Defense Industry Waiting for the Fog to Lift

As they seek to weather a perfect storm of Pentagon budget cuts, government dysfunction and uncertainty about future business, defense executives are eyeing the 2014 mid-term elections and the 2016 presidential race.

“These next elections are going to have an influence” in the future of defense industry, said David F. Melcher, CEO and president of Exelis Inc., a $6 billion firm that supplies high-tech equipment to the U.S. military.

Government contractors who depend almost entirely on sales to the Defense Department and other agencies are hoping for a more stable business and political climate, and are looking at 2015 and 2016 as key mileposts in their corporate strategies, Melcher said Oct. 2 at a conference hosted by the Atlantic Council, in Washington, D.C.

The chaotic political climate that led to massive spending cuts known as sequestration and the shutdown of the federal government Oct. 1 has kept defense industry in a wait-and-see mode. Investments will be put on hold, Melcher said, “until the fog lifts.”

The political gridlock that has kept the Pentagon funded by stopgap measures for the past three years has effectively frozen corporate planning, he said. “We spend time on the Hill trying to protect programs and giving members our opinions,” he said. But none of that outreach helped avert sequestration or reach a budget deal to fund the government. “We are concerned about the polarization, the shutdown being emblematic of that,” said Melcher.

The largest Pentagon contractors have been preparing for a downturn since 2010, when they began shedding workers and consolidating facilities. But beyond slashing expenses, there is not much else they can control, Melcher says. Also hurting industry is that the Pentagon, without a budget, is in a state of strategic paralysis.

“Our customers in some ways are just as confused in a chaotic environment as we are, as they try to work through these budget drills,” he said.

Although most contractors have accepted sequestration as the new reality, they are still uncertain of how damaging it will be to the industry, said Melcher.

Defense companies have seen financial success, nonetheless. They have reported some of the stock market's best returns, in part because sequestration has been baked into company valuations, said Melcher. “Wall Street believes industry understands what's going to happen and is accommodating cost structures.”

Recent hikes in interest rates also have bolstered stock valuations because higher rates reduce future pension liabilities. Defense investors have been rewarded with utility-like stock dividends, but that can only last for so long. Eventually, the industry needs to start investing in its future, said Melcher.

One of the yet-unknown effects of sequestration is the possibility that financially strapped subcontractors will go out of business. “The industrial base is a big concern,” he said. “In most cases where are have problems in programs, it is related to the supply chain. We are really pushing the boundaries of what the supply chain can deliver.”

The current government shutdown also is cause for alarm, especially if it lasts more than two weeks, Melcher said. In a protracted shutdown, contracts are not awarded, or paid, and government officials who supervise contractors are not on the job. “There is a definite and real impact for every company in this industry,” said Melcher.

The upcoming battle on Capitol Hill over raising the nation’s debt ceiling is keeping executives on edge. “It is going to be very symbolic of this nation's credibility and will have real impact on financial markets,” he said. “I'm not a big fan of the brinkmanship that has been used around the issue.”

Once some clarity emerges on federal budgets and other issues, a big wave of industry mergers and acquisitions is likely, he said. “Consolidation will happen,” he said. “There will be industry realignment. There has to be.” Shareholders like stock buybacks, but there's only so many shares to buy back, he said. “You need other investment strategies.”

Every company is keeping its powder dry when it comes to mergers and acquisitions, he said. “I don't think the Defense Department is going to stand in the way.”
Industry’s calls for funding stability have fallen on deaf ears on Capitol Hill, so companies are adjusting their expectations.

“Businesses can, and will, adapt,” said Melcher. “Budget stability is important, but we are actually interested in the government solving some other problems as well.” That includes investments in education,, corporate tax reform and trade reforms, said Melcher. “There are bigger issues than just the defense budget.”

Topics: Business Trends, Doing Business with the Government, Mergers and Acquisitions, Defense Contracting, Government Policy