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End game for Northrop Grumman’s IT services business

On Dec. 7, Northrop Grumman announced the sale of its federal IT services operations to an affiliate of Veritas Capital, confirming rumors that began in late October with a report that the company had retained a strategic adviser to review a potential divestiture of its technology services group.

The ‘spin-merge’ will create a $3B-plus federal IT services competitor

The transaction will net Northrop Grumman (NYSE: NOC) nearly $3.4 billion in cash and involve the merger of Northrop’s federal IT and mission support businesses with Peraton, the former IT services group of Harris Corp. Peraton was acquired by Veritas in 2017 for nearly $700 million. After the deal closes during 1H21, the new entity will have an initial revenue base of between $3.2 billion and $3.4 billion, by TBR’s estimates. Northrop indicated in the Securities and Exchange Commission filing accompanying the divestiture notice that the consolidated IT operations included in the transaction would account for roughly $2.3 billion in revenue in 2020, spread across three of its four principal business groups: $1.6 billion from the Defense Systems unit, $500 million from the Mission Systems unit, and $200 million from the Space Systems segment. Peraton generated just over $1 billion in revenue in 2019, according to TBR research. Veritas has not indicated plans for an IPO for the entity, and we expect the new company will initially remain privately held but eventually be taken public.

2018 blockbuster space acquisition, 2019 restructuring, and 2020 strategic defense contract bred speculation Northrop’s IT unit was losing relevance

One might trace the genesis of the announced sale of Northrop’s IT services business back to the company’s $7.7 billion acquisition of Orbital ATK in 2018. Buying Orbital ATK expanded Northrop’s addressable market in the space and missile defense sector with capabilities in small space systems, launch vehicles and propulsion, and missiles and advanced precision munitions. Orbital ATK was rebranded as Northrop Grumman Innovation Systems following the acquisition. At the time, the bulk of Northrop’s IT services operations resided in the former Technology Services (TS) group, which was eventually folded into the larger Defense Systems (DS) unit when the company restructured its business lines in late 2019. Adding Orbital ATK generated cross-selling opportunities for TS in large-scale sustainment, logistics, cybersecurity and operations services, but a similarly expanded opportunity set for the legacy enterprise IT services segment of TS remained unclear. Likewise, it was uncertain if the $13.3 billion phase of the Ground Based Strategic Deterrent (GBSD) program that Northrop won with the U.S. Air Force in September 2020 would avail enterprise IT-related opportunities in systems integration or other offerings to the company’s TS group. GBSD will clearly generate multibillion-dollar revenue streams for the company’s Space Systems unit — evidenced by the segment’s 50%, or nearly $12 billion, sequential increase in backlog in 3Q20 that is attributable almost solely to GBSD. There may be additional pull-through opportunities for mission-enhancing capabilities provided by Northrop’s Mission Systems unit as part of GBSD. GBSD may also offer occasions for Northrop DS to provide integrated air and missile defense solutions, integrated battle command systems, training and simulation, and sustainment services.

Analytics within digital transformation engagements depend on high-quality people and data

This week, TBR publishes the first Digital Transformation Insights report for 2020, building on the 2019 series, which included analysis around blockchain, digital marketing, IoT and quantum. The first report centers on IT services vendors’ strategies and performances within their analytics practices. Senior Analyst Boz Hristov notes that, “The maturing A&I services market continues to hold strong digital transformation opportunities for vendors, as long as they can address buyers’ business model complexities through collaborative and coopetitive delivery frameworks. Additionally, vendors that can address skills gaps and ensure data quality and security standards are met are positioned to win.” Next month’s DTI report will look at edge computing within digital transformation. In March TBR will examine the SAP practices of a few leading services vendors.

