2013 Outlook: Budget Cuts Will Hammer Industry

The Defense Department and its contractors begin 2013 with hope for a March deal that will shield the Pentagon from a 10 percent budget cut. But even if Defense is spared from the sequester, the business climate for Pentagon contractors will be bleaker in 2013, analysts predict.
Whereas the defense budget top line peaked in 2010 and has only dipped slightly, projected spending on new equipment already has declined by one-third since 2008 and is on a path to go down another 10 to 15 percent, says Erich Fischer, a partner at the consulting firm Booz & Company.
The reductions in procurement spending have not yet hit home for many companies because the actual outlays of funds lag behind budget projections by two to three years. The budget began to come down in 2008, outlays peaked in 2010 and companies are now starting to feel the effects of a drying funding stream, Fischer says.
Another trend that bodes badly for defense firms is that weapon acquisitions budgets continue to be squeezed by rising military personnel, health and operations expenses.
“Some businesses are seeing decline up close and personal for the first time,” says Fischer.
The reality for industry is likely to be a 40 to 45 percent plunge in procurement spending since 2008, which is consistent with, or even less severe than, the previous defense downturn, Booz analysts estimate.
As a result, “2013 is when you will see industry begin to take real action” to cope with a shrinking market, Fischer says.
The largest Pentagon contractors have moved aggressively over the past two years to shed overhead, mostly by eliminating staff. The industry overall, however, is still saddled by huge fixed costs in unneeded facilities. “The head count reductions we have seen are emotionally difficult but the easiest to address. You’ll see more,” Fischer says. About 40 percent of industry overhead is in facilities, he says. Assuming that procurement spending falls by 40 to 45 percent from its peak, industry still needs to shed $20 billion to $25 billion of fixed overhead, he says.
The government could help propel industry efficiency if it offered to share some of the savings, Fischer says. The single largest barrier to internal corporate consolidations is that the downsizing doesn’t give companies an immediate boost to their bottom line, he says. On the government side, the same excess capacity problem exists. Structural costs have been baked in over the past decade of soaring budgets, Fischer says. “It takes two [both industry and government] to make the solution work.”
Defense Secretary Leon Panetta has called for new rounds of base closures, but Congress has soundly rejected such proposals.
“There is pressure on the Department to retain excess force structure and infrastructure instead of investing in the training and equipment that makes our force agile, flexible and ready,” Panetta says in a Dec. 18 speech. He criticized the House and Senate Fiscal Year 2013 defense authorization bills for “needlessly diverting $74 billion over the next decade into programs, equipment and activities we don’t want or need.”
Some defense companies have the skills and equipment to diversify into commercial markets, but Pentagon contractors have a mixed track record in that area. “The jury is still out,” says Fischer. “Fundamentally it’s whether commercial business models can coexist with traditional defense business models.” But he cautions that commercial products increasingly will dominate the defense market.
Non-traditional defense companies such as Accenture, Airbus, Apple, Cisco, Dell, Eurocopter and Pilatus, among others, have become increasingly successful in the defense sector, accounting for around 40 percent of Pentagon acquisition spending for hardware programs,according to a Booz & Co. study. “In response to competition, defense companies should reduce capacity by focusing on structural and systemic costs such as facilities,” the report says. “Companies should then reinvest those proceeds in capabilities that will differentiate the company for future growth.”
At least 50 percent of the government services market also is served by non-traditional defense companies, he says. “What won’t work is companies leapfrogging directly into commercial businesses with no overlap.”
Defense companies in previous drawdowns have had little success in reinventing themselves as commercial product providers.
Defense contractors are going to need their customer to help, too, Fischer says. After the post-Cold War downturn, the Pentagon worked with shipyards, for instance, to restructure the Virginia-class attack submarine program, which was hugely over-budget and in danger of being terminated. “Contractors and the Defense Department worked together … cost went down … shareholders and customers were rewarded,” he says. “More of that collaboration would be beneficial.”
As they prepare for a leaner market, companies also have to adjust their expectations about future business, says Andrew Krepinevich, president of the Center for Strategic and Budgetary Assessments
“We talk about modernization, but what we get is recapitalization,” he tells an Air Force Association conference. The recent history of military procurement programs tells the story, he says. Instead of the Future Combat Systems, the Army got Strykers, MRAPs (mine resistant ambush protected vehicles) and armored Humvees. Instead of the next-generation Comanche scout helicopter, the Army gets upgraded Blackhawks and Apaches. Instead of a futuristic Crusader howitzer, the Army is buying upgraded Paladins and Excalibur precision-guided artillery shells. The Navy terminated its CGX cruiser, is only buying three next-generation DDG 1000 destroyers and, instead, is bulking up the fleet with existing Arleigh-Burke combatants. The Navy plans to buy a more advanced combat aircraft, the F-35 Joint Strike Fighter, but today is only acquiring F/A-18 Super Hornets.
“We talk about taking the great leap forward, but we’re doing in-kind replacement,” says Krepinevich.
Given the budget outlook, he says, “That might not be such a bad thing. … Why should I spend money to develop a Bradley Fighting Vehicle replacement when the end result gives me marginal improvement in effectiveness? I ain’t got the money to do that.”
Defense leaders will have to become increasingly “ruthless about whether to recapitalize or modernize,” he says.
Also on Pentagon contractors’ radar screen for the coming year are new defense policies that Congress approved in the 2013 National Defense Authorization Act.
Notably, the NDAA calls for a 5 percent reduction, over four years, in both the defense civilian workforce and service contractors that support the Defense Department. It also lowers the cap on contractor pay that is allowable for Defense Department reimbursement from $750,000 to $237,000.
One of the measures that could have substantial impact on industry is a provision that prohibits the use of cost-type contracts for the production of major weapon systems, with very limited exceptions, says industry consultant Jim McAleese of McAleese & Associates P.C.
On a more optimistic note, McAleese points to recent comments by Panetta when he spoke to troops in Kuwait this month. Panetta insisted that, regardless of what budget cuts have to be made, the Pentagon cannot afford to stop funding new technology. “We have to invest; this cannot just be about cutting,” Panetta says. “We have got to invest in space. We have got to invest in cyber.  We have got to invest in unmanned systems. We have got to invest in new technologies.”
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Topics: Business Trends, Doing Business with the Government, Mergers and Acquisitions, Partnering, Service Contracts, Defense Contracting, Procurement, Defense Department