Defense Industry’s Worst-Case Scenario: Congress Punts Budget Decisions to ‘14

As the August congressional recess looms, the future is looking cloudier for defense industry.
The draconian budget cuts that federal agencies would have to make in January have been described by defense officials and industry groups as “catastrophic.” But an even more distressing scenario is now being contemplated — one that corporate executives dread even more than budget cuts: Another short-term deal that postpones tough decisions until next year.
Some “unnerving” chatter is circulating in industry circles about Congress possibly “striking and replacing” the budget sequester, and putting off a long-term deal until 2014, says Jeremy W. Devaney, senior defense analyst at BB&T Capital Markets.
The Budget Control Act of 2011, which Congress passed as a condition to allow an increase in the nation’s debt ceiling, requires federal spending cuts of $1.2 trillion over 10 years, equally split between Defense and civilian agencies. The sequester mechanism that the law mandates would chop $53 billion from the Pentagon’s fiscal year 2013 budget.
The speculation in recent months has been that Congress will wait until the lame duck session after the November election to hammer out a deficit-reduction deal that would avert the sequester by agreeing to a comprehensive package of spending cuts and tax hikes.
But with both sides digging in their heels — House Republicans wanting to protect defense spending without offsetting it with new revenues, and Senate Democrats drawing a hard line on any cuts to social programs — there is growing concern that a lame-duck deal will only be a stopgap.
Congress kicking the can down the road might be a worse outcome for defense industry in the long run than a $53 billion cut to the Pentagon’s budget, Devaney says. “Sequestration will be bad, but at least you rip the band-aid off.” It could be painful for a couple of years, but at least companies would have a clearer picture of what’s ahead, he adds. “Once you rip the band-aid off, you can start making business decisions,” says Devaney. Any short-term deal that keeps the uncertainty going for another year would be bad for the private sector, he says. “Can you imagine the business environment that we’ve seen in the past 18 months persisting for another 18 months? … Can you imagine this budget indecision extending into September of next year?” Devaney asks. “That would not be positive for business in any way shape or form.”
During aHouse Armed Services Committee hearing last week, defense industry executives made a last-ditch effort to remind lawmakers of the economic consequences of sequestration. But also mindful that lobbying efforts to have Congress reverse sequestration so far have been futile, the executives also pleaded for the administration to lay out contingency plans on how the sequester cuts would be applied.
“With no visibility, people don’t know where to position their business,” says Devaney.
Until the fiscal stalemate is resolved, there will be little room for discourse on national security strategy and long-term funding needs, Devaney says. “We have to figure out how to deal with the fiscal issues so we can go back to address national security priorities.”
Defense firms have seen investments come to a standstill because of the political paralysis in Washington. The top firms are sitting on cash reserves and have been cutting costs, but investors are becoming nervous about the long-term outlook, cautions a recentreport by Deloitte LLP, a consulting firm.
“Defense is shrinking overall,” says the report. “Industry financial performance generally fell in 2011.” Defense companies remain “challenged to maintain revenue, let alone grow, based on the BTB ratios,” says Deloitte. The book to bill (BTB) ratio is an indicator of future revenue growth.
Devaney says the industry's relatively healthy profits so far have defied the trends. Analysts’ consensus estimates forecast falling profit margins in 2012, and a recovery for 2013.
“This doesn’t make sense in a declining market,” says Devaney. He attributes the optimistic projections to management continuing to make a case that they can keep taking costs out of their business. That well is likely to soon dry up, however, he says. “We’ve been taking cost out of the system for two to three years now.”
The top five Defense Department contractors in aggregate are operating near peak margin, which is currently about 10.4 percent, says Devaney. “When you’re at peak margin, there’s not a heck of a lot of room to go up.”
Consensus forward estimates project a 20 basis point decline in 2012 to 10.2 percent, and a 30 basis point expansion in 2013 to 10.5 percent, which is above peak margins. The assumption that companies can continue to squeeze expenses from their operations is weak at best, he says. “After about two years of taking out costs you reach a point where you are cutting into the bone.” The belief that margins can continue to go up in a down environment is not grounded in reality, Devaney says.
Following the post-Cold War military spending downturn, many companies cashed out of the market in a wave of mergers and acquisitions. That option is not available now because of the political stalemate.
Companies across the U.S. economy are not only hesitant to buy other firms but also are reluctant to invest in research and new technology until the political fog clears.
The tone was set last week by Honeywell CEO David Cote, who joined a group of former lawmakers and industry leaders to pressure Congress to commit to a bipartisan debt-reduction plan. The “Fix the Debt” campaign was started by Erskine Bowles and Alan Simpson, who co-chaired President Obama's debt reduction commission in 2010.
Cote made it clear that “all investments are on hold” until Washington tackles the deficit in a comprehensive way, says Devaney.
If and when a budget deal is reached, there is the possibility of more defense cuts, beyond those already proposed by the Obama administration. Without sequestration, Pentagon spending is projected to remain flat over the next decade. A flat top line still puts pressure on the military to downsize as the rapid rise in Pentagon spending of the past decade can no longer be sustained.
Although more Pentagon cuts are not desirable to defense companies, Devaney says, “At least you know what channels to swim in at that point.”
Private conversations with industry executives reveal rising frustration about the tenor of the defense budget debate — dominated by shrill partisanship and lacking in intelligent discussion about how to tame the federal deficit. Several industry sources who spoke to National Defense on the condition of anonymity say that congressional defense hawks should not cave unless the progressive camp yields on social spending. But other industry officials blame pro-defense GOP lawmakers and administration leaders for unnecessarily turning the sequestration debate into a fear-mongering spectacle.
Laura Peterson, national security analyst at Taxpayers for Common Sense, a watchdog group, says even the Pentagon has proposed reasonable spending cuts that Congress has shunned, such as closing Abrams tank factories in Michigan, Pennsylvania and Ohio. HASC blocked modest reforms to the TRICARE military health system that would save billions, Peterson says. “It prevented the retirement of C-27J cargo aircraft; stuffed in money for Navy cruisers and ballistic missile submarines the Pentagon wants to defer; and nixed additional rounds of the Base Closure and Realignment Commission.”
Near the end of last week’s HASC hearing, Ranking Minority Member Rep. Adam Smith, D-Wash., lashed out at the industry witnesses for implying that only Congress is responsible for the current gridlock and indecision.
“That is exactly what public policy has come down to in this country. Everybody protects their own piece,” Smith says. “Everybody who comes back here is concerned about what happens to Medicare and Social Security, or they're concerned about this tax going up, or they're concerned about defense being cut, or they're concerned about something else. … So what happens is we divide and destroy, and every little piece of our country protects themselves and makes no argument whatsoever beyond that because that's easy.”

Topics: Business Trends, Business Development, Doing Business with the Government, Defense Department, DOD Budget, DOD Leadership, Procurement