Additional assessments publishing this week from our analyst teams

Sprint’s rising churn rates, weakening financial performance and high debt load highlight the necessity of the proposed T-Mobile merger. Subpar network quality remains at the root of Sprint’s issues as postpaid phone subscriber losses continue to escalate, despite the operator’s aggressive pricing and elevated network capex spending since 2018. A more significant capex budget is required for Sprint to successfully compete long-term in the U.S. market; however, Sprint’s inability to generate significant free cash flow hinders the company from doing so.” — Steve Vachon, Analyst

“As Infosys ramps up cyber offerings to better address the complexities associated with the next wave of emerging technologies, an aggressive pricing strategy paired with revamped account management enables the company to expand its client roster as it turns into a solutions broker.” — Hristov

Verizon remains able to capitalize on its reputation as a premium wireless service provider to attract customers willing to pay a higher price for the operator’s network coverage and premium unlimited data plans. However, Verizon’s wireless network is becoming a less significant differentiator as AT&T and T-Mobile are now on par with Verizon in LTE coverage and as the rival companies are improving signal quality and data speeds by deploying services on additional spectrum.” — Vachon

“Though AT&T is facing short-term challenges, the company’s ambition to transition from a traditional telco to a global digital service provider is a long-term endeavor requiring a broad array of assets that may not all pay dividends in the short term. AT&T also has abundant opportunity to reduce expenses without divesting core business units via initiatives such as WarnerMedia synergies, nonvital headcount and real estate reduction, and deeper integration of network virtualization.” — Vachon

“TBR anticipates Fujitsu Services will report revenue growth acceleration in 4Q19, as Fujitsu enhances its software, digital, hybrid IT and cloud offerings, which help offset declines in traditional areas. Reorganization and investments within its sales organization, such as the consolidation of its European sales force and the implementation of Account Planning and Opportunity Planning software to improve management in North America, will also contribute to revenue expansion in 2019. The business model adjustments allow the company to better execute and deliver on initiatives to drive adoption of hybrid IT and software offerings, providing recurring revenue opportunities.” — Kelly Lesiczka, Analyst

Senior Analyst John Caucis notes that the U.S. federal earnings season kicks off this week with three defense majors and one services-led defense contractor releasing the results from the final calendar quarter of 2019. First up is General Dynamics Information Technology (GDIT), releasing earnings on Jan. 29. Sales are expected to continue sliding for GDIT, owing to recent asset disposals, portfolio reshaping and operations realignment. TBR projects GDIT’s top-line revenue will decline between 11% and 12% year-to-year to roughly $2.1 billion. A strong rebound for GDIT will hinge on the full leverage of CSRA’s capabilities to win big-ticket, next-generation federal IT engagements in 2020. 

Two additional defense majors, Northrop Grumman and Raytheon, will release their earnings on Jan. 30. Northrop Grumman’s Technology Services (TS) unit completed what was likely its final quarter and last fiscal year as a dedicated, stand-alone business line offering technology, sustainment and modernization solutions in 4Q19. TS, which includes the bulk of Northrop’s technology-related services, was integrated into Northrop’s emerging Defense Systems (DS) business group, effective Jan. 1, 2020. TBR projects TS’ 4Q19 sales will continue the rebound begun in 3Q19, with year-to-year growth between 2% and 3%, bringing TS’ 4Q19 revenue to roughly $1.1 billion. Raytheon Intelligence, Information and Services (IIS), the services division of Raytheon Technologies, is expected to continue expanding its sales at a robust pace, putting the wraps on a red-letter year accentuated by consistent revenue and bookings growth, record backlog levels, improved margin performance, and of course, the pending merger with United Technologies (UT). TBR projects IIS will post revenue of about $1.9 billion in 4Q19, up between 10% and 11% year-to-year.

Finally, Booz Allen Hamilton (BAH) will release earnings on Jan. 31. We project BAH will expand its top line between 8% and 9% in 4Q19 to over $1.8 billion, building on the momentum established during the first half of its FY2020. BAH’s strong performance stems from traction with its technically focused solutions, increasingly infused with advanced technologies that enable the mission aims of its federal agency clientele. Operationalizing AI has clearly become a strategic growth platform for BAH; AI featured prominently in the company’s alliance activity, new contract awards and introduction of new offerings in 4Q19.

