by Tim Shorrock
8
The Pure Plays
“We are a national security pure play.”
—GEORGE J. PEDERSEN, CHAIRMAN AND CEO OF MANTECH INTERNATIONAL, AT THE FRIEDMAN, BILLINGS, RAMSEY GROUP DEFENSE INVESTORS CONFERENCE IN WASHINGTON, D.C., FEBRUARY, 28, 2006
ON A SWEET springlike night in 2006, a group of investors and entrepreneurs gathered in the Living Room Bar at the swank Mandarin Oriental Hotel in downtown Washington. They were there for a conference on defense and homeland security, where top executives from twenty-one companies would present their investment and acquisition strategies to a parade of securities companies, investment banks, and private equity funds. Over sushi and Chinese hors d’oeuvres, they networked, shared industry gossip, and talked about the growing business of intelligence contracting. The evening’s affair was off the record, which was fine by me; I was here to learn what was happening in U.S. intelligence from the perspective of the capitalists making money from it, and this was the perfect setting for that. The importance of the event was magnified by the presence at the conference of former CIA director George Tenet, who was scheduled to deliver the keynote address the next morning. Tenet had been deeply involved in Bush’s war on terror, and I was interested in what he had to say to the intelligence contractors who were here.
After making my way to the elegant bar, I found myself standing next to a sharply dressed man in his early thirties. He was from India and had recently become an American citizen. “I’m here to invest,” he told me, whipping out a business card listing a high-tech investment firm in Silicon Valley. A thirtyish entrepreneur standing nearby joined our conversation and informed us that he was working for his mother, a physicist from Tennessee who had spun her company out of a university laboratory with the help of a private equity fund. They were now making “very decent money” selling specialty software to the Department of Homeland Security. Over by the window, which framed a lovely view of the Jefferson Memorial and the Tidal Basin, a gray-haired man leaned comfortably on a radiator, sipping cognac and greeting everyone walking past with a friendly nod and handshake. He turned out to be one of the senior partners of Friedman, Billings, Ramsey, the Washington, D.C., investment firm that had organized the conference. This event was only in its second year, he told me, and he was delighted by the turnout. “The industry’s on a roll,” he said.
But the exuberance seemed oddly misplaced given the news of the past few days. Iraq was on the verge of civil war, and the number of U.S. military deaths there had just hit 2, 300. The lead story in the morning papers painted a grim picture: grisly attacks and other sectarian violence unleashed by the recent bombing of a Shiite Muslim shrine had killed 1, 300 Iraqis, making the past week one of the deadliest of the war. The next day, General Michael Maples, the director of the Defense Intelligence Agency, told Congress that the insurgency in Afghanistan was growing almost as fast as Iraq’s, “presenting a greater threat to the central government’s expansion of authority than at any point since late 2001.”1 Things in the Middle East seemed to be going downhill, and fast; as it turned out, these events were precursors to a tumultuous year in the Middle East that would take 1, 500 more American lives and cost the Republican Party control of both houses of Congress in the midterm elections that fall.
At the plenary session and the corporate presentations that followed the next day, the human dimensions of the war were far away. Instead, the talk focused on the business opportunities presented by the war and how the Bush administration’s military and intelligence strategies in Iraq and Afghanistan could open markets for companies specializing in information technology and intelligence, surveillance, and reconnaissance (ISR). The talk was of money and profits, “market drivers,” being “in sync with our customers,” and providing “soup-to-nuts support” to the U.S. military.
George Tenet set the tone in his keynote address. In an hour-long speech closed to reporters (and summarized to me later by some of the executives in the audience), the former CIA director explained that the chief priority of the Intelligence Community was getting timely intelligence onto the battlefields in Iraq and Afghanistan to support U.S. ground forces and fighter pilots. Over the last few years, he said, the Department of Defense had made a major effort to push information out “to the soldier at the pointed end of the spear,” and allow that soldier to download data, imagery, and intelligence from computer databases located in nearby command posts or from spy planes flying overhead. Done properly, soldiers would gain “situational awareness,” understand the scenario unfolding before them, and gain a decisive edge over Iraqi insurgents, Afghan fighters, and Al Qaeda foot soldiers.
