After Sequester, Defense Contractors Try to Assess Damage

The Navy in coming weeks will be taking four of its 10 air wings out of service. The Air Force will cut back flying hours. The Army will restrict training only to combat units that are headed to Afghanistan. Civilian Pentagon employees will receive furlough notices within a month.
Those are some of the immediate consequences of the automatic budget cuts that are now the law of the land, Defense Secretary Chuck Hagel said March 1 during his first Pentagon news conference.
For military contractors, it could be weeks or months before the damage from sequestration can be fully estimated. But there is no doubt that sequestration “will affect the private sector,” Pentagon Comptroller Robert Hale said in an interview with Bloomberg Government "Capitol Gains."
Big weapons contracts “will be cut back,” said Hale. “They won’t be canceled, but they will have to be cut back."
The sequester requires across-the-board cuts of $85 billion — $43 billion for the Defense Department, $29 billion for nondefense agencies and $13 billion for Medicare and other social programs — by Sept. 30. Defense reductions will affect about two-thirds of the Pentagon's $648 billion 2013 budget. Military personnel accounts are protected.
A Feb. 27 memo from Office of Management and Budget Controller Danny Werfel to executive branch chiefs said agencies will have considerable discretion to decide what programs to cut or delay. Once those decisions are made, Werfel said, agencies should inform contractors as soon as possible.
For the remainder of the fiscal year, the government will not be entering into new contracts or exercising options on existing contracts unless they “support high priority initiatives,” OMB said.
In the defense sector, service contractors will feel the pain immediately, whereas weapons manufacturers will take the hit more gradually, as the cuts filter down the food chain, said John F. Cooney, a government contracting attorney and partner at Venable LLP.
Cooney, who worked on the implementation of the Gramm-Rudman-Hollings sequestration in 1986, said industry should brace for more uncertainty. “There will be little advance public disclosure of which specific contracts will be cut and on what schedule,” Cooney said. “That information will be provided to contractors on an individual basis by the contracting officers, as they are given their instructions from above.”
Compared to the 1986 sequester, the current one is not only significantly larger in terms of sheer dollar amounts, but also in the way cuts are allocated. Because it was the height of the Cold War, President Reagan protected the bulk of defense spending, Cooney noted.
Pentagon officials said they are still hopeful that they will get some relief from the sequester by March 27, when the temporary budget resolution for fiscal year 2013 expires and Congress is expected to negotiate terms for an extension.
Contractors are not going to know precisely which programs will stay and which will go until agencies’ senior policy leaders have had a chance to analyze their priorities, Cooney said. The Defense Department is conducting 2,500 separate sequestration analyses for each of the 2,500 line items in its budget.
In April, the government would begin to issue furlough notices for civilian employees and contractors could start sending layoff warnings to workers. That will “increase the anxiety level of everyone involved in the government contracting process, but will provide companies little in the way of actionable information about whether their contracts are on the chopping block,” said Cooney.
The uncertainty could last for weeks or months, as agencies, technically, do not have to make the required cuts until September 30. Although the longer they wait, the more pronounced the cuts will have to be toward the end of the fiscal year.
Cooney speculated that the Defense Department and other agencies will sequence their reductions so that many of the cuts will occur after April 1, in the hope that Congress will turn off or reduce the scope of their sequester obligations by March 27. “The bill providing appropriations for the second half of fiscal year 2013 would provide a logical vehicle for suspending or further deferring the sequestration,” Cooney said.
“The Department of Defense is explicitly advocating a strategy in which Congress would use the continuing resolution to modify or abolish the sequester,” he said. The steps to implement sequestration that the Pentagon has announced are timed not to have their most significant impact until April, in order to “afford Congress and the White House the maximum time to act before the cuts really start to bite.”
The conventional wisdom is that small and medium-size contractors will bear the brunt of the financial impact from sequestration. As a result, there could be a wave of industry mergers, acquisitions and even bankruptcies, said Edward H. Tillinghast, a partner in the finance and bankruptcy practice group at Sheppard Mullin Richter & Hampton LLP.
“If contractor revenues and profits are cut, they’ll seek consolidation,” he said.
