Post-Election Takeaways for Defense Industry

For the Pentagon and its contractors, President Obama’s reelection means a continuation of the agenda already in place: Spending reductions of $487 billion by 2023, ending the war in Afghanistan in 2014, shifting military resources to the Asia-Pacific region, more emphasis on cyber, drone warfare, and special operations forces.
But as the president looks forward to a second term with renewed momentum, there are still few clues on how Obama will deal with the issue that most worries the defense establishment: Additional spending cuts of $1.2 trillion set to take effect Jan. 2, half of which would come from the military’s budget.
Obama said during the final debate of the presidential campaign that sequestration “will not happen.” To make good on that promise, though, he will have to work with a deeply divided, hyperpolarized Congress.
The president has said he would support a deal that makes the sequestration cuts go away if they can be offset by tax revenues. Comments made on election night by House Speaker Rep. John Boehner, R-Ohio, however, suggest that GOP lawmakers do not see the president’s victory as a mandate for higher taxes.
So the game of budget chicken will continue for now, which is bad news for government contractors.
“What would happen to federal programs if the parties deadlock again and, despite everyone’s intentions, a sequestration actually occurs?” asks Paul A. Debolt, a partner at Venable LLP federal contracting practice.
“The hardest part of a game of chicken is knowing when to quit,” he says. Defense contractors continue to be “hostages in this showdown between the two parties over fundamental fiscal policy decisions on taxing and spending.”
The looming expiration of the Bush tax cuts in January gives the president a major leverage point, Debolt says. But he is not optimistic about sequestration. During the coming lame-duck session, a short-term deferral of the tax increases and sequestration is the best that anyone can hope for, he says.
So contractors can expect to remain on edge for several more weeks, until a new Congress strikes a deal to push off sequestration until the end of March. That is when funding for the Defense Department is scheduled to expire under the current continuing resolution for fiscal year 2013.
“Ultimately, the overall impact on industry will be driven by a final budget agreement,” Debolt says. “They’ll have to make some cuts to government spending” and how they end up apportioning those cuts is what contractors should worry about, he adds.
Nobody should anticipate much from the lame-duck session, Debolt says. “People who didn’t get reelected will be moving out of their offices. Newly elected members will be painting offices and getting ready to move in. … It will be government by BlackBerry which I don’t think is conducive to taking major steps forward on these issues,” says Debolt. “The best they’ll do is delay the day sequestration takes effect so the new Congress can start working on it.”
As long as the threat of sequestration continues to linger, contractors’ business will suffer, analysts agree.Companies that provide professional services, particularly, will be hard hit, more so than arms manufacturers. “It’s much easier to eliminate a full time position than to restructure a manufacturing contract,” Debolt says. The Pentagon might order fewer items or stretch out the delivery schedule but is not going to shut down production.
The military’s biggest spender on service contracts, the U.S. Army, already has announced plans to shed private-sector support staff. Many of the jobs that are currently performed by contractors in specialized areas such as intelligence and program management will be transferred to commissioned and non-commissioned officers, Army Chief of Staff Gen. Ray Odierno has said.
Most of the Pentagon’s budget line items are being affected by either the planned spending cuts that are set to begin in fiscal year 2013, by the prospect of additional reductions under sequestration, and by the absence of a long-term budget.
As the post-election dust settles, the Pentagon also has to begin to think about how it willdownsize or pare back procurement programs for an era when budgets will not be growing at double-digit rates as they did over the past decade.
The president requested $525 billion for the Defense Department in fiscal year 2013 — about $45 billion less than what he had planned to request a year earlier, before the debt-ceiling showdown with Congress forced Obama to seek defense cuts. The administration currently projects a $533 billion budget for fiscal year 2014. Modest increases between 1 and 2 percent are planned for 2015 through 2017. For the Pentagon, that amounts to a flat budget.
A combination of real cuts and uncertainty about future funding will result in contract restructurings and even terminations, Debolt predicts. Defense suppliers already have seen a shift over the past six months in the way the government picks winning bids. The key deciding factor is low price, not necessarily “best value,” says Debolt. “Our clients are reporting an increase in ‘low cost technically acceptable’ solicitations,” he says. “Before the government even looks at the technical proposals, they look at who has the lowest price and if the technical proposal is acceptable, that company wins,” says Debolt. “In some cases, acceptability may be determined by no more than a resumé.”
The only silver lining in the sequestration drama is that funds that have already been obligated funds won’t be touched. But unexercised options and new orders in existing programs might be curtailed. Buying fewer systems increase per-unit prices, so even if sequestration is eventually cancelled, theinstability across defense programs will add inefficiency and cost, officials say.
Government contractors should not expect any resolution to this problem any time soon, warns federal budget analyst Stan Collender.
“There will be a big budget debate next year and it’s likely to be very ugly,” he says in an editorial in Roll Call. “The 2013 debate is more likely to resemble what happened in 2011, when a steady series of federal budget-related cliffhangers kept us on the edge of our seats through most of the year.
Given the continuing political split in Congress, he says, “There’s no reason to believe that their political strategy will be any different next year. … If Republicans and Democrats move further away from each other, a big or even medium-sized budget deal in the lame duck will be less rather than more likely.”
Photo Credit: White House

Topics: Defense Contracting, Defense Department, DOD Budget, DOD Leadership, DOD Policy