Government services: Can value be created or is it time to move on?
After two decades of growth, U.S. federal agencies are reining in spending, signaling an inflection point for the government-services industry. Some companies will determine that they can create more value for shareholders by exiting the market. Those that stay will need to overhaul their strategies, cost structures, and operating models to prosper in a slowing market that is ripe for consolidation.
Government services Can value be created or is it time to move on?
DC Martin J. Bollinger Senior Executive Advisor +1-703-682-5750 marty.bollinger @strategyand.pwc.com
Los Angeles Joseph Martin Partner +1-424-294-3745 joseph.martin @strategyand.pwc.com
New York Randy Starr Partner +1-973-410-7604 randy.starr @strategyand.pwc.com
This report was originally published by Booz & Company in 2012.
Budget pressures are forcing U.S. federal agencies to rein in the spending that fueled two decades of rapid growth in the governmentservices industry. Some companies will take this downturn as their cue to exit the market, while others will see opportunity in an industry seemingly ripe for consolidation. Those who choose to stay may need to overhaul their strategies, cost structures, and operating models to prosper in a slowing market where size may matter more and pricing has become an increasing source of pressure.
The government-services industry has reached a crossroads, as a long spending boom in contractor-provided services gives way to an era of shrinking budgets. The original value creation rationale of a highgrowth market is no longer valid, raising a question about which strategy is best for creating sufficient value for shareholders. It is important to understand that the recent period of high growth in services was a historical aberration — partially driven by a one-time structural adjustment in the market as supply shifted from government employees to contractors. Making matters worse, new entrants and restructured players are dragging down pricing, thereby creating intense pressures on sales and profits in some segments. This will likely continue for the foreseeable future. Some corporate leaders may see this as a good time to exit the industry. Others may see the environment as an opportunity. Indeed, by most measures, the U.S. government-services industry should be ripe for creating value during a downturn. For the first time in history, services will soon constitute more than half of the contractor-addressable defense spend. Furthermore, U.S. government services is one of the most fragmented industries — the combined revenue of the top 180 suppliers represents barely 70 percent of the total market. Companies that view this situation as an opportunity may need to adopt new strategies, align their cost structures to differentiating capabilities, and adjust their operating model to fit the needs of an environment that requires more coordinated control. Those that are able to do these things could generate significant shareholder value. Of course, executives will need to determine whether the cost of making these adjustments exceeds the divestiture or run-out costs of their business. Regardless of the answer, companies should decide on a course of action now. In fact, in some segments, it may be too late to exit at a reasonable premium; in these cases, it is even more urgent to adopt the approaches outlined in this report.
Creating value in government services
For the past decade, many government-services companies created value simply by “riding the wave” of spending in the US$200 billionplus market, which grew at an 11 percent annual rate from 2001 until 2009. They expanded to meet surging demand, but did little to create efficiencies or capture economies of scale as they grew. Furthermore, few companies managed to grow faster than the market. Though some doubt that the “doomsday” cuts envisioned by the federal budget sequestration process will come to pass, few question that government-services spending will continue to slow even without sequestration. Indeed, the U.S. government-services market has been effectively flat since 2009, returning to a more natural market-growth profile that was distorted during the preceding years. If companies can no longer count on organic market growth to create value, they will need new strategies to attain that goal. Our experience suggests three important actions that can contribute to value creation in U.S. government services during a downturn: 1. Cut costs to invest for competitive advantage. 2. Consolidate and capture economies of scale. 3. Align operating models to the needs of the environment. 1. Cut costs to invest for competitive advantage Government-services providers can’t escape the reality that success in many market segments has become more highly dependent on price. Competitive rivals faced with fewer contracts see each competition as a must-win, almost regardless of cost. This dynamic has effectively been under way in portions of the services market for the past three years; quoted hourly service rates have been declining across many portions of the market since 2009 (see Exhibit 1, next page). This is similar to the recent experience in some hardware markets, where certain contractors
If companies can no longer count on organic market growth to create value, they will need new strategies to attain that goal.
