and tools to succeed – all while executing the work. 

We invested over $75,000 in training to improve leadership skills. We gave employees direct lines of communication to their management chain—all the way to the CEO. We increased staffing by 35%, provided skills training for employees (624 trained in 145 courses), and implemented business process improvement tools and strategies to increase efficiencies and decreasing the need for excessive overtime work. We also improved benefits and professional development to our employees under our Total Rewards Program. 

Working closely with the customer and leveraging our cross-training program, we weathered system shutdowns and a continuing resolution stop work with minimal impacts to our employee base. In the first year of the contract, we removed the process delays in most areas and decreased in the remaining areas.  Our actions moved performance to unprecedented levels – resulting in the customer’s mission success. 
 
About NT Concepts.  NT Concepts delivers advanced geospatial, data analytics, and software solutions, coupled with skillful professional services, to enable mission achievement for our Intelligence, DoD, and Federal customers.  Our approach integrates leading technologies, proven best practices, and deep expertise, yielding innovative solutions to drive operational efficiency and inform critical decision making.  Learn more at www.ntconcepts.com.

What is Innovation in Federal Acquisition? By Stacy Stacks Director, Policies/Procedures Management Systems International | A Tetra Tech Company

The “blended federal workforce” is comprised of roughly 2 million federal employees, 3.7 million contractors, nearly 1.6 million grant employees, 1.3 million active-duty military members, and 492,000 postal workers, signaling that the role and work of PSC member companies is vital to ensuring government agencies run smoothly and efficiently day-to-day, both domestically and overseas.

But there are many factors that impact innovative approaches to acquisition and that prompt workforce limitations. In President Trump’s first few days in office, he implemented a widespread hiring freeze. Buyouts and early retirement offers have also impacted federal employee workforce figures. On the government services side, contracting officers are in high demand but short supply, and often limited on hiring more peers to meet the demands. And often, contractors are adverse to selling to the government due to the long, onerous and costly federal acquisition process.

As federal agencies aim to meet expanding citizen demands, reduce costs and identify more efficient ways of operating, even incremental improvements can make a significant impact. Perhaps this is why federal agencies look to innovation as a means to deliver public service for the future. 

So, what’s the problem?

The dedicated federal procurement workforce is trapped in a culture that, for years, has made requirements around cost and acquisition schedules the primary considerations for evaluating contract awards. Such a process fails to include an examination of innovative and best-value approaches to meet mission requirements for departments and agencies. Additionally, the ongoing failure by contracting officers, project managers and acquisition professionals to implement full and open competition in federal procurement — as required by law, regulation and policy — harms agencies’ ability to leverage market-driven innovations and cut costs. 



“It is time we take huge, but calculated risks,” one executive said in a 2017 Deloitte survey on federal career senior leadership. “Ask tons of curious questions of, rather than just directing staff. Find better, smarter ways to do things easier and simpler. Increase risk appetite and don’t punish people for trying something novel.” 
Only forty-four percent of federal managers say that they innovate to improve mission delivery.  But what about the other 56 percent?  Are we perpetuating a federal procurement culture that, in turn, limits workforce efficiency and productivity? In fact, PSC has recommended that people be rewarded for trying something new – even if it fails. And that’s where agency innovation labs come in, as one solution to help build federal workforces to meet government missions. 

Innovation Labs
In March 2016, the Obama White House announced a new initiative to accelerate the establishment of Acquisition Innovation Labs in Federal agencies, to provide a pathway to test and implement more innovative approaches to acquisitions. Innovation labs are trying to provide different approaches and tools beyond traditional contracting. The labs would also help agencies successfully adopt emerging acquisition best practices to more effectively deliver services to the American people. The White House guidance required that all federal agencies create innovation labs by May 2016. As a part of this initiative, all 24 major “CFO” agencies were expected to:

• Appoint acquisition innovation advocates (AIAs) to promote testing of new ideas and better ways of executing existing practices in their agencies through managed risk-taking;
• Ensure they have innovation labs, or similar mechanisms, to promote meaningful collaboration through an integrated product team; and
• Participate in a new council to maximize collaboration across the government and to share best practices and lessons learned.

