Government contractors on the whole are optimistic about future business. More than half grew their revenue year over year. They expect more growth as the government adopts artificial intelligence. The most recent contractor survey conducted by Deltek also shows small businesses have outsized challenges. The Federal Drive with Tom Temin got more from Deltek Senior Vice President Kevin Plexico.

Interview transcript:

Tom Temin And so the contractors are optimistic, but maybe a little bit worried about appropriations coming on time, which is a legitimate worry. And the upcoming election, also a legitimate worry.

Kevin Plexico Yeah, I think overall there’s a favorable outlook on the market that we saw in the survey results. A little bit lower optimism compared to last year, but not by much. But I think, if you think about the timing when we did the survey in January, appropriations for 2024 were not done yet. And we also have the looming elections, which creates uncertainty around what to expect in terms of the political landscape and how that might affect the funding outlook as well.

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Tom Temin Right. And especially pronounced, I would think, this year, because the election seems to be up for grabs between such diametrically opposed philosophies, parties, candidates. That does tend to depress agencies’ fervor for pressing ahead with new spending late in a fiscal year.

Kevin Plexico It’s not only the administration could change and there’s very different views there, but I think there’s also a lot of uncertainty in the leadership of Congress as well. And even that’s in play with this election as well. So it’s not just even the administration and presidential election, I think, that’s creating some uncertainty around the direction that we might take with agency outlook and funding outlook and political priorities that we see ahead. It really depends on Congress as well.

Tom Temin And there’s a lot of odd effects in the market lately. I’m looking at the CMS recompeting a contract that, by all measures, was being conducted more than satisfactorily by a services contractor, but they want a new contractor. Or if the incumbent wants to stick with it, they’ve got to enter into an agreement with a union and then have certain provisions of no-strike in order to continue that contract. That kind of provision and insertion we’ve never seen before. And I wonder how that has an effect on how contractors think.

Kevin Plexico I mean, that’s certainly unusual. And I think the labor market is definitely an area of challenge that a lot of contractors are facing, not just this particular issue, but just in general. We’re in an economic environment where labor costs and costs in general have been going up more rapidly than they have historically. Generally, the government contracting markets have been relatively insulated from the economic conditions. But I think we haven’t had inflation like we’ve had the last couple of years for a long, long time. And that’s created some unusual environmental factors. I think most government contractors have contracts that are negotiated and the prices are negotiated upfront, and then they have to adhere to those prices over the course of the entire five-to-10 year contract. So you have a lot of companies that are wrestling with how they continue to operate under contracts, where the prices that they initially negotiated are now a lot harder to adhere to given the price pressure in the labor markets.

Tom Temin Right. It becomes pulling teeth to get the government, especially on the [Defense Department] side, to release funds to compensate for even in cost-plus contracts.

Kevin Plexico It’s not like the government is getting extra money for inflation as well. So the government agencies that are looking at the vendor like, “yeah, we have that problem too. So we need you to live up to the contract you signed.”

Tom Temin And what about small business? Because the line has been that small business participation is on the upswing in terms of the percentage of dollars from contracting, but the number of players is shrinking. And one of the cited reasons for that is the amount of regulation for federal contracting that comes down in a lot of areas energy, labor policy and so on.

Kevin Plexico First of all, the economic environment, I think, has an outsized impact on the small business community. And not only do we have higher inflation rates, but also with the Federal Reserve stepping in to try to raise interest rates in order to bring down inflation, we have higher interest rates, and most small businesses rely on borrowing to pay for their ongoing cash flow costs and investment. So I think they’re paying higher costs both in labor and in the borrowing costs. And at the same time, to the point you just mentioned, we’re seeing essentially a consolidation of contracts in the federal government, which is making competition a bit more fierce. There’s fewer prime contract opportunities and contract places to go around. And that has an outsized impact on small business. And at the same time, we’re seeing this growing swell of compliance costs, whether it be cybersecurity, increasing audits, supply chain regulations that are all creating an environment where doing business with the federal market is actually getting more expensive and the barriers are going up. And that has an outsized impact on the small business community.

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Tom Temin We’re speaking with Kevin Plexico, senior vice president for information solutions at Deltek. And the government spending itself never actually goes down. But yet at the same time, there are some procurement reforms cooking up. There’s section eight-oh-this-and-that panels coming from DoD. There is also the increased use of other transaction authority spending. What about the procurement picture? It seems like maybe strategies that have been held true for so long might need to be revised.

Kevin Plexico Yeah, I think the procurement environment is strong, and that’s where the optimism, I think, comes from. The government has continued to spend more money. We’ve had years of record appropriations in the last couple of years. It has gotten a little bit tighter this year and is expected to do the same next year with the bipartisan budget agreement that came out of the debt ceiling crisis that we had back — I guess it was around last summer. And so this year, with the appropriations that got enacted, you have some agencies that are doing pretty well. Defense Department got a 3.5% increase. Some other agencies are facing increases, but others got cuts that are pretty significant halfway through the fiscal year when they found out about it. So if you think about a cost cut or an expense cut on a budget that happens halfway through the year, you have to double down to make ends meet at the end of the year. And I think there’s a few agencies that are dealing with that issue, and that’s going to put pressure on contractors. So for contractors, I think it becomes a challenge of making sure they understand the inventory of the customers that they’re working with and how the economic and funding environment is affecting those particular agencies so they can operate smarter, be more strategic about where they’re competing.