Exhibit 1 Hourly service rates have been declining since 2009
Median quoted hourly labor rates for U.S. government-services businesses (in constant 2011 dollars)
15% Change from peak -4.7% 5% Change in quoted median rates relative to 2006 quoted median rates
0% -9.0% -5% -7.9% -8.5% -7.8%
Segment Segment Segment Segment Segment
#1 #2 #3 #4 #5
Source: INPUT, Strategy& analysis
are compressing margins to maintain their share of decreasing volumes. If this is unchecked going forward, contracts in certain services segments will go to the bidder offering the lowest price, regardless of other factors. So how to compete in this kind of a market? Those who win in the end will have to think about their costs as investments — that is, every dollar of expense should ideally be an investment in a capability that will make your company more competitive. With this in mind, executives may want to consider focusing on the few differentiating capabilities that reflect the intrinsic value of the business — and therefore increase the company’s ability to win by providing more value to the customer than others can at an equivalent or lower price. To reduce your costs, invest disproportionately on developing and deploying those capabilities. In so doing, not only will you shift the competitive dialogue to areas where you have a distinct advantage, but you will be able to compete more effectively on price as well, because you will be spending less money on non-differentiating overhead. Specifically, services company executives will want to be able to answer at least the following questions: • For each segment, what capabilities are required to compete in a differentiated way? • What are your company’s differentiating capabilities today, and how do they relate to market requirements? • How much of your company’s costs are aligned to developing and deploying the three to six most important differentiating capabilities? • Assuming a reduction of nonaligned costs, what does this imply for pricing headroom? • For each relevant market segment, what is the likely price and performance trade, given that segment’s economics? Based on the answers to these questions, companies could consider (1) creating immediate pricing headroom by executing near-term cost reductions in the overhead unrelated to differentiating capabilities, and (2) redeploying some or all of the savings to invest in differentiating capabilities. This will enable you to grow stronger, avoid a “race to the bottom,” and — if needed — compete more effectively on price.
2. Consolidate and capture economies of scale During the earlier downturn in government-related hardware markets, consolidation created much of the shareholder value by removing capacity from the industry, with the result that sectors such as combat vehicles, defense aviation, and satellite manufacturing became oligopolies, if not duopolies. The potential for similar consolidation appears significant in government services. Unfortunately, the government-services industry has a poor track record of generating economies of scale — a primary mechanism for value creation in a consolidation strategy (see Exhibit 2, next page). Indeed, we have seen no evidence of systemic capture of scale economies in this industry, unlike the observed scale benefits in most commercial services-based industries. The failure to drive efficiencies through scale expansion has several likely causes: the fragmentation of service offerings during the growth of the last decade, the lack of common coordinating capabilities across service offerings, and a cost-plus environment. The current shift to fixed-price contracts in portions of the government-services market may catalyze a focus on capturing scale benefits organically, but the potential for inorganic consolidation and greater benefits of scale holds particular interest. Companies that led the way in consolidation in hardware sectors during the last defense downturn often gained competitive advantages that benefited shareholders and customers. Executives considering a consolidation strategy in government services today should determine what it will take to achieve the necessary scale in the right markets. If the cost — in capital, time, and management attention — is too high, they may conclude that exiting the business would create more value. Companies that do choose to pursue consolidation should focus on sectors with the best potential for scale benefits. That potential is low in services where the customer controls processes and practices, such as staff augmentation. Greater opportunities lie in areas like systems engineering and integration, where fixed costs are higher and contractors have more control (see Exhibit 3, page 11). 3. Align operating models to the needs of the environment During the last two decades’ boom in government services, with its double-digit growth rates and cost-plus contracting standard, companies tended toward a decentralized operating model. They allowed business units to operate with relatively little direction or control from corporate headquarters. New units proliferated as new
Exhibit 2 The government-services industry has not captured economies of scale
Observed scale impact on selling, general, and administrative (SGA) expenses, U.S. government-services companies, 2002–11
0% E ale ffe cts
SGA cost growth
3X Expected results 2X
Alion* CACI ManTech SRA NCI SAIC
* Alion data not available in 2002, revenue and SGA indexed on 2003 data. Note: Expected scale curve based on 30 to 50 percent increase in SGA costs for every 2x revenue. Source: Strategy& analysis, Capital IQ