The greatest catalyst for innovation is each agency’s willingness to embrace a culture that continuously encourages new ideas and finds better applications of existing practices. Establishing Acquisition Innovation Labs government-wide was intended to play an increasingly important role in empowering and equipping agency employees to implement their promising ideas and foster a culture of innovation that leverages proven government and private sector practices.   

Innovation must be measurable.

In the context of federal acquisition, space for creative approaches to solving acquisition problems should be required at every stage by every agency, demanded by external sources (customers and taxpayers, for example), and participatory with Industry and commercial partners. In fact, there is no need for legislative or regulatory authorization for innovation in federal acquisition.

To be clear, “innovation” is not a synonym for “information technology.” There are multiple access points for government to create new pathways to innovation in the acquisition cycle, which PSC notes will improve each agency’s challenges for solutions. The application of innovative technologies, solutions, processes and business models can provide the government with game-changing opportunities during these challenging times, and there are a plethora of current examples of exciting new pathways in federal acquisition.

One example of successful leadership at the executive level is at the Department of Homeland Security, where the agency is recognizing employees who are innovative. Its program awards “digi-badges” to those employees who are putting into practice what they are learning about using innovative acquisition techniques to improve DHS’ mission. Other efforts are succeeding at USAID, the Department of Health and Human Services, and elsewhere. [See Sidebar]

PSC as the Liaison for Innovation 
PSC leadership and member companies are actively involved with advocacy in innovation-forward movement, including continued support of the Modernizing Government Technology Act and providing a platform for agencies and the federal government to discuss critical legislation and policy. 
The biennial PSC flagship Acquisition Survey in 2016, which is the only comprehensive survey of federal of acquisition professionals, dedicated one of the five core topics to innovation, and should be a guidepost for areas where PSC member companies can influence and impact change within their companies and for their federal customers. 

PSC recommends that every agency have a Procurement Innovation Lab that looks beyond information technology and includes industry. Innovation is applying technology, tools, or processes in a new or different way that helps perform the mission better, cheaper, or faster. That is, it saves resources, time or money, or enables the user to perform their mission better. This implies that innovation is relative to the government in two ways: innovation is an idea that helps the specific agency and is new to that agency, but may not be new to the market.  

Tim Cooke, CEO and owner of ASI Government LLC, and a PSC board member, said it best in an article on innovation by and for the government: "…we need to ask how to start harvesting and using the value of these important initiatives across the landscape of invention, taking advantage of vital lessons, leveraging efforts in similar areas, enhancing communications and achieving greater returns on government investments in realizing the benefits of bringing innovative new companies and capabilities to achieve government’s missions and goals."   

PSC and its members will be evaluating the progress—and the remaining barriers to success—of these Innovation Labs. Agencies are welcome to join in that assessment.
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Here are a few examples of how government agencies are moving full steam ahead with Innovation Labs:

Department of Veterans Affairs – Center for Innovation
“Identifies, tests, and evaluates new approaches to efficiently and effectively meet the current and future needs of Veterans through innovations rooted in data, design-thinking, and agile development.” 

Office of Personnel Management – Lab @ OPM
Focuses on building design capacity to implement innovation across the federal government. This includes user experience design, service design, product design, program design, policy design, design strategy, and design research. 

DARPA – DARPA Small Business Programs Office
DARPA, the Defense Advanced Research Projects Agency, seeks partnerships with small businesses through their Small Business Programs Office. The program seeks to develop breakthrough technologies for national security, working with industry, academia, and individuals. 

Department of Defense – DIUx
The Defense Innovation Unit Experimental (DIUx) is a “fast-moving government entity that provides non-dilutive capital to companies to solve national defense problems.” DIUx acts like a Silicon Valley incubator, investing in solutions ranging from autonomy to artificial intelligence to human systems, information technology, and space, in order to solve defense problems. 

Cross Agency and Partner Learning in the Acquisition Space
With the ever-changing regulatory environment and a pathway for efficiency, workforces from both Government and Industry should take a close look at how to use and improve the Acquisition Innovation Hub & Gateway: a workspace for acquisition professionals and federal buyers to connect with resources, tools and each other to improve acquisition government-wide.