Mixed results expected in the U.S. federal sector for IT services vendors

Earnings season for federally focused IT vendors begins the week of Oct. 21. Senior Analyst John Caucis has been tracking Northrop Grumman Technology Services (TS), General Dynamics Information Technology (GDIT) and Raytheon Intelligence, Information and Services (IIS) ahead of their 3Q19 fiscal earnings release. 

Raytheon IIS is expected to be the top performer among the first group of companies to tender their financial performance, owing to new contract signings in the lucrative cyber and space sectors and expanding project volumes on existing programs in these segments. Growth is likely to moderate in 3Q19, though this is expected with the ramp down of the Warfighter Field Operations Customer Support (FOCUS) program. Some of the lost Warfighter FOCUS revenue will be offset by a recent rise in domestic bookings that is converting to revenue on IIS’ top line while IIS continues expanding its overseas footprint.

Northrop Grumman TS’ recent sales slide is expected to continue in 3Q19, though we also expect the pace of TS’ contraction to continue moderating as the impact of large engagement losses wanes and bookings with sustainment, logistics and modernization programs strengthen.

The CSRA acquisition is no longer inorganically lifting GDIT’s revenue, and recent business divestitures (GDIT’s call center and 911 businesses) are expected to further erode GDIT’s revenue base. The expiration of a handful of large engagements in 3Q19, combined with the expiration of those in early 2019, will exacerbate the impact of the aforementioned issues on GDIT’s performance. Cross-sales with the Aerospace and Mission Systems segments of General Dynamics are helping offset these headwinds, as are the large-scale awards GDIT is increasingly booking, but a complete return to top-line growth is not expected until 2020.

Additional assessments publishing this week from our analyst teams

Driving innovation across its North America client base via a senior leadership team strengthened by its new Digital Transformation Office and establishing an Application and Technology Services practice will enable Atos to ramp up activities with clients around improving business operations and results through next-generation solutions. The next step for Atos is to successfully cross-sell its solutions by explaining the company’s capabilities to internal sales and delivery teams and to existing clients, as well as to effectively deliver services to grow revenues and improve profitability in North America. Elitsa Bakalova, Senior Analyst

With Atos’ 3Q19 earnings release TBR expects cloud will remain a vibrant segment for Atos, and revenue growth in the segment will continue to outpace the company’s total revenue growth. Atos’ cloud business will be positively affected by increased activities with clients, such as around transforming legacy applications and infrastructures to cloud, orchestrating hybrid cloud, ensuring cloud security through services and IP-based solutions, and providing cloud-enabled IoT solutions. Collaborating with clients’ IT and business stakeholders during cloud transformations and adding industry expertise will improve Atos’ ability to drive business outcomes for clients through cloud. — Bakalova

TBR expects six consecutive quarters of bookings growth and cross-selling opportunities to clients that came from recent acquisitions such as Leidos Cyber will sustain Capgemini’s growth momentum in 3Q19. Enhancing client relationships and industry expertise, such as through the acquisition of KONEXUS Consulting and the proposed acquisition of Altran, and approaching clients’ CxOs will improve Capgemini’s ability to access budget stakeholders and sustain revenue growth. — Bakalova

With a robust legacy client base and deep relationships with key technology partners, Accenture’s cloud business will continue to flourish. Accenture is doubling down on Google Cloud, adding another node to its multicloud management strategy. Additionally, Accenture Security continues to provide the trust needed to win new buyers and fuel cloud opportunities. Boz Hristov, Senior Analyst

Though Verizon will continue to trail T-Mobile in postpaid phone net additions for the foreseeable future, Verizon remains able to capitalize on its reputation as a premium wireless service provider to attract customers willing to pay a higher price point for the operator’s network coverage and premium unlimited data plans. Additionally, aggressive cost-cutting and digital transformation initiatives are helping improve profitability. Steve Vachon, Analyst

HCL Technologies’ (HCLT) acquisition activity and efforts to strengthen in-demand portfolio offerings generated double-digit growth in 2Q19. We expect HCLT will leverage its partner network to gain access to an expanded client base and lead with its expertise in Engineering and R&D Services to support its ability to differentiate and compete against peers as well as maintain growth momentum in 3Q19. Kelly Lesiczka, Analyst

While competitors stumble and struggle, Raytheon continues to outperform in IT services for the U.S. federal government

The U.S. federal earnings season kicks off the week of July 22, with legacy defense contractors General Dynamics, Northrop Grumman and Raytheon releasing their fiscal results for the second calendar quarter of 2019.