In a nutshell, Tenet had laid out the basic precepts of network centric warfare. It was a subject he knew well: under Tenet’s command, the CIA had been the first agency to put these theories into action in Afghanistan, where, as we saw earlier, CIA paramilitary teams armed with mobile phones and laptops had directed air strikes at Al Qaeda and the Taliban. But looking back at his speech two years later, it’s also clear that Tenet was making the case for his own career moves. Within three months of his talk, Tenet would join, either as a director or an adviser, four companies that were directly involved with the high-tech military strategies he was endorsing: L-1 Identity Solutions; The Analysis Corporation; Guidance Software; and QinetiQ. None of this was known at the time, of course. But to the companies in the audience, Tenet’s remarks were an affirmation of their own commitment to defense and intelligence.
Netcentric warfare is “right in the sweet spot we provide for our customers,” exulted Robert Coleman, the chief operating officer of ManTech International, during his company’s presentation to investors. He described a spiraling effect: as the NSA and other agencies pushed information “out to the ultimate point of consumption,” the military was seeking “timely, accessible, and actual intelligence,” requiring more complex systems and increasing demand for “more contractors to support those systems.” Steven Waechter, the executive vice president of CACI International, noted that the Pentagon’s needs for intelligence on the battlefield had driven CACI’s intelligence business up by 26 percent over the past year; intelligence contracts, he said, now accounted for more than a third of CACI’s revenue stream. Over the next eighteen months, CACI would see a 63 percent increase in national security contracts, including a $300 million hike in classified work. Intelligence, Waechter concluded, “is a very attractive place to invest.”
ManTech and CACI are the largest companies in an elite group of six intelligence contractors known on Wall Street as “pure plays.” That term refers to companies focused on a single market and earning most of their revenue from that market. In the world of food products, for example, the Coca-Cola Company is a pure play because it only makes soft drinks and related products; but PepsiCo, which is a conglomerate that makes everything from Lay’s potato chips to Quaker Oats cereal, is not. SAIC, which depends on federal contracts for more than 90 percent of its revenue, considers itself a government pure play. But in the intelligence markets we’re concerned with, pure plays are companies focused almost entirely on spying, earning up to 90 percent of their revenue from contracts with the Pentagon, the CIA, and the national collection agencies. In addition to ManTech and CACI, they include Applied Signal Technology, one of the NSA’s leading providers of digital signal processing equipment and outsourced signals analysis services; Argon ST, a company created by former executives of Raytheon, which provides much of the NSA’s supply of sensors and is the dominant supplier of communications intelligence (COMINT) to the U.S. Navy; MTC Technologies, which operates the Intelligence Community’s fleet of U-2 spy planes so important to the NSA and the National Geospatial-Intelligence Agency; and SI International, the NSA’s leading adviser on outsourcing.*
The pure plays are riding an enormous wave of Pentagon spending on secret intelligence programs for the wars in Iraq and Afghanistan, funded in large part by supplemental bills. In 2006, on the eve of the Friedman, Billings,
Ramsey conference, Congress passed an $80 billion supplemental that included $4 billion in classified spending for “operational intelligence activities” in the military and five key agencies controlled by the Pentagon: the Defense Intelligence Agency, the National Geospatial-Intelligence Agency, the National Security Agency, the National Reconnaissance Office, and the Counterintelligence Field Activity office. That money, the Pentagon informed Congress, would enable U.S. intelligence agencies to field “new tools and methods for collection, for processing, and for detecting high value targets.”2 A few months after the supplemental was approved, Donald Rumsfeld told a Senate committee how it was being used. U.S. forces, he said, “are bringing intelligence to battalions and brigades that before terminated at corps level.” That included “HUMINT, counterintelligence, analysis, UAVs; reconnaissance, surveillance and target acquisition capability into these formations.” Troops on the ground “now have the connectivity to the joint force that will make the difference,” he said.3
