Forecast Calls for Stormy Business Climate

Bad news keeps piling up for Pentagon contractors. In the past six months alone, the defense-contracting sector has been buffeted by draconian budget cuts and by proposed new rules that would further limit government reimbursement of contractor salaries. The industry also has become the target of backlash over the former contractor and leaker of government secrets Edward Snowden.

The business climate might even get worse before it gets better. Any hope that sequester would be undone is rapidly fading as it becomes apparent that the bipartisan coalition that the defense industry could always count on to bolster military spending no longer exists.

U.S. defense budgets are projected to decline 20 percent between the post-9/11 peak reached in 2010. It will be downhill at least until 2017, according to forecasts. Weapons manufacturers had anticipated that budgets would come down after the wars ended, but were not prepared for the chilly environment on Capitol Hill. Deputy Defense Secretary Ashton Carter, who has been on the front lines of the Pentagon’s battle against sequester, recently called out Congress for allowing political agendas to take precedence over national security. “We are not feeling the recognition of the need to keep a strong defense,” he said.

Former undersecretary of defense for policy Michèle Flournoy said the Pentagon and defense industry must come to grips with the new reality that they no longer command the influence on Capitol Hill that they once had. “The politics of these issues have changed,” she said.

Defense industry leaders are just going to have to keep fighting the political and fiscal headwinds, suggested Wesley G. Bush, CEO and president of Northrop Grumman Corp. Even if industry lobbying failed to stop the sequester — which would slash military spending by $500 billion over the next decade ­— companies in the defense sector still have a “real obligation to be vocal,” Bush said. “Going silent on this issue would be a real mistake.”

Industry CEOs, with the benefit of hindsight, recognized that their plan to roll back the Budget Control Act — which Congress passed in 2011 — might have suffered from overconfidence as it had been assumed that politicians would protect defense spending because it creates jobs. Bush said industry should begin to promote other contributions, such as its potential to unleash technological advances, and, indirectly, bolster national security.

Corporate profits, meanwhile, will be squeezed on multiple fronts. The automatic spending cuts, whose effects are slowly trickling across the Pentagon’s supplier chain, will result in many delays and cancellations of weapon programs. The upshot could be more layoffs and industry consolidation. And companies might have to curtail their executives’ salaries in light of a proposed new rule that sets limits to how much the government can reimburse contractors for their employees’ compensation.

Under current policy, the top five executives at defense corporations are subject to a $763,029 cap. The revised rule would extend the cap to every contractor employee working for the Defense Department, the Coast Guard and NASA. The Senate’s recent immigration reform bill would expand the scope of the rule to executive salaries of Department of Homeland Security and National Guard contractors.

Thomas A. Lemmer, a partner at McKenna Long & Aldridge LLP, a law firm that advises government contractors, said these compensation caps are part of fiscal restraint as the government cuts back, but also are politically motivated. Companies should not be surprised by these developments, he said, as Congress is clearly in the mood to punish contractors. “These regulatory changes will impact margins on government contracts and will require exact accounting to avoid government assessment of penalties for claiming expressly unallowable costs,” he said. “Clients should strongly resist government efforts to apply these expanded compensation limitations retroactively.”

The uproar over Snowden — a former Booz Allen Hamilton employee who leaked National Security Agency classified information — is expected to spark more anti-contractor sentiment. Measures being considered by the Senate include restricting contractor participation in top-secret national security projects. There are also discussions about limiting the number of employees that a contractor can assign to sensitive programs.

This should be a “wake-up call” to companies that do business with the government, said Francis Q. Hoang, a partner at Fluet Huber + Hoang PLLC, another firm that represents federal contractors. Although it would be unfair to cast blame on the entire industry for the Snowden affair, the case is a reminder that industry has to be always on guard. Companies have to constantly review their compliance programs, he said. “I’m sure Booz Allen is taking a very hard look.”

Whether the NSA leak will have lasting repercussions on the contracting sector remains to be seen, Hoang said. “Existing regulations provide plenty of enforcement tools for the government to encourage contractor compliance and penalize wrongdoing. … I would expect, however, that agencies would use those existing tools more aggressively following the NSA leak.”

Potentially of greater concern to industry, he said, is that many contractors will see their costs increase indirectly through higher insurance premiums, legal and other compliance costs, and more customer scrutiny, which will require additional time and energy in response. There also will be heightened oversight of areas not related to the recent leak, such as more frequent audits by the Defense Contract Audit Agency or the Defense Contract Management Agency that might be looking to investigate issues that previously may have gone overlooked, said Hoang. “These will all drive up overhead costs and administrative expenses.”

But the challenges of having to quelch political fires in Washington might pale in comparison to the larger market forces that the defense industry is up against.

The defense market is changing, and whether that is good or bad depends on how companies respond to the shifts that are occurring. The oft-heard lament that the defense market is “not there anymore” is only true if one defines the market as warplanes, armored vehicles, ships and other traditional military hardware, said Chuck Wald, a consultant at Deloitte and a retired Air Force general. There is a future in “affordable high-tech” such as communications, information systems, cyberwarfare tools and tactical gear for special operations forces. Companies that intend to stay in this market, he said, must figure out what the “new normal” is and move forward.

Topics: Defense Contracting, Defense Department, Defense Watch, DOD Budget, DOD Policy