  • General Dynamics IT (GDIT) passed the one-year anniversary of its $9.7 billion acquisition of CSRA in 2Q19. Absent the inorganic impact of the integration of CSRA — and GDIT’s attempt to camouflage the multifaceted disruption — and GDIT’s portfolio makeover to improve the top line, not surprisingly, we expect sales to fall precipitously in 2Q19. In 1Q19 the bulk of GDIT’s new awards were concentrated in the defense sector. Bookings trends inverted somewhat in 2Q19 for GDIT, with a blitz of civilian sector deal activity with a potential aggregate contract value near $2.4 billion. Much of this new work will be to digitally modernize back-office processes or IT infrastructures for civilian agencies; for example, GDIT won a subcontractor position in 2Q19 on a potential $2 billion IT modernization engagement for the Department of Energy.
  • 2019 is shaping up to be another difficult year for Northrop Grumman Technology Services (TS) as headwinds from large-scale contract expirations continue to impede the company’s goal to revive top-line growth amid its ongoing restructuring program. Northrop Grumman will have to fall back on its margin performance as the best indicator of the success that its operational and portfolio realignment is improving TS’ overall cost structure. Northrop Grumman raised full-year 2019 margin guidance for the TS segment last quarter, and Northrop’s management appears comfortable standing by the elevated outlook, validating the company’s efforts to streamline operations and expand higher-value revenue streams in its order book.
  • Raytheon Intelligence, Information & Services’ (IIS) is expected to again be one of the top performing vendors in TBR’s Public Sector IT Services Benchmark in 2Q19 — IIS’ parent company’s massive merger with United Technologies (announced on June 9) notwithstanding. The Raytheon-United Technologies megadeal will result in a $73-plus billion technology giant broadly diversified across global aerospace, defense and commercial markets. Not to be lost amid the hubbub of the merger is how IIS is expected to again deliver robust growth and TBR public sector benchmark-leading margin performance in 2Q19 while expanding its book of business in the lucrative cyber and space sectors as well as with classified programs. — John Caucis, Senior Analyst  

Additional assessments publishing this week from our analyst teams

Leaders in TBR’s Public Cloud Benchmark continue to deliver strong results, but their closest competitors are aggressively innovating to challenge them. Google and IBM have enlisted Kubernetes to help them decouple PaaS business from Microsoft’s and Amazon Web Services’ (AWS) IaaS-led strongholds on the market, while pressure on Salesforce from both full-suite and modular CRM competitors is building. — Meaghan McGrath, Senior Analyst

Microsoft’s Commercial Cloud business continued to grow in FY4Q19, to $11 billion. Office 365 and Azure products accounted for 52% and 33% of total Commercial Cloud revenue, respectively. Though not yet the primary revenue driver of its Commercial Cloud business, Microsoft’s Azure portfolio is critical to the vendor’s long-term cloud growth, prompting investment in its developer community and tools as well as in high-profile partnerships that challenge AWS. — Meaghan McGrath

Tata Consultancy Services’ (TCS) revenue increased 8.6% year-to-year to $5.5 billion in 2Q19, highlighting the successful alignment of TCS’ service delivery frameworks with the needs of its global client base. Digitally based engagements constitute an ever-expanding share of TCS’ revenue base and backlog, and TCS claims nearly one-third of its revenues are digital-related, which would explain the top-line growth despite marketwide pressures facing legacy services, such as traditional outsourcing engagements. — Kevin Collupy, Analyst