A year later, with Rumsfeld gone from the Pentagon and U.S. policy in Iraq in shambles, the Department of Defense asked for another major increase in intelligence spending. Essentially, this request funded a massive counterintelligence effort in Iraq and the Middle East designed to (1) stop attacks from improvised explosive devices, IEDs; (2) determine the source of weapons being fired at U.S. troops and the origin of the attacks on U.S. helicopters; and (3) expand the fight against an organized Islamic resistance that appears to have spread widely throughout the Middle East and the Horn of Africa since Bush invaded Iraq in 2003. The $94 billion supplemental included $2.4 billion for IED Defeat, $2.7 billion for Military Intelligence, and $3.6 billion for Non-DoD Classified, which refers to the agencies outside the tactical chain of command—that is, the NSA and the NGA. Specific projects destined for contractors included “identity management for access control and persistent surveillance capabilities” (a capability offered by L-1 Identity Solutions) and “contract linguists and cultural advisers,” a contract awarded in 2006 to a joint venture of DynCorp and McNeil Technologies. In counterintelligence, there were requests for “contracted analytic efforts and related operations to enable these efforts to function 24/7 in support of operations around the world” as well as “contract support in the development and revision” of counterintelligence and human intelligence doctrine—quite a task for a private company. For signals intelligence, the supplemental requested “contracted support and personnel-related costs to ensure our forces are trained in the latest equipment and tactics, techniques and procedures.” Without those funds, “essential surveillance against the Iraq insurgency will not be as thorough or as effective,” the Pentagon said.
In the last two chapters, we saw that much of the “connectivity” referred to by Rumsfeld is provided by the large systems integrators—SAIC, Booz Allen Hamilton, Raytheon, Lockheed Martin, and Northrop Grumman. But it’s the pure plays that do the heavy lifting. They employ small armies of analysts with top secret clearances who can move in and out of war zones quickly; they supply what they call “mission-critical” technology that can detect, identify, and locate signals coming from enemy weapons and eavesdrop on communications between insurgent units; they have the technical ability to link all this collection and dissemination through mobile radios and computers down to the war-fighter on the ground. Pure plays also supply the means to counter IEDs. They make and service the sensor systems that detect enemy weapons systems. The pure plays are the shock troops of the Intelligence Community. And for the last six years, theirs has been a dizzy ride.
In Chapter 6, we met Essex Corporation, a Maryland contractor specializing in optical technology that was earning nearly 90 percent of its revenues from the NSA when it was acquired, in 2007, by Northrop Grumman. Essex is one in a long line of pure plays that have been (and will continue to be) acquired by larger companies.
In 2002, just before a major wave of mergers and acquisitions swept through the industry in the wake of 9/11, there were at least two dozen companies that fit the criteria of an intelligence pure play. The two with the brightest future were Veridian Corp. and Anteon International Corp., both of which were later acquired by General Dynamics. When it was sold in 2004, Veridian, which specialized in developing sensors and secure networks for the NRO, the Defense Advanced Research Project Agency, and other agencies, had 7, 300 employees and sales of $1.2 billion a year.4 Anteon, with $715 million in revenue in 2001, was big in IT, systems engineering, and technical management, and employed 5, 300 people, 85 percent of whom held security clearances. When General Dynamics bought it in 2005 for $2.1 billion, it was one of Washington’s best-known technology firms, with a star-studded board of directors that included former defense secretary William Perry and retired Army General H. Hugh Shelton, the former commander of U.S. Special Forces and chairman of the Joint Chiefs of Staff from 1997 to 2001.5 One of Anteon’s largest contracts was with the U.S. Army Intelligence Center in Fort Huachuca, Arizona, to train army interrogators.6
Another pure play that disappeared into a larger company is Titan Corp., which was acquired in 2005 for $2.6 billion by L-3 Communications, bringing with it several important NSA contracts and nine thousand employees, including 5, 000 with top secret clearances.7 Lockheed Martin and other large defense contractors have snatched up the rest. In 2004 and 2005, Lockheed Martin acquired the government IT unit of Affiliated Computer Services Inc., inheriting several contracts with defense intelligence agencies, and Sytex, a $425 million company based in Philadelphia that held contracts with the Pentagon’s Northern Command and the NSA/Army Intelligence and Security Command.* By 2007, the company employed 52, 000 IT specialists with security clearances, and intelligence made up nearly 40 percent of its annual business, company executives said.8
