Integrators see dark clouds, some sunshine

The ongoing conflict in Iraq coupled with shifting agency funding priorities, tightening budgets and increasing pricing pressures are complicating the business outlook for contractors as the federal fiscal year nears an end.

The situation appears most acute in the Defense Department and, particularly, the Army. The service disclosed in mid-July that it would extend spending restrictions imposed in May to the end of fiscal 2006 and into fiscal 2007.

“Recently there have been concerns that our industry may have entered a challenging funding environment due to the escalating cost of the conflict in Iraq and potential delays in [passing] appropriations bills,” said Brad Antle, president and chief executive officer of SI International, during the company’s recent earnings call.

“We are closely monitoring the federal government funding environment and recognize that some of our customers are facing challenges in government fiscal 2007 and beyond,” he said.

Renny DiPentima, president and chief executive officer of SRA International, said the situation in Iraq will continue to put spending pressures on DOD. “The war effort has caused some customers to redirect funds away from [information technology] initiatives,” he said.

Russell Freeman, chief financial officer at Perot Systems, said he has noticed cautiousness in spending but is hopeful that the situation will reverse itself in the second half of 2007.

Some executives hope the weakened funding situation will be short-term. In the meantime, they say they are concerned that tighter funding could dampen growth and cause pockets of weakness in DOD sectors. Specifically, program management, systems engineering and technical assistance support could face spending cuts, they said.

Impact on growth

Antle said funding pressures could push SI’s near-term organic growth to the lower end of the company’s annual target of 10 percent to 15 percent. Organic growth represents revenue from existing operations and not from acquired companies.

But the tighter funding environment has already affected discretionary spending, which SRA executives said fuels the purchase of such “rebillable” items as software licenses and hardware. Stephen Hughes, SRA’s chief financial officer, reported that revenue from rebillables dropped more than $7 million in the company’s fourth quarter, which ended June 30, compared to the third quarter. SRA had reported such a possibility in a May earnings call.

However, it appears contractors have focused most of their attention on monitoring the Army’s spending moratorium.

Robert Nabors, director of DOD and Army programs at EDS, said the Army continues to pursue its transformation initiative and the base realignment and closure program, which requires upfront investment to realize projected cost savings.

Although the current environment hasn’t affected EDS’ work with the Army, it has had an impact on new business. “What I’ve seen is a slowdown in terms of new contracts, new task orders and new work,” Nabors said.

Austerity and outsourcing

DiPentima said government austerity can actually create business opportunities. A service forced to reduce its staff, for example, will offload work to contractors or acquire IT to make the remaining employees more productive, he said.

Antle said SI International’s outsourcing puts the company in a position to grow in a period of fiscal restraint. Outsourcing, he added, often lets government entities reduce program costs while coping with the growing shortage of federal employees.

Low price, high anxiety

The government’s budget-consciousness has increased pricing pressures, which could result in a change in the way agencies award contracts and put contractors into a confusing situation.

Renny DiPentima, president and chief executive officer of SRA International, described a cycle in which federal agencies award contracts based on lowest price. Then, when they become dissatisfied with the results, they eventually return to awarding contracts based on best value.

“I think we are currently in that cycle of budget pressure making low pricing more attractive,” he said. But not everyone in government has abandoned best value, he added.

— John Moore

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