Fish Story

Companies expected to land big deals when Homeland Security was created four years ago. Things haven't panned out as they anticipated.

When Congress passed the Aviation and Transportation Security Act on Nov. 19, 2001, it created more than a new bureaucracy to oversee transportation security. It also spawned enormous anticipation among government contractors. The law required airports to be equipped to screen all checked luggage for explosives by Dec. 31, 2002. No exceptions. Many in the private sector looked at this requirement, and the enormous purchasing power of the soon-to-be-created Homeland Security Department, and saw boundless procurement opportunities ahead.

The checked-luggage deadline resulted in the purchase of more than 7,000 explosives detectors under a contract between the newly established Transportation Security Administration and Boeing Co., a contract originally estimated to cost between $508 million and $1.3 billion. When DHS finally was created in 2003 to address what seemed like countless nationwide security vulnerabilities, contractors saw more lucrative opportunities as the agency's first annual budget topped $41 billion the following year.

But for many, those early expectations of contracting largesse proved elusive. They are based on the misguided or exaggerated predictions that often accompany what appears to be the birth of a new industry and the creation of scores of companies and lobbying shops to serve it.

"The pool of folks chasing homeland security work was far greater than [opportunities that] existed," says John Clerici, a partner in the government contracts practice of Washington law firm McKenna, Long and Aldridge.

A little more than five years later, Clerici and others see a different contracting landscape than the one many first imagined. For security firms, lobbyists, market analysts and others, five trends are emerging in this still nascent industry.

Size Matters

The first myth that can be dispelled is the notion that the terrorist attacks of Sept. 11, 2001, and the subsequent creation of DHS gave birth to a wholly new industry. In fact, many see the homeland security sector as simply an extension of the defense industry. Indeed, the largest beneficiaries of Homeland Security funding undoubtedly are the same behemoth companies that dominated the federal marketplace before 2001.

In fiscal 2006, DHS' top four contractors were the goliath firms called in for Gulf Coast recovery after the devastating 2005 hurricane season: Bechtel National Inc., CH2M Hill Constructors Inc., Fluor Enterprises Inc. and Shaw Environmental Inc., with more than $3.2 billion in federal contracts combined. Not far behind were IBM, Unisys Corp. and Integrated Coast Guard Systems, a Lockheed Martin-Northrop Grumman partnership.

But even before hurricanes Katrina and Rita ravaged the Gulf Coast states, the largest beneficiaries of DHS' procurement dollars were big-name contractors. In fiscal 2004, the top three contractors were Integrated Coast Guard Systems, Unisys and Boeing Service Co., which won a combined $1.2 billion in contracts from the department.

"Those opportunities for the larger contractors who received a fairly significant increase in business definitely exceeded their expectations," Clerici says. "A lot of the stuff that needed to be done to increase . . . the response levels because of the incidents in 2001 was consistent with goods and services already available."

The opportunities for smaller firms have been fewer. DHS has a relatively high percentage of small business contracts: Of all the dollars it spent on prime contracts in fiscal 2006, 31 percent went to small businesses, slightly exceeding the department's goal. And that figure was even higher before the Gulf Coast recovery (38 percent went to small businesses in fiscal 2004, for example). But for small firms to win a piece of the most lucrative procurements, partnering has emerged as a crucial strategy, analysts say. In an arena inundated with new technologies and ideas, few small technology firms offer a product or service so unique that it immediately separates them from their competitors.

And five and a half years after Sept. 11, the demand on homeland security agencies is not for technology alone, but rather for solutions-to communication problems, detection deficiencies, and other vulnerabilities and shortcomings. According to a November report on the industry by Washington consulting firm Civitas Group LLC, that means the ideal technology could lose out if others are more widely compatible or are already integrated into a functioning system.

"Partnering in this market is particularly critical, especially for smaller companies," the report notes. "Obtaining market share can depend upon agreements with complementary services [or] products."

Bubble Technology Industries is a good example. The Canadian firm has a 50-person staff with expertise in radiation detection technology. It partnered with the much larger Raytheon Integrated Defense Systems, and the team last year won one of the advanced spectroscopic portals procurements-a contract potentially worth hundreds of millions of dollars to develop and deploy next-generation radiological and nuclear detectors for sea and truck cargo.

"The way to market has been to partner with the bigger companies and make sure your technology is the primary technology used, while the larger companies bring the project management and integration skills needed to tie the whole thing together," says Jeremy Grant, a senior vice president and emerging technologies analyst at Stanford Washington Research Group.

