Federal contractors may be feeling only a budget pinch now, but sequestration — the automatic, across-the-board government spending cuts that went into effect March 1 — could threaten to squeeze some companies out of the industry.
In the first 2 1/2 quarters of fiscal 2013, the number of federal contract awards fell by 32 percent compared to a similar stretch of time the year prior, according to an analysis of federal procurement data compiled by Govini. The total value of awarded contracts also fell by more than 31 percent.
However, experts say there are strategies contractors can use to manage through the cuts, including both long-term planning and short-term coping mechanisms.
Many companies are already doing so.
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“Last year, around this time, people were looking at sequestration as something that could be avoided,” Kevin Plexico, vice president of information solutions at Deltek, told Federal News Radio as part of our multi-day special report, Private Side of Sequestration. “And now I’d say the outlook is sequestration is most likely going to be sticking around. So, I think companies are planning for the worst and hoping for the best, whereas last year they were planning for the best and hoping to avoid the worst.”
Companies need to reimagine, retool
With government spending declining and new business opportunities shrinking, many companies will need to find ways to reimagine themselves and to diversify their offerings into new business areas, experts told Federal News Radio.
Companies need to closely monitor how sequestration is affecting or will affect their existing business opportunities, as well as how their partner agencies are preparing for planned reductions, Plexico said.
“If you see a big impact, you have to start paying attention to where agency spending is more liberal and not facing the same steep reductions,” he said.
This so-called “white space” provides areas and opportunities where spending will remain a priority and that haven’t yet become over-saturated, he added.
This is especially important for DoD contractors who — even setting aside the budget cuts stemming from the 2011 Budget Control Act and a second wave of cuts from sequestration — would likely see diminishing contract opportunities and revenues as the U.S. military disengages from the long wars in Iraq and Afghanistan.
Companies are diversifying away from DoD “by necessity,” said Tom Captain, vice chairman of Deloitte LLP and the company’s U.S. aerospace and defense leader. “There’s just not enough work to go around anymore.”
For traditional defense companies, that means breaking out of their niches and updating their portfolios of products and services to realign them with new spending priorities. These include next-generation intelligence, surveillance and reconnaissance tools as well as both offensive and defensive cyber capabilities, Captain said.
Some companies are sticking with their traditional offerings, but shifting their customers, Captain said.
For example, foreign military sales in emerging markets such as Japan, India and Brazil, among others, are expected to increase and could help some big weapons- makers make up some of the difference from declining U.S. sales.
Finally, some companies are expanding their non-government work, adapting traditional defense technology for the commercial world.
The commercial aircraft sector, for example, “is experiencing a virtually unprecedented and prolonged up-cycle,” according to Deloitte’s 2013 Global Aerospace and Defense Industry Outlook.
One of the ways companies can quickly expand into new opportunities is through mergers and acquisitions, Plexico said.
More than 34 percent of respondents in Federal News Radio’s exclusive survey of contractors said their companies were engaging in mergers and acquisitions to prepare for coming budget reductions, including 16 percent who plan to access new markets and 11.4 percent who want to grow their contract bases.
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But Plexico said the continuing climate of budget uncertainty could put a damper on some industry moves.
“I’m probably going to be more inclined as a business owner to hold pat until there’s a bit more certainty and the valuations come up,” he said. “The behavior for most business owners would be, ‘Why would I want to sell now when the market’s probably in the worst state it’s been in the last 10 years and probably the worst it’s going to be for the next 10 years?’ So, I might be inclined to hold out for a couple of years and see if the environment improves before I sell.”
Short-term strategies take aim at cost-cutting
Beyond diversifying — whether through acquisitions or organic business development, both of which can take considerable time and resources — companies can also put in place shorter-term strategies to better manage the cuts.
Above all, companies are looking for ways to cut costs and reduce overhead, so they can remain competitive in pricing, said Ray Bjorklund, president of BirchGrove Consulting and a long-time analyst of the federal market.
According to Federal News Radio’s survey, contractors are undertaking a number of cost-cutting maneuvers. Sixty-three percent of respondents said their companies were reducing salaries and benefits, including bonuses, to prepare for ongoing budget reductions. About 36 percent of respondents said their companies were cutting technical experts at their companies, while 28 percent said their companies were cutting sales staff and business-development staff.
Companies, particularly small and mid-size firms, are likely cutting costs to remain competitive in pricing, Captain said.
“One of the ways they can be more competitive is to have scale economy,” Captain said. “And the way you gain scale economy is through size — spreading your overhead over a broader base. ”
But companies won’t survive sequestration only by cutting and thinking smaller. They’ll also have to think smarter.
The federal government is already looking for ways to shift contracting risk onto contractors. The administration has made moving away from high-risk contracts, such as cost-type and time-and-materials contracts, one of its top acquisition priorities.
Companies, themselves, now have to find ways to manage risk, particularly in the bidding process: “In pricing, in whether or not you submit a proposal and, even earlier, whether or not you even write a proposal,” Bjorklund said.
Overall, though, Bjorklund cautioned against thinking there will be a single silver-bullet solution for contractors.
“I don’t know that there’s a panacea or a perfect solution to a lot of these problems,” he said. “There are just a lot of rational business decisions that must be made.”
For many companies, sequestration is arriving just when they have begun to dig themselves out of the last financial crisis that roiled through the industry — the 2008 recession.
But there’s one big difference between then and now, and it could work in contractors’ favor, Bjorklund said.
“When government spending was contracting as a manifestation of the recession, it was something that nobody could really put their finger on — it was kind of intangible,” he said. “And so a number of those large companies and business units within those companies kind of put their heads in the sand.”
Sequestration has been rearing its head for much of the last two years, and lawmakers, industry CEOs and acquisition groups haven’t been shy in raising the alarm about the damage that could result from the cuts.
“When you start hearing those hard numbers, then it becomes much more evident,” Bjorklund said. “And so, unlike the recession where some people were avoiding addressing the problem so they could maintain their financial status, companies now, I think, are taking a little bit more concrete action.”
MORE FROM OUR SPECIAL REPORT, PRIVATE SIDE OF SEQUESTRATION:
Data Analytics: Sequestration’s impact on contractors by-the-numbers
Audio Interview: Government market ground zero