The biggest problem for companies now is not being able to make accurate projections or to plan for the future, he said, adding: “The uncertainty is not good for business. … Nobody has a good picture of where sequestration will most affect.”
Executives and analysts will make educated judgments but “nobody has any real confidence in those projections” because of the political stalemate over government spending, said Tillinghast. In recent conversations with Wall Street insiders, he said, the consensus was that the stock market has not reacted negatively to sequestration yet because the market is not sure what “normal” means anymore, he said. After the 2008 crash, “normal is a fairly volatile concept.”
With regard to cuts in government spending, the market will wait and see what happens, and deal with events as they come, Tillinghast said. The obvious truth is that nobody knows the exact impact, he said. “It’s going to take some number of weeks and months to sort it out.”
A similar conclusion was expressed by industry consultant Michael S. Lewis, of the Silverline Group. “We believe the operating environment will remain very volatile as program offices stay sidelined from normalized procurement activities,” he wrote in an email to clients. “Until program offices see budgetary visibility within their areas of responsibility, award flow will remain at the current, below average levels.”
Other analysts believe that the hand wringing in the defense sector over sequestration has been overplayed. “It’s been positively theatrical,” said Gordon Adams, professor of foreign policy at American University and a former Office of Management and Budget official.
The impact on government civilians and service contractors, indeed, will be abrupt, Adams said March 1 during a National Security Network Conference call. For weapons suppliers, “it will be a slope.”
Adams is skeptical that Congress will reverse the sequester when it tackles the 2013 budget resolution in late March. That would require both the House and Senate to waive a truckload of rules that govern budget making. ”If you don't want sequester, you have to change the way Congress makes budget,” he said. “That gets really complicated. … It is a quite a procedural mountain to climb to use the continuing resolution to fix the sequester.”
Lawmakers’ “casual attitude” on the day sequester took effect also bodes badly for any chance of reversal, he said. “It's hard to see where the energy will come from.”
That said, he added, “It is enormously unpredictable what will happen in the next five to six weeks.”
Todd Harrison, senior fellow at the Center for Strategic and Budgetary Assessments, said that much of the anticipated chaos could have been prevented had the Pentagon been better prepared. The sequester has been in the books since August 2011, when Congress passed the Budget Control Act, and yet the Defense Department did not start making contingency plans until November 2012, Harrison said. Defense officials reckoned that making cuts ahead of the sequester would be a self-fulfilling prophesy, and their gamble did not pay off, said Harrison. Former Defense Secretary Leon Panetta’s bombastic rhetoric about sequestration being a doomsday device that will turn the United States into a “second-rate power,” he suggested, distracted the department from preparing to cope with the cuts.
Hagel will not be embracing Panetta’s apocalyptic turns of phrase. He told reporters March 1 that the U.S. military has the world’s “best fighting force” and that budget cuts would not change that. “This is the security of the United States of America that we’re talking about,” he said. “We will do what is necessary.”
The challenge for the defense sector will be to get through the next two years, which will be messy, said Harrison. Budget reductions are mandated in 2013 and 2014, but the long-term forecast shows defense spending staying flat or slightly rising between 2015 and 2021. The current drawdown is expected to reduce defense spending overall by about 20 percent from its 2010 peak. That would be a “relatively mild” drop compared to previous post-war declines in military spending, Harrison said.
Industry groups are still holding out hope for a last-minute deal. “Despite our extreme disappointment that sequestration was not averted, we are by no means giving up the fight,” Aerospace Industries Association President and CEO Marion C. Blakey said in a news release. March 27 is the “next major opportunity for Congress and President Obama … to put a stop to the damage that sequestration is doing to our country.”
It had been assumed since the sequester was introduced in 2011 — as a mechanism to force a budget deal — that the defense industry would have enough political clout to make it go away. When it became clear that sequestration would happen, outside observers expressed surprise that military contractors were rather powerless to stop the cuts. “If the defense industry was unable to prevent the sequester, maybe it's not the political behemoth we make it out to be,” energy blogger David Roberts tweeted March 1.
Photo Credit: Defense Dept.

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