Budget cuts from the sequester continue to pinch the profitability of most government contractors, as federal agencies pay less and put off awarding contracts. However, companies that can compete successfully on price and manage their costs well should still thrive in the mid-to-long term.
Same for less
In the current tight budgetary environment, the U.S. government is seeking contractors who can deliver a minimum standard of services at significantly lower prices. One company that will fit the bill is Engility Holdings (NYSE:EGL), the country's largest pure-play government service company.
Engility provides a diverse range of services to the government, including systems engineering, training and program management, with no single contract accounting for more than 10% of its revenues. Prior to its spinoff in July 2012, Engility was part of L-3 Communications. Aligning itself with the feds' priorities, it has thrived by committing itself to competitive pricing.
During the company's Q2 2013 results conference call, Engility CEO Tony Smeraglinolo, quoted an unnamed customer who said that Engility was its only qualifying contractor because Engility could still bill at 2010 labor rates. Another example was the $68 million U.S. Navy Shore Networks contract announced in July 2013, for which Engility's pricing was 10% lower than two of its competitors.
If you want to compete on price, you must get your cost structure right first. The restructuring efforts Engility completed in Q1 2013, in which the company cut its indirect workforce to 60% of its original size, enable its competitive pricing.
Engility's peer Booz Allen Hamilton (NYSE:BAH), a provider of management and technology consulting services to the government, is also working very hard to drive costs down. Similar to Engility, it adopted a more decentralized organizational structure by reducing its number of divisions from 22 to eight. In addition, it is downsizing to smaller facilities as its current leases expire. This is in line with the company's increasing trend of working directly at its clients' sites, often at their request, which reduces reimbursements related to facilities cost.
Booz Allen Hamilton has acknowledged pricing competition, but claimed it will not price aggressively on all accounts to take market share. Instead, it will optimize its pricing strategy on a case-by-case basis, given the diversity of its projects.
Contract type plays a big part in a contractor's pricing strategy and cost management. Engility's cost savings from its restructuring efforts benefit the government directly, since it generated close to thre- quarters of its fiscal 2012 revenues from cost-plus and time-and-material contracts.
Under cost-plus contracts, the government pays Engility a fixed fee and certain milestone-based award fees for its services, and also reimburses it for allowable costs. Similarly, the government reimburses Engility for material and labor costs incurred under time-and-material contracts. For these two types of contracts, the government pays out less in reimbursements when working with a cost-efficient contractor such as Engility.
In contrast, Engility's competitor CACI International (NYSE:CACI) derived only about 28% of its revenues from fixed-price contracts historically, but has stated its intention to shift its focus to this type of contract work. It recently announced its proposed acquisition of Six3 Systems, a key contractor of the Department of Defense and other national security agencies in October 2013. Six3 Systems' high proportion of fixed-price contracts -- which represent some 70% of its total business -- was one of the key considerations for the transaction.
But although these fixed-price contracts are potentially more profitable, contractors run the risk of losing money if cost exceeds price. CACI's disclosure at the most recent Q1 2014 results conference call echoed these concerns.
CACI suffered a loss of $4 million on a significant fixed-price contract, due to two contributing factors. Firstly, there was a mismatch of revenue and expense recognition due to accounting rules. Revenue was recognized evenly over the period of the contract, while expenses recorded on the P&L were actual costs incurred. Secondly, expenses increased because of "a surge in customer requirements," according to management. Therefore, I prefer contractors like Engility with a lower proportion of fixed-price contracts, since they are less exposed to risks associated with cost overruns.
With the market generally disinterested in government and defense-related stocks in the current environment, there are hidden gems to be found among companies like Engility. It has shown a remarkable ability to be price-competitive, while still maintaining a low cost structure.