•  https://www.accenture.com/t20150707T195237Z__w__/us-en/_acnmedia/Accenture/Conversion-Assets/DotCom/Documents/Global/PDF/Dualpub_11/Accenture-Three-Must-Haves-For-Federal-Government-Innovation-2.pdf#zoom=50
• https://fedtechmagazine.com/article/2017/05/federal-procurement-modernization-requires-cultural-change
• https://1yxsm73j7aop3quc9y5ifaw3-wpengine.netdna-ssl.com/wp-content/uploads/2017/10/75616-State-of-SES-Findings_v6-EMBARGOED-UNTIL-OCTOBER-4-2017.pdf 
• Accenture and the Government Business Council; “Is Government Making Inroads On Innovation? A Candid Survey of Federal Managers;” December 2014; http://www.accenture.com/us-en/Pages/insight-government-making-inroads-innovation-impacting-government.aspx 
• https://obamawhitehouse.archives.gov/blog/2016/03/09/fostering-culture-innovation-across-government-through-acquisition-innovation-labs 
• http://www.pscouncil.org/a/News_Releases/2017/PSC_Applauds_Senate_Passage_of_MGT_Act_9_18_17.aspx 
    David Kriegman, Z2B-LLC
• http://www.govexec.com/excellence/promising-practices/2017/10/innovation-and-government/141433/?oref=river 
  
  

Acquisition and Business Policy Spotlight

January 16, 2018
By Jeremy Madson, Public Policy Director

ABPC Spotlight: A To-do List for 2018

At the dawn of this new year, PSC and its Acquisition & Business Policy Council (ABPC) have a long to-do list—from accelerating the security clearance process to improving how government and industry do business together. But even two weeks into 2018, we have already been hard at work. Read more about what PSC is up to and how you can be part of it.

Get the Big Picture by Taking Part in PSC’s 2018 Acquisition Policy Survey & Conference 
2018 brings PSC’s 9th biennial Acquisition Policy Survey, offering PSC members a unique opportunity to interview government acquisition leaders in federal agencies, the administration, and Congress about the major issues shaping the federal acquisition landscape. To volunteer to be an interviewer, register now for the survey kickoff meeting on Wednesday, January 24, at 11 a.m., or contact Jeremy Madson for more information. First priority for scheduled interviews will be given to those who attend the kickoff meeting. The results of the survey and related developments in federal buying will be a focal point for discussion at PSC’s 2018 Acquisition Conference on July 18. 

IN THE AGENCIES
Services is Our Middle Name: PSC & GSA Working Together in 2018
The General Services Administration (GSA) is a driving force in how the government goes to market, managing billions of dollars of federal purchasing, and helping set policy for how and what the government buys. PSC is working closely with GSA on a number of initiatives and has lined up numerous members-only opportunities to engage with GSA. 

Mary Davie, Deputy Commissioner of GSA’s Federal Acquisition Service (FAS), kicked off the PSC program year as the guest speaker at the January 5 Government Affairs Committee (GAC) meeting. She provided a sweeping overview of GSA’s efforts to improve data collection, improve processes, optimize contract vehicles, and capitalize on commercial capabilities, among many other initiatives. The next GAC meeting will be held on February 2—six more weeks of winter or not. A guest speaker will be announced shortly, and 2018 sponsorship opportunities are available; contact Jeremy Madson for more information. 

Continuing the conversation on commercial buying, PSC EVP & Counsel Alan Chvotkin joined a panel on January 9 at GSA’s public meeting on “Procurement through Commercial e-Commerce Portals.” The meeting was part of GSA’s effort to implement Section 846 of the FY18 National Defense Authorization Act (NDAA, see below), which directs the agency to develop a plan for leveraging existing online commercial marketplaces. Chvotkin expressed PSC’s support for a “a transparent, robust, and accelerated phase-in” for federal adoption of online e-commerce portals, and offered recommendations for their implementation. PSC also intends to provide written comments to on implementation of Section 846 as requested by GSA. 