The remaining pure plays are often the subject of acquisition rumors. In 2006, for example, several British publications reported that CACI International was about to be acquired by BAE Systems; both companies denied the reports, and the rumors quickly died down. Still, the churning in the industry never stops: by the end of 2007, L-1 Solutions, one of the companies Tenet works for, had joined the ranks of the pure plays and announced plans to expand further through acquisitions. Robert LaPenta, L-1’s CEO, told investors that his company was buying companies “in the high-end government services arena” to challenge the large IT and systems engineering firms for intelligence contracts. Among the companies on his hit list were CACI and ManTech.9
It’s easy to see why investors would be attracted to the pure plays. They are highly profitable, and individuals and investment funds that have risked their capital in them have seen the value of their stock skyrocket. In 2006, A. G. Edwards’s Defense Banking Group, a Boston fund that invests in intelligence, traced the growth of nine pure plays—CACI, ManTech, SI International, Dynamic Research, SRA, Essex, NCI, MTC, and Anteon—by tracking their public market capitalization (this was before Essex and Anteon were sold, of course). That capitalization figure, derived from a company’s stock price per share multiplied by the total number of shares outstanding, is generally a good indication of investor interest in a specific industry. Collectively, the value of the intelligence pure plays exploded in the first five years of the war on terror, from $980.5 million in 2001 to $8.3 billion in 2006. Imagine a bar graph showing the capitalization of these companies. In May 2001, the companies stood at 100 percent. Two years later, just before President Bush sent U.S. troops into Iraq, they had risen to nearly 300 percent of their pre-9/11 value. On election day in 2004, when President Bush won his second term in office, they peaked at nearly 900 percent. By May 2006, they had settled down—to 543 percent of their value in the months before 9/11. Over that time, by comparison, the S&P 500 rose by a factor of 4 percent and the top defense stocks increased by 56 percent.
Much of this capital flow was the direct result of a string of initial public offerings that reverberated through the defense industry in the wake of 9/11. The first defense-related IPO after the
attacks took place in December 2001, when the Carlyle Group sold off its shares in United Defense Industries, the maker of the Bradley Fighting Vehicle and other weapons systems widely used by the Army. The timing of the IPO drew sharp criticism from some analysts, who accused the well-connected private equity fund of capitalizing on the terrorist attacks and the Bush administration’s first strikes in Afghanistan to push its stock. William Conway, one of Carlyle’s founders, told me at the time that the IPO had been planned for many months before the attacks. “No one wants to be a beneficiary of September 11,” he said.10 That may have been true, but Carlyle’s willingness to tap the capital markets at this sensitive moment in the nation’s history inspired other companies to do the same.
When ManTech launched its IPO, it had just emerged from a reevaluation of its business strategy with a plan to focus exclusively on its military and intelligence contracts. To obtain the cash it needed for expansion and acquisitions, it went public in June 2002. In its pitch to investors filed with the Securities and Exchange Commission, ManTech explicitly linked its future with the war on terror. “Our solutions enable our customers in the intelligence community and Department of Defense to identify evolving foreign and domestic threats, including terrorism; to quantify exposure to these threats, and to implement prudent physical and cyber countermeasures,” ManTech said. It made note of its large number of cleared employees, “including over 1, 000 with access to Top Secret Sensitive Compartmented Information, allowing us to work with our customers in highly classified environments and at front-line deployments.” And it predicted, accurately it turned out, “strong growth opportunities” for IT and technical service providers and increased defense spending on “C4I (command, control, communications, computers and intelligence), homeland security and intelligence activities.”11
