Budget Squeeze Could Spur Defense Industry Shakeup

By Sandra I. Erwin
To borrow a line from Casey at the Bat, there is no joy in Mudville. Defense industry executives, with good reason, are experiencing considerable anxiety as Pentagon budget cuts lurk around the corner.

The true scope of future cutbacks to weapon programs may not be known for some time, but contractors already are bracing for the end of business-as-we-know-it.

In anticipation of what could be a contentious environment for selling products and services to the Pentagon, some suppliers have taken steps to downsize and curtail spending. Others, especially small businesses that are hanging on to few contracts, expect the worst.

As industry waits for the budget dust storm to settle in Washington, several hot topics are dominating the conversation in corporate suites. One is whether the Pentagon will make any sweeping changes in how it buys equipment. Another bugaboo for the industry, which surfaces in every defense downturn, is whether the Pentagon will make any provisions to protect some industries that might need to “surge” production if there is another major conflict.

Top industry executives believe that even if the “doomsday” scenario of a trillion dollars in cuts over the next decade is avoided, based on past history, reductions will be deeper than the currently projected $480 billion. They worry that if cuts come too abruptly, the industry will be forced to make impetuous decisions on whether to ride out the storm or exit the defense market.

Even the cash-rich upper-tier Pentagon contractors are anxious. They see the potential shakeout of the subcontractor base as ominous, because as prime contractors, they depend on smaller suppliers for key components. Executives also are sounding alarms about the newly accepted wisdom in the Defense Department that industry should bear more of the financial risk of developing new technologies.

The military increasingly is asking for “mature technologies,” says Elizabeth Ferrell, a partner at McKenna Long & Aldridge government contracts group.

Saving money and simplifying the procurement system are “admirable goals,” she says. But some of the latest acquisition guidelines, “from the contractor’s perspective, place the cost of development on contractors … with no assurance that they’re going to be able to recoup their investment with future sales.”

Ferrell cites the Army’s “buy fewer, more often” approach as an example of policies that are giving some executives heartburn. Defense Department officials have not explained how this buying method will be put into practice, she says. Ferrell, who represents Pentagon subcontractors involved in cutting-edge technology, says many of her clients fear for their future. “They question how they will know whether the government, when they announce a requirement, will fund development or ask for mature products.”

The Army says that instead of buying equipment to last for the next five years, it will buy just what it needs for six months. “That makes sense,” says Ferrell. “But when they say they want mature technologies, who’s supposed to pay for that?”

In this environment, what may be one company’s misery is another’s opportunity. The Army, for instance, is inviting vendors to turn over products such as radios, smartphones and solar panels to soldiers so they can evaluate them. Companies that already paid for their products’ designs obviously prefer that approach, versus firms that wait for a Pentagon research contract to pay for advanced technology. The Army is expected to follow a similar model as it seeks to buy new light armored trucks and scout helicopters. Some companies already have gambled that they know what the customer wants better than the customer, itself, and have spent millions of dollars on new truck and helicopter designs that they hope the military will pick.

Rickey Smith, director of the Army Capabilities Integration Center, says the “buy fewer, more often” policy might scare those contractors that are afraid of competition. It is different than what the Army has been doing for decades, he says. Industry has been “used to the government not trying to harvest the best of industry.” Now, the Army is asking for vendors to “show me,” he says. “There’s no promise but they can compete. It does change the model.”

Some technologies always will be funded by the government simply because they do not exist in the civilian world. But the Army is realizing that it could save billions of dollars by capitalizing on what industry already paid for.

That competitive dynamic could ultimately put some defense contractors out of business. “If you’re in the defense industry and want to stay ahead of the non-defense industry that wants to compete, you’re having to take some risk on yourselves,” says Smith.

“Risk” increasingly is becoming the operative word for corporate strategists. For companies that must deliver profits to their shareholders, betting billions on an uncertain future may not be in the cards. Companies would be in a bind as they seek to offload defense portfolios in a market with few buyers.

Manufacturers of weapons — in contrast to providers of services such as equipment maintenance and network security — are seen as the most vulnerable. Industry analyst Jason Gursky, of Citi Investments, says it is too early to ring the death knell. “Budget overhang is real but fundamentals at large defense companies are still strong,” he says. The next “catalysts” will be budget decisions that will be leaked out of the Pentagon in coming weeks.

For defense executives, planning for cutbacks would not be so bad if only they knew what to expect. Because of strict rules that restrict direct contact between government buyers and sellers, and also as a result of anti-industry sentiments among some Pentagon officials, it is becoming harder to even speak to military and civilian leaders, one industry chief says.

“The opportunity for dialogue is harder,” he says. “It’s becoming more difficult to do business.”

Topics: Defense Department, DOD Budget

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