Stuck in Fog of Budget Uncertainty, Pentagon Suppliers Plan for Austerity

7/6/2012
By Sandra I. Erwin

By Sandra I. Erwin
TheFarnborough Air Show in the United Kingdom next week will see a defense industry subdued by the U.S. and European budget gloom. Setting the tone was the announcement on the eve of the event that the host country is dramatically downsizing its armed forces to levels not seen in more than a century.
U.S. military suppliers — most of which have scaled back spending on marketing and attendance at international arms shows — are fretting over looming budget cuts that could slice more than $50 billion from next year’s Pentagon budget.
Fiscal cliff melodrama aside, U.S. weapon makers are carefully studying ways to reposition themselves in the defense market. They are scouting overseas opportunities and incursions into civilian aerospace as they look beyond the political crisis that has paralyzed spending by their biggest customer.
The industry mood at Farnborough could be described as, “Let’s manage to the new environment and the new reality,” says Richard Bergmann, managing director of Accenture North America aerospace and defense.
What Bergmann calls the “new world order” for defense industry is one where the Pentagon will be buying less equipment and pressuring contractors to lower prices, where opportunities for foreign sales will remain despite a tougher market, and where military spending will be shifting from heavy hardware to all things cyber.
“One of our themes at Farnborough is ‘program profitability,’” says Bergmann. Defense contracting companies can still make a lot of money amid global austerity, but they will have to change how they do business, he says. Some of the immediate items on the to-do list are to trim fat from corporate structures. Defense firms have grown accustomed to being reimbursed by the Pentagon for expansive overhead, he says. In the future they will be greatly scrutinized for their ability to complete programs on budget and on schedule, and they will have to compete for fixed-price contracts, which favor leaner suppliers.
Sour feelings across the industry about possible sequestration are legitimate because the budget cuts are automatic, not planned, and could wreak havoc on corporate balance sheets, says Bergmann. But the temporary crisis doesn’t alter longer term financial realities for defense industry and for governments that procure equipment, he says. “There will be a macro reduction in total sales.”
Within the U.S. defense market, a shift already is under way, he says. Top Pentagon contractors are making major investments in what they see as the “new battlefields,” including cybersecurity, electronic and drone warfare. This trend alone is going to force companies to downsize their traditional operations, Bergmann says. “If I’m focusing on cybersecurity, do I need 10,000 people at a manufacturing facility?” he asks. “Unmanned aircraft are less expensive to build than fighters or bombers.” The evolution in the market would happen regardless of the nation’s fiscal woes, he adds. “It’s not just an austerity issue. It’s also necessary change.”
The traditional industry OEMs (original equipment manufacturers) will need to become leaner in order to compete in these new market, says David Fitzpatrick, managing director at AlixPartners aerospace and defense practice. “People who have the confidence to play in cybersecurity don’t come from the OEM prime contractor bureaucracy,” he says. “They come from small high tech firms. They can bring the price of that stuff down,” says Fitzpatrick. “If OEMs try to use their normal complexity, the prices jump.”
Companies in the cyberwarfare world are being scouted by potential buyers, Fitzpatrick says. There is significant investment capital waiting for the sequestration mess to get sorted out, he says. Investors are asking: “Who can I buy now that might have a big play later?” says Fitzpatrick. “There’s quite a few conversations on that topic that could lead to some interesting mergers-and-acquisitions activity in the next 12 to 18 months.”
In the international arms business, meanwhile, the big prizes are still in heavy hardware. Only a handful of nations currently are in the market for new tactical combat aircraft, but every major manufacturer is fighting tooth and nail to win those deals, Fitzpatrick says. The number of fighter jets that countries are buying have declined, but “those programs are so significant because they mean thousands of jobs,” he says. “They could have an impact on company fortunes and national employment in certain areas.”
Farnborough, despite the current doldrums, still offers one of the most lucrative showcase opportunities for military suppliers. For U.S. firms, international sales will not make up for Pentagon cutbacks, but will help keep employment and profits relatively steady, Fitzpatrick says.
Annual U.S. government foreign military sales have grown from an average of about $12 billion at the beginning of the last decade to an average of roughly $38 billion over the last three years. About one-third of U.S. defense industry output today is supported by exports, according to Defense Secretary Leon E. Panetta. In a June 28 speech to the U.S. Institute of Peace, in Washington, D.C., Panetta laid out U.S. plans to boost international military sales.
A slew of bureaucratic reforms are under way to help expedite the export licensing process, Panetta says. “This means better anticipating partner needs ahead of time and fast-tracking priority sales.” The Pentagon has set up a new “special defense acquisition fund” to buy “long-lead, high demand items in anticipation of partner requests,” he said. Panetta also has assigned a group of officials to focus on international business development. These new “expeditionary requirements generation teams” will send experts abroad to help U.S. allies better define and submit their requests, he says. A “defense coalition repair fund” is being proposed to pay for equipment repairs in anticipation of customer requests.
Panetta cited India as one country that is being pursued as a customer.
Plummeting defense budgets across the NATO alliance means U.S. firms will need to expand into new regions where pockets of growth still exist, such as the BRICs [Brazil, Russia, India and China] and the Middle East, Fitzpatrick says. “Competition will be fierce.”
Damien Lasou, managing director of Accenture aerospace and defense business, says U.S. industry might see growing opportunities in Brazil and China, but these nations also are becoming both stronger consumers and suppliers of aerospace technology, and will compete with U.S. firms in the global market. “Russia and China are reportedly planning to build a new long-range aircraft,” says Lasou. “This will likely be a hot topic of conversation at Farnborough.”

Topics: Aviation, Business Trends, Business Development, Defense Department, DOD Budget, International

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