Contractors Face Fight-or-Flight Decisions

The defense industry has only just begun to feel the sequester bite. Most of the top players — as evidenced by stock prices and executive compensation over the past two years — continue to prosper even in a down market.

But many companies in mid and lower tiers of the defense supply chain will likely be either financially unable or unwilling to weather the storm. Executives see Washington headed for yet another year of budgetary games of chicken and stopgap funding measures, and their reaction is a collective, “uh-oh.”

The usually reliable guideposts for determining where the business is headed are nonexistent today. The Obama administration proposed a defense budget for next fiscal year that ignores the 2011 deficit-reduction law. The House and Senate each unveiled its own budget blueprints that reflect ideologically divergent views on how the nation should balance spending against revenues.

Anyone trying to discern the direction of defense spending is left shaking his head, says Jim Stein, vice president of government affairs at SCHOTT North America. The company, which manufactures high-tech glass and other materials used in military equipment, is a subsidiary of Germany-based SCHOTT Group.

Pentagon spending reached its peak in 2010 and has been falling since as a result of sequester and the end of two major wars. In the long term, the cutbacks are expected to be less draconian than previous post-war military downturns. While up and down cycles are the norm in the defense business — and companies adjust accordingly — it is the political environment that is causing angst.

“It’s affecting us in how we look at the defense market,” says Stein, a former Navy officer who spent many years in the Pentagon. “When you see three budgets out there and so much uncertainty … that is a lot of churn for us.”

Companies such as SCHOTT, whose business does not depend entirely on government contracts, are increasingly questioning whether to invest in military-focused technology or even whether they should continue to do business with the Pentagon. In the current environment, research-and-development funds most likely will focus on products that have commercial applications. This is, “unfortunately, to the detriment of the war fighter,” Stein says.

No one should be surprised that companies choose to not pursue expensive ventures that are aimed at the defense market. Midsize and small firms, Stein says, are “hunkered down, trying to sustain what we have.”

Industry groups have been sounding alarms about a fragile “defense industrial base” where the weakest companies — some of which are sole-source suppliers for items the Defense Department buys — will be shutting down when contracts dry up.

The Pentagon understands the problem, but sees it as a natural consequence of a down spending cycle. It is not the Defense Department’s job to be a “lifeguard” that rescues failing companies, says Brett Lambert, deputy assistant secretary of defense for manufacturing and industrial base policy. “We have a tremendous amount of excess capacity across all sectors. ... And we have to start rationalizing it,” he tells a recent industry conference. Lambert predicts “there’s going to be a lot of bad news” for some companies.

The idea that the market, not the government, picks winners and losers has been the de facto industrial policy of the Defense Department for decades. “There is a belief in the Pentagon that they will always have suppliers when they need them,” Stein says. But he wonders if that conviction will hold true during the coming downturn. “I don’t think they understand that the dynamic has changed,” Stein says. Companies that are diversified will see defense work as something that they don’t have to do. “Is the component base going to be around?” he asks. “Not as much as the Defense Department thinks it is going to be around.”

The administration and Congress have been in a budget stalemate that is heading into its third year, and this is keeping contractors on edge. “For now, we’ll stay on the sidelines until this all plays out,” Stein says. “If things don’t work out the way we want to, we’ll get off the playing field. … We aren’t going to stick around and subsidize the Department of Defense.”

How does a company decide it is time to exit the defense market? Stein says the “real friction point” is when a company can no longer afford to keep its highly skilled employees. SCHOTT, for instance, has experienced technicians who manufacture fiber optics for military night-vision goggles. If there are no contracts for those products, the company must still continue to pay those workers. The question executives must wrestle with is how much revenue loss is acceptable to keep those employees on board.

“We just want to see some decisions,” says Stein. “We want to participate in national security and be contributors, but we are kind of stymied.”

Many companies have echoed similar sentiments. Contractors fear that, in the absence of insight about where the market is going, they might eliminate portions of their business that they are going to need for future growth, says Jeremy W. Devaney, defense industry analyst at BB&T Capital Markets. It is the same reason why corporate mergers and acquisitions are at a near standstill. “Nobody understands where the future fast moving water is,” he says. “You don’t want to be too quick to pull the trigger.”

Weapon manufacturers and services providers that are entirely focused on defense are always tempted to shift gears and venture into commercial markets, but their track record in diversification is rather poor. “At some point you run the risk of being distracted from the core mission,” Devaney says. “Traditional defense contractors find it challenging to operate in the commercial market.”

Also fueling the uncertainty is that the government has not offered any projections to contractors on what programs might be cut, says George A. Price, also a BB&T analyst. “What I’ve heard clearly from my conversations with companies is that agencies have had little communication with contractors on the magnitude, scope of cuts and how they’ll be handled.”

If contractors thought political dysfunction hit rock bottom in fiscal year 2013, they could be in for a rougher ride in 2014, as members of Congress gear up for mid-term elections and presumably maintain rigid ideological positions.

Topics: Business Trends, Doing Business with the Government, Defense Contracting, Defense Department, Defense Watch, DOD Budget, DOD Policy