Integration Is Key

DHS' Transportation Security Administration oversees 429 airports. The Customs and Border Protection directorate manages 317 ports of entry, and oversees more than 6,000 miles of land borders and 95,000 miles of shoreline. An initial list made last year to inventory the nation's critical infrastructure contained more than 77,000 assets. Clearly, interconnecting separate pieces of the security puzzle is a huge part of the picture.

"Part of the problem is you generally can't just be buying sensors," says Penrose "Parney" Albright, managing director at Civitas and former assistant secretary of Homeland Security for science and technology. "A lot of the companies that have [science and technology] expertise to develop this technology are not systems integrators."

Systems integrators are companies such as Accenture Ltd., Boeing, Lockheed Martin, Northrop Grumman and Unisys-firms that, in the case of integration contracts, often don't actually build anything but collect and organize credentialing stations, sensors and other devices into a functioning system. These integrators increasingly are looking to homeland security as the defense market tightens, Albright says. And DHS more often is looking to them.

TSA awarded Unisys a $1 billion contract to build a telecommunications infrastructure connecting the 65,000 employees at the agency's command center, its 21 field offices and the nation's 429 airports. Accenture headed a team that won a DHS contract potentially worth as much as $10 billion to construct US VISIT, a system to track the arrival and departure of foreign nationals in and from the United States, confirm their identities and check for immigration violations. In 2004, the department awarded a contract with an estimated value of $224 million to McLean, Va.,-based BearingPoint Inc. to construct a financial management system for the department's 22 component agencies. DHS tapped Boeing last fall to lead a team that organizes and coordinates sensors, cameras, radios and other equipment to improve security along the country's land borders-a potentially multibillion-dollar enterprise. And Lockheed Martin and Northrop Grumman combined to form the team that the Coast Guard hired to manage and build its $24 billion fleet modernization program.

Most of these programs have fallen behind schedule and gone over budget, inviting harsh criticisms of DHS. In the case of the Coast Guard's troubled Deepwater program, these problems even led the agency to announce in April that it would take over the integration functions from the Lockheed-Northrop partnership. But with the department's latest effort, Boeing's SBInet, Homeland Security leaders say they have learned from past failures and created the management safeguards and personnel necessary to effectively run the program with Boeing as lead integrator. This and the likely demand for compatibility between programs-border and maritime security systems that share data, for example-bode well for large systems integrators, the Civitas Group report says.

Contractors Assume Risk

The integration projects demonstrate another emerging truth about the homeland security industry: The agency is shifting more risk to the private sector.

With SBInet and other performance-based procurements before it, DHS asked industry to tell the department "how to do [its] business," as Deputy Secretary Michael Jackson famously said at an SBInet Industry Day in 2006. The contractor, in other words, essentially creates the business model. But, as the Civitas Group report notes, the government favors models in which the private sector makes upfront investments and assumes the initial risk. In these models, the firms make most of the money down the line, if the system is a success.

Boeing could be paid as much as $2 billion for SBInet-DHS' inspector general said that figure could be as high as $30 billion-but was guaranteed only $2 million initially. BearingPoint's eMerge2 contract to create a new financial management framework for DHS was valued at as much as $229 million, but the firm received only about $23 million before the department scrapped the project because of various problems.

"More and more risk is being shifted to the private sector," says Alan Chvotkin, senior vice president of the Professional Services Council in Arlington, Va. "It's a good marketplace, still fairly open and robust, but it's unquestionable that some of the risk issues are shifting back toward industry. And that's having people scratch their heads."

Project BioShield, the Health and Human Services Department program to develop and procure countermeasures to biological weapons, has operated this way more or less from its inception. Despite the inherently unpredictable nature of drug development, BioShield contractors making vaccines and other therapies get the bulk of their money at the end, when they deliver an effective product. The results can be ugly if problems arise. VaxGen Inc. of Brisbane, Calif., seemed to score big in November 2004 when it won an $877 million contract to supply 75 million doses of a next-generation anthrax vaccine, its primary product. But last December, HHS canceled the contract after the company missed a deadline for starting a clinical trial. Less than a month later, Lance Gordon, VaxGen's president and CEO, resigned and corporate officers cut the workforce by half.

The Market Is Here to Stay

The point of BioShield when it was launched in 2004 was straightforward; by laying out what kinds of products it intended to buy, HHS would create a market for those products. Investors would then fund the development efforts of drug manufacturers, knowing that the return of a large federal procurement awaited if the firm was successful.

