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August 14, 2018 | International, Aerospace, Naval, Land, C4ISR

For IT companies, the secret to success in defense is all about big growth


WASHINGTON — The secret to tackling the defense information technology market may be scale.

Looking specifically at the pure-play IT companies that landed on the 2018 Defense News Top 100 list, many of those that have doubled down in some capacity saw defense revenue increase during fiscal 2017. That came on the tail end of another trend among the largest defense primes, to get out of the IT business.

“The evolution started a couple years ago, where the large defense primes who had boned up on IT service work during the war [on terror] started to realize that for a variety of reasons they might not be able to compete as effectively, or extract the returns they want out of a business like that,” said Jon Raviv, senior analyst and vice president for aerospace and defense at Citi Research.

Divestitures followed, and pure-play IT companies were able to quickly scale up not just in size and their ability to support massive contracts, but also in capability set. The acquisition of Lockheed Martin's IT business transformed Leidos from a $5 billion company to a $10 billion company. That deal closed in late 2016, explaining how the company saw double-digit growth in defense revenue in both 2016 and 2017 — despite the buy actually making the company less defense heavy overall.

Similarly, CACI closed on the acquisition of L3 Technology's National Security Solutions for $550 million in February 2016 — three months before the end of its fiscal year. The associated revenue contributed to the 16 percent increase in defense revenue during 2017.

Leidos CEO Roger Krone, in an interview with Defense News in 2016 soon after the acquisition closed, pointed to “scale, but not scale for scale's sake” as a big factor in the buy — noting, too, the importance of balancing the portfolio and geographic distribution. He also pointed to sheer numbers — 15,000 employees specifically — many with security clearances.

The trend does seem to be continuing. CSRA chose to not participate in the 2018 Top 100 because its $9.7 billion acquisition by General Dynamics closed by the time data collection for the list kicked off. While General Dynamics is a top defense prime, its IT business functions as a largely separate entity, similar to the pure-play IT companies. The acquisition of CSRA, which reported $2.25 billion in defense revenue for fiscal 2016 — will add significant scale to GDIT. It is also likely to influence the company's Top 100 rank next year.

The future promises more cyber and IT-related merger and acquisition activity in the vein of that deal, according to Daniel Gouré, a vice president with the Lexington Institute think tank.

“Raytheon is still in acquisition mode with cyber, so it's an area that's still kind of churning,” he said. “I wouldn't be surprised to see some of these big players acquire some of the more defense-oriented cyber players.”

Unclear is what the sweet spot may be for those exclusively IT-focused firms.

“Where we sit right now, it's not clear what the right size is,” Raviv said. “GDIT and Leidos are about $10 billion in sales; SAIC and CACI and ManTech are lower tier. All of those companies say they are happy with scale but could do a deal. Whether they call it scale, or marrying capability sets — it's all marketing, I suppose.”

And there are other tactics that achieve scale without acquisition. Perspecta emerged on the 2018 Top 100, having launched June 1, 2018 through the combination of DXC Technology's U.S. public sector business, Vencore, and KeyPoint Government Solutions. As one entity, Perspecta reported $2.73 billion in defense revenue and ranked 37. To put that in perspective, Vencore ranked 67 in last year's list, with $886.59 million in defense revenue. And all of these pure-play companies are increasingly marketing themselves as conduits to the “nontraditional players” that the Pentagon is so keen to attract. Amazon Web Services, for example, will often partner with government IT companies on defense contracts to hand off some of the contracting morass.

That said, for all the potential, the bulk of the defense IT market is notoriously fickle. Services often set aside IT projects in an effort to preserve platform buys, and margins can be low. Agencies also struggle to balance upkeep of existing systems versus modernization efforts versus research and development into the next great technological marvel.

But as Raviv noted, it's all IT.

“Yes, there are companies working on high-end cyber, the ability to launch attacks through cyberspace or to harden the communication node on a new missile so it can't be hacked by, say, China. And while the word cyber came up a lot three or four years ago, now you hear a lot about AI, autonomy and machine learning. But it's all technology. And it's a lot of smart people working on a lot of advanced things many of us don't understand.”

