By Joseph Walent, Analyst
General Dynamics Information Systems and Technology struggled to avoid contracting sales, even without the impact of noncash charges
New Chairman and CEO Phebe Novakovic took leadership of General Dynamics amid continued uncertainty in the federal IT services conditions. The prolonged adverse business conditions in the federal IT services market revealed the weaknesses in General Dynamics Information Systems & Technology (IS&T) operating model in 4Q12. IS&T revenue contracted 11.8% year-to-year to $2.58 billion, with continued downward pressure on Tactical Communication Systems business and lower volume in Information Technology Services business. For the full year, revenue was down 10.7% to $10.0 billion for 2012 from $11.2 billion in 2011. The cuts to legacy programs, expiration of short-term contracts used in IT services delivery, the shift to “lowest price, technically acceptable” in procurement policies and increased reduction of scope on current engagements were all significant factors in the reduced earnings.
The reduction in business necessitated the re-evaluation of the IS&T group’s book value, requiring a goodwill write-down of $1,994 million for the company. Like CSC and peer Raytheon, General Dynamics IS&T had been aggressive in its acquisitions for the last 15 years, but was less successful in integrating those purchases to maximize revenue growth potential. TBR anticipates an informal moratorium on M&A activity as General Dynamics IS&T concentrates its focus on optimizing its operations and extracting organic growth opportunities.
The mix of IS&T revenue continued to shift to lower-margin IT service delivery, and away from higher-margin tactical communication systems and ISR solutions during 4Q12, compounding the impact of the noncash write-down against goodwill and inventory, wiping out profits for the quarter and the year. Operating margin for 4Q12 was -78.2% during 4Q12, and -13.7% for the year. Removing the impact of the one-time charges, 4Q12 operating margin was 5%, and 8% for the full year. TBR believes IS&T will face additional charges against profitability in 2013 as it seeks to restructure its operations to drive longer-term profitability and invest in high-growth areas where it currently operates.
The increased frequency of recompetes and “lowest price, technically acceptable” standards reduced pricing power
Public sector budgets cuts are considerably altering the government contracting market due to a renewed focus on price and increased competition caused by the growing scarcity of programs up for bid. Government procurement decision makers are increasingly looking to “lowest price, technically acceptable” standards to accommodate tighter budgets. TBR believes that pricing will continue to take precedence over value due to the government’s ability to squeeze value out of the contractors by leveraging the extremely competitive bidders’ needs to attain revenues, even at the cost of margins.
General Dynamics faced several recompetes recently such as the Vangent CMS contract and the ITES-2S task order. Recompetes have increased industrywide due to government agencies using them as a way to cut costs. The emergence of recompetes has pushed margins down due to the incumbents’ willingness to lower their prices to hold on to contracts and competitors willing to do the same.
IS&T is accelerating its shift to more value-added IT services and products
IS&T is actively shifting to more value-added services and products due to downward pressures on margins for commoditized offerings. This pressure is coming from budget cuts that reduced the number of contract opportunities, leading to more competition for contract awards. An example of this shift can be seen in IS&T’s discontinuation of its ruggedized computer business. The business was largely driven by price and was getting more crowded, without a competitive advantage or value add, IS&T made the quick decision to move on.
TBR believes that acquisitions will play a key role in building value in IS&T’s offerings by merging the acquired companies’ technology with current offerings to strengthen capabilities. IS&T’s acquisitions of Fidelis, OpenKernal Labs and Vangent brought additional value to existing offerings due to their value-added offerings that are better protected from pricing and margin pressures. In FY2013 IS&T will look to ally with companies that have proprietary solutions in high growth areas of government IT services spending, especially cyber, mobility and healthcare.
IS&T is preparing to sell more ISR capabilities to Asian allies
IS&T is making a push to sell ISR capabilities to Asian allies in lockstep with the U.S.’s strategic pivot of focus to Asia. The group is looking to exploit the U.S.’ wishes that its allies have the ability to monitor their neighbors and collect accurate intelligence in a timely fashion to reduce the chances of misinterpretation that can often lead to unnecessary conflict.
The firm will look to sell its geo-intelligence, electro-optical offerings and other ISR related capabilities. IS&T recorded a recent success with the delivery of its D-VEX video capture and analysis solution to the Australian armed forces.
Please feel free to use this content or call/email Joseph Walent (603-929-1166) for additional commentary.
