The Business of Iraq

A lot of American contractors have done very well during the Iraq war. What happens if it ends?
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Wayne Dadetto spent the last leg of his 22-year military career in the Delta Force, a highly secretive counter-terrorism unit and arguably the most elite of the U.S. Special Operations Forces. In 2002—on the heels of 9/11—he leveraged his military expertise and founded Tactical Support Equipment, a defense contracting company supplying reconnaissance equipment to troops. Buoyed by rising Pentagon spending on the wars in Iraq and Afghanistan, the firm has enjoyed double-digit growth rates for the past five years. This year it ranked No. 4099 on the Inc. 5000.

Dadetto's story is not uncommon. Since 2001, the size of the government contracting industry has exploded—more than doubling to 96,000 contractors by 2005. The Department of Defense remains the biggest federal consumer of services, accounting for more than 60 percent of total contract actions, according to a report issued by the Center for Strategic and International Studies. The defense budget is set to reach $500 billion this year and cash-flush public contractors like Lockheed Martin and Boeing have seen robust sales. Smaller privately held contractors—including more than 30 Inc. 500|5000 companies—were awarded millions of dollars in contracts of their own.

Uncertain Times

As the military attempts to modernize and take advantage of new technologies, it has increasingly turned to the private sector, explains Stan Soloway, who was a deputy undersecretary of defense in the Clinton administration. "The private sector is where most of the talent to do that work resides and the war is emblematic of that trend," says Soloway, CEO of the Professional Services Council, a government services trade association. "When the war begins to wind down and a withdrawal takes place, you will see a reduction in spending on that work because that work won't exist anymore."

But on the cusp of the next presidential election, industry insiders remain uneasy. If Washington pulls the troops out of Iraq, Dadetto worries that the defense boom could take a nosedive. "The political environment is more of a concern of mine than anything else," he says. "If they completely pull out, it could cause a major ripple in a lot of defense companies."

Still, there is no guarantee that military spending would decline if the troops came home. "It's really hard to tell at this stage of the game," says David Berteau, director of the Defense-Industrial Initiatives Group at CSIS. "The only way you can reduce the amount of money spent on contracts is if you either reduce the amount of work that needs to be done or build up the in-house government capability. And each of those things could happen." Even then, it could take years before the impact is felt. Defense budgeting is a three-year process, with a time lag between budget approval and actual liquidation of funds. "It's quite likely that things that would look like automatic reductions will come slower and later than predicted," says Berteau.

A Plan to Diversify

Steve Sliwa, CEO of Insitu, ranked No. 236 on the Inc. 500, is closely watching for changes in federal defense spending. His company develops robotic aircraft systems that collect intelligence in conflict zones. Sliwa expects to see a decline in supplemental funds, which are set aside in the defense allocations process to prevent the military from running out of money to cover war costs. "They're expecting those supplemental appropriation bills to be reduced or maybe go away over the next three or four years," he says. "And because of that, defense spending is going to flatten out. That's going to cause some challenges."

As Iraq's grip on the industry weakens, contractors like Tim McCune are scrambling to diversify their businesses. McCune is the president of Integrated Wave Technology, a company that builds hands-free translators that work in tactical situations in Iraq and Afghanistan and is ranked No. 200 on the Inc. 500. "I don't know if you have a category for the quickest shrinking company, but maybe we'll be there in a couple of years," says McCune, whose firm draws 99.9 percent of its revenue from DOD. "We hopefully would be selling stuff for medical and police applications by then."

While a troop withdrawal could spell trouble for some contractors, it could potentially free up funds for others. As president of MIKEL, an undersea warfare technology company and No. 2037 on the Inc. 5000 list, Kelly Mendell is wary of mobilizing navies across the Pacific. "It's one area of defense that's not receiving a priority because this is a land war. The funding isn't as plentiful as it once was because of that," says Mendell. "So if we scale back [in Iraq] there would be additional funds available to concentrate on other areas. And I think that would overall be a good thing." Defense funding and priorities have historically shifted as wars die down. "What you'll likely see is a lot of those funds moving over to other pent up needs within the Defense Department and to other agencies whose needs have gone unmet," says Soloway. "Some individual companies may feel the effect more than others."

In the Safe Zone

Those companies will likely be selling hardware to DOD, says P.J. Braden, President of Gryphon Technologies, ranked No. 2863 on the Inc. 5000. She doesn't expect her own firm, which provides engineering and technical services to the Navy, to incur significant losses. "I think that the services side isn't as vulnerable," says Braden. "Maybe the Democrats would say, 'We're not going to buy anymore weapons, because we're going to invest in health and human services.' So whoever has that weapons system would get hurt worse than me who's just doing the engineering work."

Information and communications technology is the fastest growing market segment of the federal services industry, according to the CSIS report. And as Iraq cools, ICT CEOs like Tom Gilmore don't expect to feel much of a pinch. His company, Omega Defense Systems, No. 2802 on the Inc. 5000, develops deployable communications systems capable of providing connectivity anywhere in the world. "It will not impact us because one of the mainstays of military operation and one of the most fundamental of all requirements is communication," says Gilmore, a former marine. "We chose communications because we knew it has broad applicability. Everybody in the world needs to communicate."

Democratic lobbyist Heather Podesta predicts that an incoming administration—particularly a Democratic one—would fully review current contracting programs. "You will see Democrats institute more fiscal responsibility," says Podesta, whose lobbying firm serves clients like Boeing. "In no way is it an attack on contracting, but we need to stop and reassess what's going on here."

Berteau says government outsourcing of professional services, which dates back to the Eisenhower administration, is a trend that probably won't ebb any time soon. "The real challenge is how the federal government and the national security establishment can identify innovations taking place in the private sector that need to be taken advantage of," he says. "And that challenge will never go away."