By Jason Rigoli, Principal at The White Oak Group

A week or so ago, Lockheed Martin, the global security company that designs and develops technology systems, products and services for the government, offered its executives an early retirement package with the intention of streamlining and reducing their overall workforce.

The program was put in place as part of a larger movement to reduce costs in light of ongoing cuts to defense spending that has already seen the company divest two business units and drastically reduce expenditures.

The overall result? 600 executives walked out of the door. That’s about 25% of the company’s executive workforce.

The media has made a huge deal about this early retirement program, and the sheer number of executives leaving. They’re looking at the executive exodus and comparing it to rats leaving a sinking ship, escaping Lockheed as defense spending budgets are slashed and the Department of Defense (DoD) analyzes and changes the way it does business with government contractors.

It’s true that as the DoD strives to cut costs, they are looking to the contractor community to do the same. Secretary Robert Gates has instructed the defense contracting community to reduce overhead and thus reduce the rates they are charging the government for their services and products.

He has also made it clear that he expects to cut the contractor workforce by 10% annually for the next three years. Most of these cuts will be in domestic intelligence analysis positions and in “advisory-type” positions, but since 9/11 these service categories have grown to encompass the largest number of contractors in the space.

Both of these trends will have a chilling effect of the growth of defense and intelligence service providers for the foreseeable future and will impact growth for defense contractors. However, it is not a sinking ship. This is an inflection point.

The days of 10% to 15% organic growth for the large prime contractors and 20% to 30% for the smaller ones is over. The defense and intelligence budget is no longer getting bigger so companies will need to work harder and unseat an incumbent to get new contracts and increase their piece of the pie.

Although these government contractors aren’t sinking, they will see long-term impacts from the reductions in defense spending. Increased competition means tighter margins and tighter margins mean less earnings and a decrease in organic growth. This can and will lead to a general reduction in the value of publicly traded defense contractors. What could potentially result is a new increase in merger and acquisition activity in the government contractor space as these publicly traded prime contractors look to M&A to fill a hole in their growth rate.  

The end result of this dynamic industry shift could be an increase in the value of smaller contractors as prime contracts deploy the tremendous amounts of cash they have accumulated over the last decade.  

The defense contracting community has experienced similar circumstances in its history, including the late 1970s / early 1980s and again in the early 1990s. It was during these challenging times that the giants of the industry were established.

So, the executive exodus from Lockheed shouldn’t be taken as a sign of a coming apocalypse in the government contracting space. Granted, reductions in defense spending and recent actions taken to make the DoD more efficient can and will negatively impact the organic growth of defense contractors, the market will survive and potentially see a new round of consolidation and corporate growth through M&A.

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