Defense services companies face ‘structural issues’ as tech disruptors surge

Traditional government services providers face a stark future, where they either need to transform themselves or risk becoming irrelevant.

That was the prevailing message in a presentation Thursday from Brian Gesuale, managing director of the Raymond James Equity Research Group. Geusale was the luncheon keynote at the investment bank’s annual defense and government market conference in Washington, D.C..

Gesuale’s research indicates large government services firms such as Booz Allen Hamilton, CACI International and Leidos derived 60% of their growth from acquisitions rather than organic expansion over the last decade.

Gesuale used a non-traditional methodology to make that calculation.

“Generally, we think of acquired growth as company A buys a company in January 2024, and once we get past January 2025, it becomes organic growth in perpetuity,” he said.

But for this analysis, Gesuale and his team continued to track the contribution of the acquired companies and did not add them to the organic side of the ledger.

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By doing this, he was able to show that the acquired companies represented 60% of growth.

This is important because services companies are running into financial challenges in making the type of acquisitions they traditionally make, Geusale said.

“We think there are a couple structural issues that the services companies have to solve,” he said. “Those that are successful at this will see their multiples expand while those that aren’t will see their multiples stagnate, and their growth rate stagnate.”

One structural issue involves how artificial intelligence is displacing many labor positions. Services companies can position themselves to take advantage of AI, he said.

A second structural issue is the multiples being paid when privately-held companies are acquired.

“There is a massive amount of multiple inflation for the private companies that these (public) companies generally acquire,” he said, adding the result is either a lower return on investment or a slowdown in M&A activity.

Publicly-traded government services companies have been attractive investments over the past two decades because they are the “ultimate cashflow compounder," which Geusale described as businesses that generate predictable returns and attract substantial institutional capital investment.

His projections show that these publicly-traded companies will struggle to maintain their historical growth rates through 2035. He predicts both organic expansion and acquired expansion will decline.

“We think the majority of service companies as they're built today are going to need to self-disrupt or they're going to sink to irrelevance,” he said.

A different story is unfolding for a group of defense technology companies that Gesuale sees as disruptors. This group of companies includes Palantir, AeroVironment, Kratos and Karman Holdings.

“They don’t all have the same value proposition. Some are hardware, some software, some merchant suppliers but all of them are solving problems,” he said.

He sees three key areas of opportunity that these companies are addressing – AI, software and manufacturing.

AI and software are what Gesuale called superpowers because they are areas of strength and opportunity, while manufacturing is a bottleneck that needs solving.

“If you're solving anything along those three areas, those are going to be really areas of big needs and you're going to see considerable investment from both public and private investors,” he said.

The challenges faced by the traditional defense services companies and the growth of the technology disruptors are part of what Gesuale called a "Fifth Defense Revolution."

That is happening as the market enters an era dominated by robotics, algorithms, and mass-produced warfare. Previous defense revolutions were driven by mechanization, aviation, nuclear weapon and IT.

“Essentially, technology is now driving the train and that’s going to take a lot of opportunities,” Gesuale said.

Geusale said that for services companies, the challenge is acute because they must fundamentally reimagine their value proposition and move away from labor-based work.

But the opportunities are there for the taking.

“We’re in a generational upgrade cycle in many areas,” Gesuale said. “Air defense is more than just Golden Dome. There is space, AI, autonomous technology, and the proliferation of affordable hardware that needs to be linked with software. Lots of areas to invest in.”