PSC previously provided comments to GSA on its FedRAMP “Secure Cloud” Request for Information (RFI) on helping agencies adopt secure cloud technologies. PSC’s December 15, 2017 letter commended GSA’s effort and reiterated the need for agency reciprocity with respect to cloud service provider authorization, in order to accelerate cloud adoption and increase competition, and to consider more agile methods of certification and authorization, and pledged additional input based on evolving industry considerations. Contact Kevin Cummins, PSC Vice President, Technology, for more information or to provide your input on FedRAMP best practices or contract language.

On January 11, PSC’s Smart Contracting Working Group hosted representatives from GSA’s Government-wide Professional Services Category for an Industry Exchange Forum (IEF) kickoff meeting on improving the agency’s use of RFIs and collection of industry capability statements. PSC members provided extensive feedback to help GSA better understand industry’s perspective on the utility of RFIs, how they decide to respond and the costs of doing so, and the potential benefits and pitfalls of creating a new online repository for industry capability statements. 
GSA will return to the Smart Contracting Working Group on February 8, when Christy Hermanson, Design Lead for the Integrated Award Environment (IAE) in GSA’s Federal Acquisition Service, will provide an overview and demonstration of GSA’s efforts to modernize, upgrade, and integrate several federal information systems under the new System for Award Management (beta.SAM.gov). Her presentation will cover the status and timeline of changes to industry role management, migration from FedBizOpps (FBO.gov), transition from WDOL.gov for wage determinations, and other elements of this far-reaching integration initiative and what it means for contractor system user. 

PSC is again working with GSA to plan its second Reverse Industry Day (RID) program, to be hosted by FAS on February 20, 2018. Three sessions will explore elements of industry decision-making with respect to barriers to entry, bid strategy and teaming, and execution and compliance issues in the federal marketplace. While this session is fully subscribed, based on the positive reception from GSA and strong response from industry, there are additional opportunities for PSC member participation in the near future. For example, PSC and GSA are in the planning stages of another RID event with the Public Building Service this spring. In addition to GSA, we have partnered with IRS and DHS on 2018 RID programs, and expect to have similar engagements with more agencies this year. Contact Bradley Saull, PSC Vice President, Civilian Agencies, for more information on PSC’s Reverse Industry Day activities.

SeaPort NxG Strategy Discussion with NAVSEA 1/17
As part of PSC’s continuing engagement with NAVSEA on their follow-on to the SEAPORT-E contracts, we will host Susan Tomaiko, the Seaport Program Manager, and Sharon Rustemeier, the Services Acquisition Strategy Manager, on January 17 at 10 a.m. to discuss the government strategy and industry recommendations for the SeaPort-Next Generation (SeaPort-NxG) program. Learn more and register here.

PSC Welcomes Publication of White House Federal IT Modernization Report
PSC welcomed publication of the White House “Report to the President on IT Modernization,” which sets a strategic vision and outlines steps to upgrade outdated technology systems and strengthen cybersecurity across the federal government. The final report released December 13 incorporates recommendations from PSC related to transitioning to cloud computing, legacy IT replacement, and expanding shared services. 

All Quiet on the Regulatory Front?
As the latest development in the Trump Administration’s regulatory reform and relief efforts, OMB’s Office of Information and Regulatory Affairs (OIRA), which has responsibility for overseeing administrative agencies’ regulatory activities, has expanded their regulatory plan to include regulations halted or intended for removal in addition to those being promulgated. Issuance of new regulations precipitously declined in 2017 due to the president’s regulatory freeze, regulatory budgeting, and “two-for-one” mandates. While the freeze has been lifted, a thaw has yet to fully ensue. Coupled with agency reorganization plans being rolled out in coordination with the president’s FY19 budget proposal, along with other regulatory review efforts such as the Section 809 Panel chartered by the FY17 NDAA, 2018 could bring a major paradigm shift in the federal regulatory framework. PSC will continue to closely follow these developments and educate members on their implications. 

ON THE HILL
FY18 NDAA Signed Into Law
PSC welcomed the president’s signing of the Fiscal Year 2018 National Defense Authorization Act (NDAA), which became law on December 12, 2017. It authorizes national security funding, provides policy direction, and significantly changes rules governing how contractors provide services and ensure mission success for the Department of Defense. “PSC worked diligently throughout the year to offer recommendations to the House and Senate Armed Services Committees and conferees on this bill and we are pleased that the president has signed it into law,” said PSC President and CEO David J. Berteau. Read PSC’s full statement and our analysis of some of the major acquisition and technology-related provisions.