Tom Temin And for contractors on the manufacturing side that make things, platforms and so forth. They’re still dealing with pretty significant supply chain issues, even though we’re having the COVID pandemic pretty much in the rearview mirror.

Kevin Plexico Yeah, I think there’s two aspects to the supply chain. The first is the ability to get the products that they need. That has gotten better than what it was during COVID, but it’s still there and still an issue and still is something that the administration is focused on: How do we make sure that the federal government gets the products and parts that it needs to be sustainable? But I think you’re also starting to see an emergence of a new set of supply chain challenges around where the products that the contractors are bringing to the government being manufactured. Ideally, they’re manufactured in the U.S. Absent that, we definitely don’t want them manufactured in places like China or North Korea or Russia. And we’re seeing, like the growing compliance requirements in other areas, we’re also seeing compliance requirements emerge in the supply chain world that are putting additional costs on contractors.

Tom Temin And getting back to that compliance cost. That’s a blanket that covers all contractors, whether they’re services contractors or not. All of the provisions coming along proposed or already in rulemaking and so forth, like [the Cybersecurity Maturity Model Certification], all have a implied threat that you could be caught in a False Claims Act situation if you don’t comply or if you state you comply, but they find somehow that you’re not complying with this or that provision. Does that weigh on contractors more?

Kevin Plexico I think what I’ve seen is a pivot in compliance in terms of how it’s administered and how companies think about it, to being a way that companies think about leveraging compliance for competitive differentiation. And I think one of the big changes that I’ve seen is it used to be that you would pursue an RFP and the compliance requirements would be spelled out in one of the sections of the RFP, like, “by the way, if you win this, you’ve got to comply with this, this and this.” And what we’ve seen is with the sort of adoption of these [indefinite deliver/indefinite quantity (IDIQ) and governmentwide acquisition contract (GWAC)] contracts, a lot of those compliance requirements are built into the section now in Section M, where they’re basically giving you points for your demonstration of your ability to comply with requirements. So I think what is separating the serious players in the market from the casual players is that dedication and commitment to compliance as a differentiator and an ability to separate yourself from other companies that maybe aren’t willing to make that same investment in the compliance requirements that agencies are looking for in order to do business with certain companies.

Tom Temin Yeah, that sounds like a fundamental shift where something that would just simply be a given table stakes, if you will, for every supplier. Now, just compliance with the law and regulation becomes a differentiator. That seems like an emerging trend that’s a little bit disquieting.

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Kevin Plexico Disquieting, or maybe just something that the savvy contractor needs to be mindful of if they’re serious about competing in the market. I mean, I think you think about this small business challenge and the diminishing number of small businesses, yet the growth in the small business contracting, those ones that take advantage of this opportunity, I’ll call it, to really get differentiation through compliance as well as your corporate capabilities, are the ones who are winning positions on these mega-billion dollar contracts. And when they win those positions, they’re set up to really have a very high likelihood of being successful on those contracts. And obviously, if you don’t win a position, you can’t win anything. So it really becomes an opportunity to differentiate and accelerate your growth. And the small businesses that are making those investments are the ones who are being successful in getting an outsized share of the market.

Tom Temin And for those so-called innovative contractors that have a brand new type of product or service that is increasingly being sought by DoD, but also in the civilian side, they have the pressure or the impetus to try to present themselves and for the government to see them as just plain old commercial. Otherwise, they’re stuck with having to invest in an accounting system that is compliant with the government audit requirements. Not the case if they’re just commercial, even if it’s a brand new type of innovative product. Little bit of a conundrum there.

Kevin Plexico Yeah. I mean, I think if you’re a company that has the best products in the world for what you do, it still might not be necessarily an attractive option for a government agency because of all the compliance requirements they have and want. Clearly, they are stipulating in these RFPs, they want people who have done and have the experience of doing business in the government market over in some respects, whether your corporate capabilities are super strong in a particular area, but they really aren’t willing to make the trade off. They want both. And that shows up in the way they’re evaluating the RFP, for sure.

Tom Temin So bottom line, still a good market to be in for profits and growth.

Kevin Plexico I think it’s a great market for those that are willing to make the investment in the compliance requirements and that are able to differentiate themselves. Once you have a government customer for a particular area of need, you have a great platform to expand your business with that customer and also expand your product offerings, which is, I would say, another area we’re seeing in the the data from the survey, is companies are making a conscious effort to expand their offerings. Once you have that compliance platform, it gives you a great opportunity to leverage that to providing other types of services to government agencies on that platform. Obviously, it’s a great market, stable market and one of the most stable markets you’ll find. But it does carry with it the cost of doing business, which can be a lot higher than a lot of other markets.

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