Industry and congressional critics say BioShield has been a disappointment, however, because HHS has been too slow to conduct threat assessments, release contract solicitations and process procurements. The result, they say, is that many of the large pharmaceutical firms the government had hoped to lure into the biodefense arena have become discouraged and opted for more lucrative markets elsewhere.

But outside of BioShield, most observers say the homeland security market has solidified as DHS has matured and major firms have made investments in the arena. "We continue to believe in the long-term potential of this market," the Civitas Group report says. It projects steady growth in the years ahead.

For one thing, much currently deployed technology falls short of addressing completely the vulnerabilities that Homeland Security agencies and first responders face. As long as the terrorist threat remains in the public consciousness, as seems likely, opportunities will exist for the manufacturers of next-generation equipment.

"You're never going to be completely happy with your bio detection or nuclear detection capacity," Civitas Group's Albright says. "You're always going to want to be doing a little bit better."

And though the mandates originating in the immediate aftermath of 2001 have mostly been contracted for, there remain other, unfulfilled procurements where the department continues to clarify its priorities and needs.

In January, DHS began the Secure Freight Initiative to test radiological and nuclear detection portals at six foreign ports that process cargo bound for the United States. In March, the department published draft requirements for the state-issued identification cards envisioned in the REAL ID Act; after May 2008, all driver's licenses and other credentials issued by states must meet the final DHS requirements. And an emergency supplemental spending bill now being negotiated in Congress could give states the right to impose security requirements on chemical plants that are stricter than those coming from DHS, a change that would create a sizable business opportunity.

"Even if there isn't substantial regulation, just a more serious focus on [chemical plant security], that will in itself push [facilities] to start doing more, and that will increase the market," says Doron Pely, vice president of the Washington-based Homeland Security Research Corp. The firm's most recent report projects the homeland security market will grow by 50 percent over the next five years.

Critics on Capitol Hill and elsewhere note how long it has taken Homeland Security to initiate these requirements and programs. But observers say industry has mostly adjusted-or resigned itself-to the frustrating pace of the department.

"Without naming names, I've heard large defense contractors say, 'We're done with Homeland Security,' and they're still in it," Clerici says. "I don't see how [with] an agency that has a budget of [more than] $30 billion, any responsible contractor can say they're going to ignore it."

Stanford Washington's Grant says savvy investors take into consideration the low likelihood of the department meeting aggressive program deadlines.

"Yes, DHS continues to be a difficult place to do business . . . but a lot of the investment community is building all those risk factors into their equation," he says. "You've got to be very patient to do business in this environment. People have stopped complaining about it; they've kind of accepted it."

R&D Shapes New Business

The other sign of an enduring homeland security market, the Civitas Group report notes, is the department's prodigious research and development funding.

Operating mostly under DHS' Science and Technology directorate, the budget for such activities has grown to more than $1 billion a year. Appropriators last year trimmed the budget in response to a perceived lack of direction, but their concerns appear mostly mollified by promises from new Undersecretary Jay M. Cohen.

And now, four years after the department was created, the products of initial research finally are arriving in the marketplace. While much of the technology first deployed after the 2001 terrorist attacks was retrofitted from other uses, the next round will be specifically tailored to meet post-Sept. 11 requirements, as the Civitas Group report puts it.

The department this year will begin procuring advanced spectroscopic portal systems-next-generation radiological and nuclear detectors that screen cargo, including tractor trailers, more effectively and with fewer false alarms than existing machines, which sometimes register the radiation given off by bananas and cat litter as a threat. The $1 billion-plus contract would help DHS screen maritime cargo for radiological and nuclear materials by the end of this year, and all cargo by the end of 2008, according to the agency's 2008 budget request.

And DHS soon will deploy the third generation of BioWatch, a surveillance program that aims to detect airborne pathogens within 36 hours of release. Now, technicians must visit the existing monitors daily to retrieve filters for analysis at a laboratory. The new monitors, Albright says, do the analysis internally, meaning that several dozen can be deployed in a city to provide more extensive coverage with less effort.

Other biological and chemical sensors are being tested against real agents in laboratories and could be tested in the field later this year, Albright says. "You're starting to see a new generation of technology come out that really does meet the requirements," he says. "So you're going to see a lot of things migrating out of [research and development] into procurement and integration contracts, which is where you make money."