Understanding Government Contracts Part 2

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If you invest in companies that earn their income as government contractors, you need to understand the basics of federal contracting.  In part one of this three part series, we looked at Fixed Price, Cost Reimbursement, and Time & Materials contracts.  In part two of the series, we will look at the Indefinite Delivery, Indefinite Quantity contract and talk about contract modifications.

Indefinite Delivery, Indefinite Quantity

Indefinite Delivery, Indefinite Quantity (IDIQ) contracts are often used by the federal government because they are more flexible.  When an IDIQ contract type is selected, the government knows it wants goods or services, but does not know exactly how much (“Indefinite Quantity”) or exactly when it will be needed (“Indefinite Delivery”).  In an IDIQ contract, the government sets maximum and minimum quantities, negotiates per-unit prices within that range, and establishes a period of performance (the time limit after which the contract will expire).  IDIQ contracts can be used to replace Fixed Price, Cost Reimbursement, or Time & Materials contracts, reducing cost, quantity, and schedule risks to the government, but adding some uncertainty for the contracting company.

As an example, last month, there were stories out in multiple news outlets about how the U.S. State Department was buying Kindle e-book readers from Amazon.com (NASDAQ: AMZN) for $6,600 each.  Sensationalized headlines abounded.  "Government fraud and waste!" declared the bloggers.  And then, just as quickly, the furor subsided and everybody was forced to print corrections and retractions (see The Atlantic Wire, Paid Content, and what seems to be the original source of confusion, NextGov.)  What went wrong?  Someone quickly reading the original contract document didn't understand how IDIQ contracts worked.  They took the maximum order ceiling of $16.5 million and divided by the minimum quantity of 2,500 Kindles to arrive at that $6,600 per unit price.  (Also, the contract includes money for support and custom software programming, but let's keep the example simple.)

Sure, the State Department could have negotiated a contract for exactly 35,000 Kindles at a fixed price.  But the State Department doesn't want 35,000 Kindles showing up on their doorstep next week.  They would gather dust and grow obsolete in a warehouse while the program is slowly rolled out.  The government's delivery schedule is indefinite.  And what if the pilot part of the project doesn't go well, and the Kindles for the wider program expansion are no longer needed?  Or what if it goes really well and they need more Kindles than expected?  The government's required quantity is also indefinite.

Modifications

Sometimes you will see a company tout in a press release that they have won a modification to an existing contract.  There are many kinds of modifications to contracts, and the government modifies contracts all the time.  Sometimes modifications are simple things like changing the names of the key personnel or changing the delivery address for invoices.  Sometimes the modifications are for big things like changing the quantity of goods or services being acquired or extending the period of performance.  But the one modification type which really spurs companies to issue press releases is the funding modification

Consider this press release from Lockheed Martin (NYSE: LMT) announcing $715 million in funds to build two Littoral Combat Ships.  If you read the press release, you will note that they were already awarded the contract to build ten ships, worth a total of $3.6 billion, back in 2010.  This modification (with a big dollar value attached for emphasis) is simply announcing that the US Navy has officially obligated the funds to build ship #3 and #4 in the ten ship contract.  If you had already accounted for this revenue coming to Lockheed Martin back when the original contract was announced, then the Navy committing money to the contract is not really such a big event for investors. 

(On the other hand, when you are talking about an IDIQ contract, a funding modification might be announcing a new order within the contract, which is telling you about real revenue coming to the company above and beyond the minimums guaranteed by the original award.)

An Aside: "Best Value to the Government"

Contrary to popular jokes, the federal government does not always select the lowest bidder.  Government contracting officials are instructed to select the proposal which offers the best value to the government, a notion that investors should understand.  When comparing proposals, the government is usually willing to pay more for a better product, more experienced or skilled personnel, a superior technical solution, a company with a history of successful contract performance, a qualified small business, or a veteran-owned business.  Price is only one of many factors that goes into selection, just as investors do not pick stocks solely on price (otherwise, we would all be penny stock investors).

Coming Up in Part 3...

In part three of the series, we'll talk about multiple awards, GWACs, and other complicated contract types, and then wrap things up.


Gordogato owns shares of Amazon.com. The Motley Fool owns shares of Amazon.com and Lockheed Martin. Motley Fool newsletter services recommend Amazon.com. 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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