Why Booz Allen Hamilton, SAIC, and Other Government Contractors Are Down Today

The U.S. Department of Defense has launched a massive review of consulting services contracts, with an eye toward making cuts.

Investors are concerned about the implications for the companies providing those services. Shares of Booz Allen Hamilton (NYSE: BAH) and Science Applications International (NASDAQ: SAIC) both traded down as much as 5% on Friday, and shares of Leidos Holdings (NYSE: LDOS) and General Dynamics (NYSE: GD) were off 4% and 2%, respectively, though Booz and General Dynamics made back some of those declines as the trading day went on.

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A changing of the guard

These companies are some of the largest providers of IT and other services to military and civilian government agencies. These so-called "Beltway Bandits" have been taking an ever-larger role in the defense industry as part of previous Pentagon efforts to grow more efficient, but now the target is on them.

This week, the Department of Defense issued a memo calling for a review of all consulting services contracts, "for the purpose of terminating or descoping contracts for activities that are not essential." The results of the review are due starting in March and extending through mid-April.

The outcome of the review is tough to predict, and the definition of what makes a contract nonessential is not clear. But there are likely to be cuts. The Department of Government Efficiency has already announced the termination of a five-year, $1.9 billion Internal Revenue Service modernization agreement, and Leidos lost a deal to provide enterprise IT services to the Social Security Administration.

There is also some fear that the nature of contracts will shift from a "cost-plus" model to a fixed-fee model, which would create both opportunities and risks to company margins.

The memo, and the surrounding uncertainty, caused investment bank William Blair to downgrade a wide number of companies, including Booz Allen, CACI, Leidos, and General Dynamics, to market perform from outperform.

Are government IT stocks like Booz Allen a buy?

Each of these companies have indicated on post-earnings calls and other public events that they anticipate changes to their businesses as the new administration makes its mark, but there had been some hope in the industry that the push to streamline government could create more opportunities for the sector instead of cuts. At best, it now appears that it will be a mix of both.

Investors need not panic. Unwinding even a portion of the deals in place would cause the government significant disruptions and added expense. And in this environment, it is tough to imagine the Pentagon bringing back in house activities that had previously been outsourced.

But it will take time for the dust to settle and for companies and investors to get more clarity about the new working environment. Until that happens, there is likely to be significant volatility in these stocks.

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Lou Whiteman has positions in Booz Allen Hamilton, General Dynamics, and Leidos. The Motley Fool recommends Booz Allen Hamilton. The Motley Fool has a disclosure policy.