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"To achieve this outcome, we must increase funding for shipbuilding and the readiness that sustains a larger force. Doing this, and finding the money within the Navy budget and elsewhere to make it real, is something both the Navy leadership and I are committed to doing. The Pentagon sought $207 billion for the Navy in its fiscal 2021 budget request. Even a 2 percent shift under that top line would represent $4.14 billion in extra funding for shipbuilding — real money, even by Pentagon standards. The call to shift funding toward shipbuilding comes amid an accelerating naval arms race in the Pacific, with China investing in both a massive fleet and shore-based, long-range anti-ship missile capabilities to keep the U.S. Navy's powerful carrier air wing out of striking distance. China is building toward a fleet of as many as 425 ships by 2030, according to the Center for Strategic and International Studies, while the U.S. Navy is building to a fleet of more than 355 ships, Esper said. The decision to increase shipbuilding funds, which Esper billed as a “game changer” in his remarks, comes as a result of an internal “Future Naval Force Study,” led by Deputy Secretary of Defense David Norquist. That study — which essentially superseded a review from the service itself — was delivered to Esper this week. That envisioned fleet will include a number of unmanned systems that will “perform a variety of warfighting functions, from delivering lethal fires and laying mines, to conducting resupply or surveilling the enemy,” Esper added. “This will be a major shift in how we will conduct naval warfare in the years and decades to come.” In his remarks, Esper said the forthcoming study “will serve as our guidepost as we decide on, program and build out future fleet and conduct follow-on assessment in select areas.” “In short it will be a balanced force of over 350 ships, both manned and unmanned, and will be built in a relevant time frame and budget-informed manner,” he added. Part of the increased funding could come from Congress shifting around authorities. Esper called on the defense committees to allow the service to “put unused end-of-year Navy funding directly into the shipbuilding account, rather than see it expire.” Traditionally, unspent dollars at the end of the fiscal year are no longer usable by the military. But an internal shift in the Navy's budget, without a corresponding overall increase, means a shift in priorities elsewhere — likely, at least in part, through the retirement of older systems. A key question is whether the Navy will need to fully fund the budget realignment from inside its own coffers, or whether the Department of Defense will realign its own priorities to cover any of the increase, something Esper has been hesitant to commit to in the past. The Navy's shipbuilding budget has been squeezed by the arrival of the Columbia-class ballistic missile submarine, the exorbitantly expensive next generation of nuclear deterrent-bearing boats. Adm. Michael Gilday, the chief of naval operations, said in a January speech at the annual Surface Navy Association symposium that the DoD budget should be realigned to cover the cost of the new Columbia class because it is eating a disproportionate share of the shipbuilding budget at a time the country is trying to grow the size of the fleet to match China. Even a single percentage realignment would make a difference, Gilday argued. To compare, he said, the Navy's budget in the 1980s — when it was building the Ohio-class ballistic missile submarine — was much higher than today's budget. “One percent of the DoD budget would be $7 billion per year in the shipbuilding accounts,” the CNO explained. “If I make some comparison from today and I go back to the 1980s, there are some similarities there.” “Right now we are building the Columbia-class submarine. That is my highest priority,” he added. "By the time we sundown the Ohio class, we'll have 42 years in those hulls. We need to get Columbia out there. “Now, let's go back to when we were building Ohio in the 1980s: It was about 20 percent of the shipbuilding budget. Right now, Columbia is about 20-25 percent. In FY26-30 it's going to be about 32 percent. That's a lot of dough. In the 1980s, the Navy's percentage of the DoD budget was 38 percent. Right now, it's 34. So I think historically I have a case to make.” Jerry Hendrix, a retired Navy captain and analyst with the Telemus Group, said the recognition that the DoD is underfunding shipbuilding is a big step. “It sounds like he [Esper] has recognized that given where we are going with the Columbia class, that the Navy needs more money for shipbuilding, and that's an important recognition,” Hendrix said. “The other part of this is: Is this coming from the Navy's budget, or is it coming from the DoD budget? Because the Navy still needs the rest of its budget to do training and readiness. So that is a very important aspect of this.”

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