Understanding Government Contracts Part 1

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If you invest invest in companies that earn their income as federal government contractors, you need to understand the basics of federal contracting.  When companies put out press releases touting their latest contract win, you should understand the terminology they are using to describe the contract in order to better understand what the company has actually won and what the risks of the contract may be.  In part one of this three part series, we will look at the three simplest federal government contract types: Fixed Price, Cost Reimbursement, and Time & Materials.

Fixed Price Contracts

The most basic type of contract is the Fixed Price contract.  In a fixed price contract, the government negotiates a set price for a set quantity of items or services.  The government tends to favor this type of contract, because most of the risk is on the contractor.  The most common variety is the Firm Fixed Price (FFP) contract, but there are other varieties that may include incentives, inflation adjustments, material reimbursements, etc.

Here's a real world example.  Recently, Lockheed Martin (NYSE: LMT) was awarded a firm-fixed-price contract for $184.3 million to deploy 29 Persistent Threat Detection Systems (PTDS) in Afganistan.  That works out to around $6.4 million per system.  If Lockheed Martin can build and deploy a PTDS for $6 million each, then they make a nice profit of $11.6 million.  But if there are cost overruns and it ends up being $6.8 million per PTDS, the Defense Department will still pay $184.3 million, and Lockheed Martin will be stuck with a $11.6 million loss.  The downside to the government is that if they decide that they really want 35 systems, or maybe only 20 systems, they would have to either start from scratch renegotiating a new contract, or issue a modification to the original contract (usually at terms favorable to the contractor).  But the cost risk is primarily on the contractor.

Cost Reimbursement Contracts

The next variety of contract is the Cost Reimbursement contract.  Here, the contractor performs the task specified, and the government reimburses the company afterwards for their actual costs.  The government is trying to move away from these contracts, because the risk for cost or schedule overruns is now on the government.  The most common variety of Cost Reimbursement contract is the Cost Plus Fixed Fee (CPFF) contract, giving the contractor a fixed profit margin, or the Cost Plus Award Fee (CPFA), in which the company's profit margin depends on incentives for meeting performance goals. 

As a real example, Booz-Allen Hamilton (NYSE: BAH) was recently awarded a Cost-Plus-Fixed-Fee contract worth $73.1 million over five years to support the Department of Energy's Advanced Research Projects Agency. They will provide a variety of scientific and administrative support employees for the program.  Here, the costs of their service have been estimated by the government and the company, and Booz-Allen Hamilton's profit margin (the "fixed fee" part) has been pre-negotiated.  The risk to the government is that the work could require more staff than anticipated, leading to a trade-off of either ending the contract early when the $73.1 million threshold is reached, or having to go back and negotiate an extension, creating an unexpected cost overrun. 

Time & Materials

Time & Materials (T&M) contracts are primarily used for providing service employees to the government.  An hourly rate is negotiated, the time required for the task is estimated, and a time period for the performance of the work is set (usually one base year plus up to four option years).  The cost of other materials that are required to perform the work—such as cleaning supplies for a janitorial contract, or computers for a software engineering contract—may be reimbursed as well.  Time & Materials is actually a specialized type of Cost Reimbursement contract where the contractor's overhead and profit margin are baked into the hourly labor rates.  Thus, T&M contracts have the same risks to the government for cost overruns or unfinished work.  There are some risks to the contractor as well, though: the labor rates are all negotiated up front based on today's prevailing wages; if personnel depart and have to be replaced at a higher wage a few years down the road, the company's profit margin could shrink or go negative.

For our real world example this time, SAIC (NYSE: SAI) was recently awarded a Time & Materials contract worth an estimated $33.9 million over five years for IT support to the Health Resources and Services Administration (HRSA).  Note the word "estimated" in SAIC's press release.  In this case, the required labor categories (IT specialist, software engineer, database engineer, etc.) and their hourly rates are pre-determined, and the number of hours per person per year is estimated.  But if overtime is required for the project, the government faces the same risks as with a Cost Reimbursement contract.

Coming Up in Parts 2 and 3...

In part two of this series, we'll talk about Indefinite Delivery Indefinite Quantity contracts and contract modifications.  In part three, we'll talk about multiple awards, GWACs, other complicated contract types, and then wrap things up.

Gordogato has no positions in the stocks mentioned above. The Motley Fool owns shares of Lockheed Martin. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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