PSC Urges Congress to Fully Fund MGT Act in FY18
Among the PSC-supported provisions included in this year’s NDAA is the Modernizing Government Technology (MGT) Act. The law incentivizes agencies to invest in new and innovative IT systems, and authorizes $250 million for FY18 to do so. With an omnibus appropriations package expected for the remainder of fiscal year 2018 in January, PSC urged Congress to include full funding for the MGT Act to achieve the law’s intended benefits. Read our December 21, 2017 letter to the House Appropriations Committee.

For more information on upcoming PSC events and engagement with federal agencies and policymakers, visit the PSC website, or contact any member of the PSC Policy Team. 

--Happy New Year from PSC--

Government Services: A View from Wall Street

By Edward Caso, Jr., CFA Managing Director, Senior AnalystIT/BPO Services, Wells Fargo | April 27, 2018

The light at the end of the “BCA Tunnel” was not an oncoming train after all, but the prospects for renewed growth. In addition, the once distant glow has also proved to be much brighter than we believe anyone thought possible even a few months ago. And, this comes on the heels of federal tax reform that has given a major financial lift for nearly all the federal government focused service providers, who historically have been near marginal tax rate payers. So, calendar 2018 has gotten off to a great start and is one that we believe will have legs for some time.

In recent weeks, Congress has passed and the President has signed legislation to increase the level of discretionary federal spending by about $150 billion in each of the next two government fiscal years (GFYs). In December, Congress approved legislation that reduced the federal tax rate to 21% with most service providers now indicating expected overall tax expense rates in the 23-26% range down from the mid-30%s. So, more client dollars to pursue and more bid & proposal dollars to pursue them.
So what do we see?  Several years of strong demand, with a particularly high growth rate in calendar 2019, combined with a modest upward bias in EBITDA margin. This should lead to strong free cash flow generation freeing up financial resources to enhance investor return or invest in market expanding acquisitions. So, in our view, a great time to be an investor in federal government focused service providers.

The good news: 

• Dramatically expanded addressable market for both Information Technology (IT) and mission support services. 
• The sizeable increase in the Budget Control Act 
  (BCA) of 2011 spending caps effectively eliminates “sequestration” relative to the prior spending increase line, and we doubt that Congress will back track to the BCA caps for GFY20 and beyond that are still the law of the land.
• While the initial Trump Administration plan was to have “FedCiv” be a bill payer for increased national defense spending, the budget deal has them enjoying significant funding upticks as well.
• Focus turning to more enduring offerings such as readiness & training, IT modernization, and cybersecurity as compared to the 2000s bias to warfighter support.
• Clients that are looking to capture the advantages of IT modernization (e.g. mobile phone applications) that are already embraced in the commercial market.
• Pricing pressure should moderate as budget tightness wanes and the use of low-price/ technically acceptable (LP/TA) contracting is constrained by law.
• Earnings and free cash flow generation is enhanced given the lower required tax payments which should free up some funds to enhance new business efforts.
• The last five plus years have seen providers meaningfully “lean up” their organizations to remain cost competitive with their wrap (overhead) rates suggesting some amount of operating leverage. 
  
   

The author knows his reputation in the industry is that of “Mr. Sunshine,” so he would like to offer some additional context to consider this good news.

• Outstanding bids on larger contracts that are sometimes stuck in multi-year long decision cycles still reflect pricing indicative of the tight BCA period of 2012-16 and in some cases 2017.
• Clients have not completely given up on LP/TA like pricing even when not appropriate, in our view.
• Most providers would suggest that current capability/ capacity of the contracting system could use some enhancement.
• Congress, with their late completion of regular way appropriations, has once again challenged a stretched contracting system by leaving a very brief window (by September 30th) to deploy the GFY18 appropriated funds onto the contracts. We hope efforts to get Congress to extend some of the deadlines prove successful as we expect appropriated dollars may be “left on the table” again this GFY.
• Given the tight deployment time-frame, look for a significant increase in scope of existing contracts as opposed to the decreased scope of recent years. This should favor incumbents. We expect new initiatives/ contracts to be more focused on the GFY19 award cycle.
• Our sense is that competition for major re-competes has yet to ease.
• With contract awards again expected to be biased to GFQ4 (September), the impact on revenue is not likely to be meaningful before the first calendar quarter of 2019, but then should be sustained for an extended period of time.
• Although sector CEOs have recently banded together to push Congress and the Administration to improve the much maligned security clearance process, improvement remains very slow. We believe finding and retaining the appropriately skilled and cleared personnel will be the number one limiting factor to potential revenue growth. 

