How defense contractors are adapting to today's demands

After several years of divestitures and portfolio reshapings by defense contractors, three large primes have kept their IT and government services businesses, choosing to reposition and differentiate themselves in a crowded marketplace.

And as speculation of more services divestitures has slowed down significantly, full-year 2017 results for the three continue to showcase the challenges and opportunities for each. This trio consists of General Dynamics, Northrop Grumman, Raytheon.

But beyond the numbers from 2017 is a larger theme of how these giants aim to stand out in a field that has seen commercial and other emerging players gain footholds in government IT and services. This has forced the primes still in to rethink their approach to the market and tie their services businesses more closely to their core defense work, analysts say.

“One way we’ve seen big primes deal with crowding of the space is to fundamentally tie information technology projects to the more tactical edge that can allow them to target a premium for security-related offerings,” said Chris Meissner, a principal at Avascent who focuses on public sector IT. “IT contracts that are called things like C2, modernization or C4ISR infrastructure are still fundamentally IT contracts. That nuance is different among the different major primes.”

Meissner told me the past decade in federal IT was an “explosion of competitive intensity” that has seen commercial entities like Accenture, IBM and Deloitte gain large footholds in government. Then there is the push for increased scale by more pure-play federal services firms like Leidos and CSRA to create additional competitive pressure, he said.

Technology trends such as cloud, cybersecurity and data center consolidation have also “created an environment where new entrants have been able to differentiate around new offerings,” Meissner said. “Existing entrants move up the value chain.”

Consider also the renewed emphasis by the U.S. military on maintaining its technological advantages in a geopolitical environment that also has seen emerging players and threats. Defense firms in the IT arena have emphasized innovation and positioning to address that, according to Joey Cresta, public sector IT analyst at Technology Business Research.

“Whether in traditional warfare or in emerging domains such as cyber, where the U.S. is clearly feeling the impact of clandestine efforts to undermine democracy and the U.S.’ status on the world stage, there is significant, lucrative and growing opportunity to address these challenges,” Cresta told me.

Northrop and Raytheon in particular have gone “all-in on addressing these pain points, almost exclusively and thus limiting their exposure to the broader IT services market,” Cresta added.

That is a contrast from General Dynamics’ strategy with its information systems and technology segment: one division is focused on traditional IT services and call centers, with a second focused on defense and space communications hardware. This places the defense contractor in a different risk profile against more competitors, particularly in IT services.

GD saw its information systems and technology revenue fell 2.8 percent last year to $8.89 billion. But the company did see a fourth quarter pickup from the prior year period from both its civilian and defense customers.

The contractor now forecasts information systems and technology sales to increase 4.6-5.7 percent this year and 5.5-percent compound annual growth through 2021. And its operating margin saw a big jump last year to 11.3 percent from 10.2 percent in 2016. That indicates solid return on investment for a segment that requires lower capital investment than the shipbuilding and land vehicle businesses, plus generates cash to support those larger platform businesses.

General Dynamics does face a headwind this year as it awaits a decision from the Army on the future of the WIN-T communications program for which it is the prime contractor. Cresta told me this secure communications area is one of opportunity for the company to increase its innovation efforts.

“The challenges with WIN-T are a microcosm of the broader challenges facing the DOD due to technological advancements that erode its traditional advantages – cyber and electronic warfare capabilities reducing the reliability of the networked communications systems,” Cresta said.

For Northrop, its IT approach has translated to a retuning of its technology services portfolio away from what it sees as commoditized IT work. In its place is a two-fold approach: more discipline on what the segment bids for and increased focus on the “higher class of services” as described by CEO Wes Bush in an Oct. 25 conference call with investors.

This shift has also meant revenue declines by design as 2017 sales fell 1.4 percent year-over-year to $4.75 billion. The company expects revenue to fall further into the mid-$4 billion range this year. And Northrop’s treasurer Stephen Movius said at the February 2017 Barclays Industrial Select Conference in Miami that segment sales will fall again to the low-$4 billion range next year.

Of course, those forecasts were made before Northrop announced in September last year its acquisition of Orbital ATK, which will become a fourth segment for Northrop. Cresta said this will pull Northrop even further into classified programs with long-term service requirements: a potential second boon for Northrop.

But like General Dynamics, the bottom-line performance for Northrop’s technology services business has held steady. Operating margin for Northrop’s service business was 11.4 percent last year from the 10.3-percent recorded in 2016.

Raytheon has also held its intelligence, information and services segment steady in recent years. The contractor reported flat IIS sales of $6.18 billion last year and is forecasting this year at little-to-no growth either. Also forecasted is a modest operating margin increase to the high 7-percent range this year from mid-7 percent range last year.

But its strategy of staying away from enterprise IT and instead focusing on specialized technologies is more about looking down the road, especially in cyber as evidenced by its recent win of the $1.2 billion “Domino” Homeland Security Department contract.

“Investments in analytics, artificial intelligence, utilization of agile and DevOps methodologies, all show that Raytheon sees that the trends defining the commercial IT market are going to slowly infiltrate the defense sector,” Cresta said. Raytheon’s recently-announced relationship with Pivotal, a company with a cloud platform for building software, is one example of that push.