Atos is well positioned to compete in the dynamic digital transformation (DT) services market. With Atos’ shift to an industry-specific go-to-market strategy, developing outcome-based vertical solutions will help Atos not only build a business case that persuades clients to invest in DT but also expand mindshare among existing clients, a necessary move as Atos tries to grow sales from digital services. Expanded cloud capabilities with partners such as Microsoft and Google Cloud enable Atos to design, build, manage and deploy cloud solutions and grow revenues in the segment. Two cybersecurity capabilities set Atos apart from its IT services peers: its portfolio of security services and IP-based solutions, and its verticalized cybersecurity offerings. Partnerships with established technology vendors and increasingly with startups enable Atos to innovate its portfolio and expand client reach. — Elitsa Bakalova, Senior Analyst

Fujitsu continues to invest in its portfolio offerings to provide vertical-oriented solutions, including within travel and transportation as well as healthcare. As the company looks to focus on its primary markets, Fujitsu expands its talent bench to support market presence and portfolio development, evidenced by the opening of a security operations center in its office in Canberra, Australia. The center will enable Fujitsu to maintain its client base in the region while also capturing upselling opportunities. We expect these investments will allow Fujitsu to build out its presence outside Japan to bolster revenue streams. — Kelly Lesiczka, Analyst

Recently, Analyst Stephanie Long hosted a webinar on how the quantum computing market will evolve from research-centric to commercial use cases as the technology reaches economic advantage — algorithm by algorithm — in the next two to five years. Once this occurs, developments will be rapid and organizations with the foundation built to take advantage of quantum computing will quickly reap the rewards of their early investments. Quantum computing, as a transformation-inducing technology, will impact multiple aspects of the IT environment, including power consumption, data generation, security and classical computing tie-ins. The swift impact of quantum computing will be a key factor in determining who wins and who loses in this technological transformation. Check out the replay of this webinar anytime in TBR’s Webinar Portal.

Federal initiatives around IT modernization translate to revenue growth for public sector services providers

Growth opportunities across defense and civilian agencies uplift vendor performance

The results of TBR’s 2Q18 Public Sector IT Services Benchmark demonstrate clear top-line benefits for services providers as government agencies accelerate IT modernization initiatives. Revenue for the 16 benchmarked vendors improved 5.3% year-to-year, which does not even factor in General Dynamics IT essentially doubling in size through its acquisition of CSRA. Including the impact of the acquisition, revenue grew 13.5% from 2Q17.

Graph showing weighted average total year-to-year revenue growth versus organic year-to-year revenue growth for 2Q17 through estimated 3Q18

Industry consolidation remains a prevailing theme in the market as the near-term opportunities tied to U.S. federal budget growth and the pursuit of innovation create a sense of urgency for vendors to capitalize. Scale advantages, complementary capabilities and broadened customer relationships make consolidation a compelling tool to facilitate near-term deal capture. Consolidation will remain a prominent strategic concern, evidenced by the announcement after the close of 2Q18 that SAIC (NYSE: SAIC) plans to acquire Engility (NYSE: EGL). However, in the long run, TBR anticipates the importance of scale will diminish as rapid technological change disrupts legacy business models.

TBR believes that the door is open for industry stalwarts to be disrupted if they elect to ignore the prevailing signs that the federal government, in particular the U.S. Department of Defense, seeks change in how it procures and fields technology.

 

TBR’s Public Sector IT Services Benchmark examines the key strategies, investments and performance metrics of leading government consultants, systems integrators, and IT and professional services providers. The benchmark examines 16 vendors across three groups: services units of aerospace and defense firms, U.S. federal government pure play vendors, and public sector verticals of commercially led IT services companies. We mix qualitative analysis of key investments and strategic initiatives with quantitative analysis of financial performance to uncover the drivers of business success for vendors that offer services to government customers.

What should be on Warden’s to-do list as Northrop’s new CEO

But there’s also an opportunity here for the company to broaden its pursuits to capitalize on the current bullish services environment in the federal sector due to the need for technology modernization. — Joey Cresta, Analyst