Sequester Impact: More Than Meets the Eye

Recent news reports seem to imply that sequester isn’t so bad after all. The economy doesn’t appear to be falling off the cliff. Corporate earnings are good, and the market remains on an upward vector. Jobs are being created, and unemployment is falling, though at a tepid pace and as a result of more part-time jobs. The downside to falling unemployment is that total employment remains down, and as a percentage of the workforce it is at a historic low. But pundits generally agree that this sequester thing has been overstated and overblown.

The defense sector merits further analysis. First, the largest defense companies are beating expectations on earnings per share. In the second quarter, top defense firms such as General Dynamics, Lockheed Martin, Boeing Co. and Raytheon Co. reported better than expected performance. On the surface this all seems quite good, until one drills down a bit more. 

At GD, only the aerospace segment is up. Combat, marine and information systems all are down in operating income, and project a steady decline in backlog. For Lockheed, revenue is actually down and the aeronautics and information systems segments are flat with mission systems and missiles up in profit.

Boeing’s performance is driven by an uptick in commercial and international sales of airliners. It also benefits from an aggressive cost-cutting program. In Boeing’s military segment, revenue is down though earnings are up. Raytheon’s revenue is up slightly though backlog is down. Intelligence, information and services, and space and airborne systems divisions are down in both revenue and operating income, while integrated defense systems and missile systems are comfortably up because of robust international sales.

The conclusion is that when one digs deeper, the results are more mixed, with increases driven by cost cutting, and commercial and international business. The U.S. defense market is now showing signs of a beginning slide. Recall that the sequester cuts for 2013 were $37 billion. Some of the reductions were accomplished through prior year unobligated balances. And what most folks don’t talk much about are reductions to 2013 outlays — the money actually spent. Because some money is not spent the same year it’s authorized, the reduction in outlays for 2013 was $20 billion, rather than $37 billion, according to Bloomberg Government estimates. In 2014, the sequester would amount to $52 billion but the outlay hit grows by 50 percent to $30 billion. What this means is that, over time, the pain will grow.

So even though things seem OK for now, a steeper decline is coming. Jay DeFrank, vice president of Pratt & Whitney, said industry leaders are apprehensive. DeFrank was chairman of the Aerospace Industries Association steering committee’s “Second to None” campaign that sought to raise awareness of the damaging consequences of sequester on the aerospace and defense industry. “One of the things that worried me is that the campaign made it seem we were going to go off a cliff when sequestration started,” he said at a Brookings Institution gathering. “I never really liked those countdown clocks. Danger is not in year one. It’s cumulative. Impacts magnify each year.”

Most media reports have oversimplified the issue. “Big defense contractors are weathering the federal budget sequester far more easily than they projected, in part because they have quietly eliminated jobs over the past few years in anticipation of spending cuts,” noted The Washington Post. But contracts are booked many years in advance, and it will take time for the full effect to be felt. Defense Department spending plans extend over five years, so reductions to budget authority in year one will take some time to play out.

Meanwhile, Senate and House appropriators continue to mark up and vote on the president’s 2014 budget as if the Budget Control Act (BCA) caps and sequester did not exist. Both have voted on 2014 appropriations in the neighborhood of $527 billion for the base budget, well in excess of the BCA caps. It is likely that we will begin the new fiscal year on Oct. 1 with another continuing resolution that will be subject to sequester. Because of the building bow wave of lower budget authority and higher required outlays, 2014 will begin to show more serious cracks in defense industry earnings.

Smaller suppliers are beginning to feel the bite in advance of the larger firms as contract awards slowed, and subcontracts slackened or stopped. The fact is that less work is being subcontracted. Small businesses are trying to diversify, but their options are much more limited than they are for large firms, which started their adjustments three years ago.

As the Defense Department begins to feel a tighter bite next year, it remains to be seen how the military services ultimately absorb the cuts. Civilian furlough days for this year were reduced from 11 to six, but Defense Secretary Chuck Hagel has already laid his marker that involuntary reductions in workforce in 2014 remain a real possibility if BCA and sequester are not adjusted.

Assuming sequester continues for some time, the choices are shaping up to be between force structure and investment. There is talk of a reduction of flying squadrons in the Air Force, lower numbers of Army brigade combat teams, fewer battalions in the Marine Corps and a smaller fleet of Navy aircraft carriers. The problem is that force structure takes some time to come down. That leaves investment — research, development and procurement — and operations as the bill payers in the shorter term. No one but the professionals appreciate the impact this has on readiness and war fighting capability. Some significant damage already has been done. Sequester extending to 2014 will do more.

Investment accounts will increasingly see the strain. A safe bet is that, about this time next year, one won’t be seeing headlines such as, “Sequestration Headwinds More Muted Than Across-the Board.” In the story, Bloomberg noted that 62 percent of firms reported a detrimental impact on revenue. Next year that could well be higher.

Financial gains made by larger firms via cost cutting and increased international sales will not be available to the same extent in 2014. And deeper cuts by the Defense Department will be expected as unobligated balances are depleted. One technique not seen yet is that the Defense Department could slow payments to contractors as the Pentagon stretches to cover the $30 billion outlay bill.

One last point: 2014 is an election year. Everything will have a political cast to it. A bipartisan agreement to adjust the BCA is unlikely. Like a tsunami, we can see further pain fast approaching. The wave hasn’t hit full force just yet, but it will.

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