Industry Consolidation Should Accelerate
As demand prospects improve, driving enhanced financial visibility, we expect to see ongoing provider consolidation to extend capabilities into new clients and expand service offerings. We also expect to see renewed interest by those outside the government contracting community.

The market has already been surprised by two transactions this year. First, staffing firm On Assignment (ASGN) entered the federal space with the purchase of ECS Federal, which greatly expands the staffing firm’s addressable market. ASGN believes its staffing expertise can yield a competitive advantage to ECS allowing them to fill sometimes numerous open recs and therefore limit lost revenue. Second, General Dynamics Information Technology (GDIT) announced all cash purchase of CSRA (CSRA) that builds a $10 billion IT focused powerhouse. It again raises the question of “does size matter.” We still struggle with that one and those we speak with offer views from both ends of the spectrum. Given the initial success of Leidos’ acquisition of the services arm (IS&GS) of Lockheed Martin (LMT) creating an approximately $10 billion provider, we have a modest bias to “bigger is better.” 

Of course the low-end of the market is dominated by the protected class of small business (SBA) providers that get nearly 25% of award activity directed to them. The challenge with the SBA incentives is you can only get so big. We expect an increasing number of them will become available as larger providers seek to fill in client and offering needs, while the sellers seek to monetize their hard work. 

This leaves us with the mid-market. Let us call it from $200 million to $3 billion in revenue size. We expect this group to be increasingly challenged given a lack of client and offering breadth, as well as less attractive wrap rates.

Exhibit 1 provides a list of the larger public, private and subsidiary service providers and some of the smaller public ones. We expect this list to be a little shorter in the next year or so. We also could be adding a few new names as units are spun-out to capture the current valuation of the publicly traded companies. In addition as rates rise, purely debt driven strategies will become more challenging, which should benefit those public providers with strong (equity) currencies. While the defense “primes” (other than GD) seem to have little interest in expanding their services exposure, the private equity firms may have interest given the improved sector prospects and historically strong cash flow characteristics. We do note that some private equity (PE) firms have been sellers of late (e.g. PE Veritas and their Vencore unit), but we believe this reflects more the aging of those investments within the PE’s portfolio.

Exhibit 1. Selected Government Service Providers, by revenue:

Note: GD, NOC, KBR, PAE, DynCorp, BAE, Peraton, Vectrus, Unisys and KeyW are not covered. GD and NOC are covered by Wells Fargo Securities, LLC Analyst Sam PearlsteinNote: All forward figures for NOC TS, Vectrus, Unisys Federal and KeyW reflect the midpoint of management guidanceNote: Pro Forma DXC/USPS + Vencor e+ Keypoint reflects October 2017 investor presentation. Note: Pro Forma KBR figures include approximately $500MM revenue from pending SGT acquisition; BAE and PAE per articles in Washington Business Journal (in April 2015 and June 2015, respectively), Peraton per press article on sale to VeritasNote: All other figurers are Wells Fargo Securities, LLC estimatesNote: Guide figures represent the midpoint of guidanceSource: Company data, Factset and Wells Fargo Securities, LLC estimatesrecs 

What Do Investors Want Now?
During the 2000s when organic growth was consistently in the low teens, many companies came public with several later consolidated. We note service providers we once covered that were acquired by private equity or absorbed into larger entities:  
American Management Systems, Anteon, CSRA (pending), DigitalNet, DynCorp, NCI, SI International, SRA, Stanley, Titan and Veridian.
During the first half of the current decade, revenue growth has been challenging, if not non-existent, so the better run organizations focused on returning capital to investors. We credit Booz Allen (BAH) and their then PE owner Carlyle Group with shifting the focus to margin enhancement and cash return optimization. Nearly all the other public providers followed suit.
Now, with the expectation of an expanded market opportunity, accelerating growth and an improved tax profile, the providers are debating a shift in capital deployment to growth enhancers, i.e. M&A. We believe investors are still adjusting to this change in corporate focus. While they would like to capture the growth, they have come to enjoy the strong cash returns. We believe the investor profile will continue to shift toward growth over value/return as the improved growth outlook leads to upward estimate revisions. 