Exhibit 3 Scale potential of different government-services offerings
Service offering type
– Customers deﬁne processes and practices
Returns to scale
– Little opportunity to leverage ﬁxed costs – Limited opportunity to capture and exploit learning – Suppliers deﬁne processes and practices
Systems engineering and technical assistance (SETA)
– Some opportunity to leverage ﬁxed costs (e.g., knowledge management systems) – High beneﬁts to improved utilization rates – Suppliers deﬁne some processes (within constraints) – Some ability to leverage ﬁxed costs – Moderate learning effects – Suppliers deﬁne processes (within constraints) – High ability to leverage ﬁxed costs – High learning effects – Suppliers deﬁne processes (within constraints)
Systems engineering and integration
Technical and program management
– High learning effects – High opportunities to leverage ﬁxed investments – High opportunities to reduce downside margin risk
Source: Strategy& analysis
services markets opened up. Business unit executives had both the authority and the incentive to pursue as much new business as possible, in some ways regardless of how well it served broader corporate objectives. This operating model outperformed other models in an era when top-line growth drove the value creation strategies at many services providers. But as the market has plateaued over the past two to three years, operating models that are unified around capabilities, with corporate headquarters playing an active role, are delivering better results. Why is this? More integrated and actively managed corporate models can create greater value in the current slow-growth, price-conscious government-services market by maximizing economies of scale, concentrating resources on high-return opportunities, and executing self-reinforcing corporate strategies. To get there, companies must fully absorb acquisitions, allocate decision rights in a way that fosters the type of control needed, and strive for a more common corporate culture. These are certainly not small tasks; executives should determine if this evolution not only is feasible in their companies’ current situations, but also is worth the costs and management attention required. The answer depends on the role of services in the overall corporate portfolio and value creation strategy currently being employed.
Operating models that are unified around capabilities, with corporate headquarters playing an active role, are delivering better results.
The way forward
Government-services businesses face big, but not insurmountable challenges. The strategies that worked in the past are unlikely to create value in the future. This suggests a number of questions that business executives will want to answer: • On what basis will you compete? Even if you do not want to compete on price, many leaders will want to immediately start cutting the costs that provide no competitive advantage. Determining the specific set of capabilities that will enable competitive success in this type of environment, and directing investment toward these areas, is an important first step. The net result should be an enhancement of the capabilities that drive competitive advantage, and a cost structure that will improve the ability to compete and win in price-sensitive markets. • Can removing industry capacity and gaining scale provide an advantage? Services businesses should first consolidate internally and make the structural changes needed to maximize efficiencies. But executives should understand that these internal savings might not be enough to create a cost structure that can compete and generate healthy returns in a low-price environment. With an eye on structural and systemic costs, leaders of services businesses may want to determine if adding scale and reducing industry capacity will create a longterm competitive advantage. • Are you organized for efficient growth? Organize your business in a way that will foster growth in austere times while enabling the retention of bottom-line benefits as the business grows. Determining the proper operating model and degree of functional centralization of the services business is an increasingly critical activity. In a larger, mixed hardware/services portfolio, operating model changes for the services business in isolation may prove insufficient. For executives in this position, determining if the services business can achieve competitive success within the
confines of the broader portfolio is likely warranted. If the constraints are too large, executives will want to determine if the services business could create more value for shareholders in someone else’s portfolio or as a stand-alone entity.
Businesses unable to address these challenges and adjust to new market realities will face significant risks. Though it is tempting to “stay the course” in times of uncertainty, this is often the wrong choice, and it is certainly not a recipe for success in the current market. Some will determine that the costs of change are too high and decide that the best way to create value is to exit the market. Others will find more value in making the adjustments needed to win in the governmentservices market over the long term. Either way, companies can create significant value, but they should take action now, before market realities further limit their ability to capture this value.
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This report was originally published by Booz & Company in 2012.
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