As Amazon pursues federal contracts in cloud computing and Blue Origin looks for aerospace contracts, the federal contract market is facing potential upheaval.
Will privately-held companies take over the lion’s share of new research and development contracts?
This post was written with contributions from Charlotte Irwin. Charlotte is a Research Strategist in the ETF and Mutual Fund Research Team.
When Amazon isn’t processing your orders for a new phone case and groceries, it’s busy pursuing billion-dollar federal contracts in cloud computing. Amazon founder Jeff Bezos is also after aerospace contracts for his privately held Blue Origin, a rocket manufacturer and suborbital spaceflight company. This month, both companies will be involved in rulings that could disrupt the federal contract market.
At the end of October, the US Department of Defense (DoD) announced the winner of one of the most coveted technology contracts in US history — the Joint Enterprise Defense Infrastructure (JEDI). Following months of legal and political controversies, the 10-year, $10 billion contract to establish the Pentagon’s cloud computing systems was awarded to Microsoft. The decision not to go with Amazon, whose cloud business leads the industry with 48% market share and has already built out services for the CIA, seems questionable to many. President Trump had, after all, publicly opposed granting the contract to a company controlled by his political nemesis Bezos. Given the scale of the contract, and the high likelihood that it could lead to future federal business, it is possible that Amazon will challenge the ruling in the coming weeks.
This won’t be the only battle a Bezos-owned business faces over a government contract this November. Blue Origin lodged a protest with the Government Accountability Office (GAO) in August arguing that the current bidding process for next-generation rocket development favors incumbents and perpetuates a duopoly in the sector. The GAO’s response is due by November 20, and a ruling in Blue Origin’s favor could go a long way in signaling the government’s openness to nontraditional — and often non-publicly traded — bidders.
Follow the money
It’s no secret that the US government is, to put it mildly, a bit of a spender. Much of that largesse goes to mandatory programs like Social Security and Medicare, and to servicing the ever-increasing national debt. The rest, however, is divvied up each year between the various departments and agencies on a discretionary basis to fund existing operations and to drive strategic initiatives. Frequently, as is the case for the DoD’s cloud services development and the Air Force’s next-gen rocket program, government agencies will use their allocated budgets to contract out services to private companies. More than $2 trillion in federal contracts have been awarded in fiscal years 2016–2020. And 2018 saw these contract values increase for the third-consecutive year, to hit $559 billion, the highest total since 2010.
With modernization a top priority across departments, the areas doling out the most lucrative contracts are telling. In particular, IT obligations had a record year, with the DoD spending $33.8 billion and civilian agencies spending an additional $30.8 billion, a 9.5% year-on-year increase. And that includes only unclassified tenders. The Trump administration has requested nearly $90 billion in IT spend for 2020, with $27 billion earmarked for cybersecurity. And with Congress having passed a $1.4 trillion spending bill in late July, another year of growth is virtually guaranteed.
Source: World Bank, Bloomberg Finance LP as of November 8, 2019.The Bloomberg U.S. Startups Barometer measures both the occurrence and level of historical and recent venture activity for US-based startups, excluding biotechnology. The index is a gauge of startup activity that equally considers capital raised, deal count, first financings, and exit count. Each of the input factors is normalized for its historical volatility, and then the normalized factors are combined in equal proportions to form a normalized index for constructing this barometer.
It’s a perfect storm
These shifting priorities in the federal contract process will likely threaten many publicly listed firms’ bottom lines. An analysis of the Federal Procurement Data System showed that in 2017, four independent firms were awarded federal contracts worth over $14 billion. That’s more than the entire annual Environmental Protection Agency or Interior Department budgets. The top five firms were, not surprisingly, all defense contractors.
While legacy contractors’ share of the pie will surely remain massive, it’s likely to compress as issues like cybersecurity, artificial intelligence and autonomous capabilities receive more funding. These new industries have been developed alongside the shift to private funding. The impact is already registering. Bloomberg Government’s 2018 list of the top 200 federal contractors had 32 new entrants and 68 incumbent companies slipped in the rankings.
With technological innovation accelerating over the past few decades, the appeal of being a public company has virtually disappeared. Various measures, from the Sarbanes-Oxley Act in 2002 to the 2012 Jobs Act have made it easier to raise capital and more appealing to keep financial information private. At the same time, plummeting yields and two major market pullbacks have made private investments more appealing to pension funds, endowments and other large pools of capital. Globally, private equity and venture capital now totals $4.2 trillion, roughly 10% of developed market equity market capitalization. Since the mid-1990s, the number of publicly listed companies has been cut in half due to cheap-debt fueled share repurchases.
As a result, an increasing share of intellectual property and R&D now occurs in privately held companies and educational institutions. As innovation increasingly occurs behind closed doors and with extended lockup periods, the US’s push to modernize might put an increasing share of the world’s biggest spender’s cash out of the reach of listed companies.
The views expressed in this material are the views of Michael Arone through the period ended November 8, 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal. Past performance is no guarantee of future results.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors’ express written consent.