Valuation
We look at valuation for the government service providers in three distinct periods. First, the period after the September 11th attack brought a significant uptick in federal spending (roughly a doubling of defense outlays) and significant opportunity for a new breed of government service providers, particularly those focused on supporting the war-fighter either directly or indirectly. As seen in Exhibit 2, this period saw above average valuation as defined by enterprise value (EV) divided by earnings before interest, taxes, depreciation and amortization (EBITDA). 

Second, as troop levels in Afghanistan and Iraq dropped precipitously in the last 2000’s, revenue growth decelerated, competition increased and Congress began to acknowledge the size of the annual deficit. This led to the Budget Control Act (BCA) of 2011, an incomplete piece of legislation, in our view, which created years of no budget growth, but more importantly, uncertainty around spending priorities. The BCA contributed to valuations falling well below historic averages and M&A activity being all but non-existent as the visibility of contract waterfalls began to dry up. The valley of despair came with the sixteen day government shutdown in October 2013. While the turn in fundamentals was still several years away, value investors saw the attractiveness in the sector’s strong cash flow and the service providers’ willingness to return it. So the bounce off the bottom for valuation was driven by the strong return of capital during a period in which the overall economic recovery remained sluggish.

We believe the third leg began with the election of Donald Trump as President and the increased focus on national security spending. We note that the shares of the government contractors moved up about 20% in the days following the November 2016 election when the S&P500 index went up about 5%. The recent two year budget deal that dramatically raised the spending caps under the BCA, and the tax reform bill, should be viewed as the fulfillment of the Trump promises 
(i.e. spend more on defense, reform taxes and reduce regulation). While we could see modest improvement in the EV/EBITDA multiple from here, we are more likely to see improved EBITDA levels given higher revenues, and increased M&A activity to improve positioning and accelerate growth. 

Exhibit 2. Annual Price Performance Relative to the S&P500:

Source: FactSet and Wells Fargo Securities, LLC

Of course the challenge for Boards and management will be that investors always prefer their return sooner rather than later. This means a preference that publicly traded companies be sold (at a premium) rather than be a buyer focused on enhancing longterm shareholder value. We see the worst case scenario for investors is the Board/ management pursuing neither strategy as we believe this will only erode their competitive position and long-term value. One of the challenges of the “buy” approach is that most (not all) of the publicly traded providers already have financial leverage of about 3x net debt/EBITDA. While recent comments by managements suggest a willingness to temporarily let that rise to 5x, this could limit the amount of revenue expansion driven purely by debt financing.

So, will investors embrace new equity issuance to help drive value creation during this third period that should be defined by significant organic growth opportunity? In a way they already have with the Reverse Morris Trust (RMT) transactions of Engility 
(EGL) and privately held TASC, Leidos with Lockheed’s IS&GS unit, and the proposed DXC Technology’s (DXC) USPS unit with privately held Vencore and Keypoint. All create new equity shares that need to be absorbed by the market. We note that CACI (CACI) pursued a cash (25%) and stock (75%) deal for CSRA, as well as did another unnamed bidder. Investors seek growth, and as noted above the sector is coming out of a period of retrenchment into one of expected significant growth. We would expect to see new capital move into the sector.

In conclusion, we see a significantly expanded market opportunity with the bigger contracts being won by a smaller group of leading larger service providers. We look for a modest improvement in the EBITDA margin after a step up in new business expenditures and potentially investments in intellectual property. We see sustained, and even more visible, strong operating cash flow and limited capex requirements. Industry consolidation should continue, and new entrants (investors) are likely given the dramatically improved demand and therefore revenue visibility. So the sun is shining, especially for the best managed providers.

Source for cover image: © iStockphoto.com

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