As the Pentagon Tightens Its Belt, These Companies Could Get Squeezed

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The Pentagon found $4.372 billion in cost savings during the recently completed fiscal 2018 and expects to find at least $6 billion more this year. That's a small drop in the bucket for a department with a $700 billion-plus budget, but it could have big ramifications for contractors in the years to come.

Lisa Hershman, acting chief management officer for the Department of Defense, told reporters during a Dec. 11 briefing that during the year, the Pentagon identified more than 100 projects that are expected to result in the savings. She said the department has already found $1.7 billion in additional savings for fiscal 2019 -- well on the way to the $6 billion goal for the year.

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The Pentagon has been under pressure to reduce costs ever since reports surfaced in December 2016 that the department had dismissed an internal analysis detailing ways to save $125 billion over five years by streamlining bureaucracy. Defense officials are currently looking to find and capture about $46 billion in savings by the end of fiscal 2023.

Pressure to show results

As acting chief, Hershman is under pressure to show results after her former boss, John Gibson II, resigned in November. According to media reports, Gibson was pushed out by Sec. of Defense Jim Mattis after only nine months on the job because of a "lack of performance," reflecting the urgency inside the building to find savings that can be redirected toward war-fighting measures.

After two years of substantial hikes, Pentagon officials are bracing for a more modest spending boost at best in the next fiscal budget.

Any savings could be redeployed toward areas of Pentagon emphasis. The government is hoping to increase funding for advanced missile and missile defense research, having handed several contracts to Lockheed Martin in 2018. There's also a push to modernize the nuclear triad and to grow the Navy, meaning additional funds could boost the growth rates for the ship-building operations of General Dynamics (NYSE: GD) and Huntington Ingalls.

IT in the crosshairs

For other contractors, the efficiency push appears as much a threat as it is an opportunity. Hershman said that information technology is a major focus of the streamlining effort. A review of about 300 IT systems in place at the Pentagon found that nearly half of them were redundant, with an estimated $900 million in potential savings if they are eliminated.

Installing and maintaining those systems is a primary business of a handful of government services companies headquartered in and around Washington, D.C., led by Leidos Holdings (NYSE: LDOS). A push to streamline some of those contracts, or even a focus on bringing down the cost of maintaining those systems via more stingy future project awards, could eat into the growth prospects of those IT companies.

Already there has been massive consolidation among these so-called "Beltway Bandits" as companies race to gain economies of scale and be more cost-competitive. Leidos was formed via a merger, and in September, Science Applications International (NYSE: SAIC) said it would acquire rival Engility Holdings for $2.5 billion.

Earlier in 2018, General Dynamics doubled the size of its IT business with a $9.7 billion deal for CSRA, and in June, a three-way deal among Vencore, KeyPoint, and parts of DXC Technology created Perspecta (NYSE: PRSP).

Other major companies that could be affected include Booz Allen Hamilton (NYSE: BAH) and ManTech International (NASDAQ: MANT).

The companies will argue that they can be part of the answer for the Pentagon by offering lower-cost alternatives to the bureaucracy managing systems in-house. There are also opportunities for these companies to use new technologies and innovation to bring down expenses. On an investor call in September, Leidos CEO Roger A. Krone said that the Pentagon's IT modernization push is "really good for us" because "helping our customers operate more efficiently is center in our wheelhouse."

It's also possible the Pentagon will conclude that in some less mission-critical cases, the most cost-efficient solution is not to modernize, eliminating some potential additional business for these companies.

Stay vigilant

The Pentagon belt-tightening should not be a cause for investors to run for the exits. The world's largest defense department figures to have substantial funding for the foreseeable future and no shortage of needs for contractors to address.

Still, the ongoing effort should be monitored for both risks and opportunities. With Washington gearing up for what could be a long and highly public budget battle in 2019, the Pentagon is going to be under extreme pressure to show it is a good steward of the funds it receives. That could lead to a slowdown in contract awards, or at least tighter terms on deals that are negotiated. And with it continued pressure on small to mid-sized contractors to find partners and continue the current wave of consolidation.

If the Pentagon is serious about cutting costs, it's inevitable that contractors will feel an impact over time.

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Lou Whiteman owns shares of Perspecta Inc. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.