Sequester Sinks In, Extent of Fallout Unknown

What a difference a year makes. Pentagon officials spent the summer of 2012 talking themselves out of the possibility that sequestration would happen. A memo from Deputy Defense Secretary Ashton B. Carter to civilian and military leaders called for the Pentagon to “continue normal spending and operations.”

Carter struck a much different tone last month when he spoke at the Aspen Security Forum. “We are taking very seriously the prospect that this craziness is going to continue into the next year, because that’s the path of least resistance for the political system,” he said.

A budget deal that would reverse sequestration is nowhere in sight, so the Pentagon is adapting. A number of what-if scenarios emerged from the Strategic Choices and Management Review. Although the SCMR was billed as a menu of options and not a budget blueprint, it does get the Pentagon moving toward a new normal of reduced spending.

After a chaotic 2013, when the Pentagon had to slash $37 billion between March and September, Defense Department accountants ought to be better prepared for the next round. That will be a $52 billion hit for the budget year that begins Oct. 1.

It will not be pretty, Carter acknowledged. “We’ll get rid of old things we don’t need as fast as we can … treat our people as decently as we can, recognizing that we’re going to have to shed people.”

At first glance, sequester is simple math: Each account is sliced by 10 percent. But there are variables that can result in some accounts being hit harder than others. Personnel budgets were exempted in 2013, and the administration has yet to decide whether to continue that policy in 2014. If military payroll and benefits are spared again, the remaining accounts will bear more of the brunt. Another difference from a year ago is that the Defense Department in 2013 had unspent “prior-year” appropriated funds that it could use to shore up gaps in programs that lost funding as a result of sequester. That cushion is now gone, which would leave acquisition programs in 2014 exposed to deeper reductions.

For defense contractors, the outlook is still murky, as the Pentagon has not yet terminated major programs and so far has made sequestration a slow-speed event.

“I’m still waiting for the other shoe to drop,” said Tom Captain, leader of the aerospace and defense sector at Deloitte.

Remarkably, the revenue statements of major U.S. defense firms have not yet reflected the draconian sequester cuts. Because firms have been slashing costs for the past two years, they continue to make profits.

Nobody can yet predict when the bottom will fall out. “This period of uncertainty is resulting in a lot more fear about defense cuts than the reality has shown,” said Captain. Even if sequester is extended into 2014, “I do not expect U.S. companies’ revenues next year to shrink by 10 percent,” he said. “That is because of the uncertainty and the way we’re approaching sequestration.” The process, although highly disruptive, is turning out to be less dramatic than what had been speculated. A recent Deloitte report noted that revenues decreased 1.3 percent in the defense sector in 2012, and operating earnings declined 1.6 percent. “The BCA [Budget Control Act] hasn’t made its way to the income statements of [the top 20] defense contractors,” Captain said.

If and when these trends will change is hard to predict, he said. The consensus in the industry now is that sequestration will take time to take effect in a way that causes Washington to react.

The financial damage caused by sequester in the defense industry varies by sector and by company size. Overall, “it’s an enormous impact but it’s not immediately visible,” said retired Air Force Lt. Gen. David Deptula, who opposes across-the-board cuts. “When the traveling public was inconvenienced by reductions to the Federal Aviation Administration’s budget, the problem was immediately corrected,” he said. Defense cuts are not widely noticed outside of communities with a disproportionate share of military-related jobs. The danger, Deptula said, is that “it may be accepted as the norm.”

Industry analyst Jeremy Devaney predicts that, once job losses begin to mount in the defense sector, Pentagon contractors will have a stronger hand in their lobbying efforts against sequester. “It’s been a lot slower event thus far, more likely as a result of the Defense Department delaying how to apply sequester.”

Civilian furloughs, which only hurt government workers, did not make anyone budge an inch toward a bipartisan budget resolution that would remove sequester. But furloughs in 2013 only accounted for $2 billion of the $37 billion cut to the Pentagon’s budget. If the Defense Department starts canceling major programs, ripple effects across the defense industry could lead to job losses that are far greater than the pain suffered by public-sector workers.

The group that led the war on sequester for the past two years, the Aerospace Industries Association, has not given up. An AIA official told The Hill newspaper that the association is about to begin a new offensive, arguing the short-term budget “won’t stem the long-term damage.”

Another industry group, the Shipbuilders Council of America, also believes there is a chance that Congress will undo the cuts once lawmakers begin to feel the political heat from job losses in their home states. “Between the economic outlook and sequestration, the whole industry could be in a very bad place in 10 years,” said Joe Carnevale, senior defense advisor at SCA. Many lawmakers have not yet “connected the dots” between budget cuts and “real jobs in their districts,” he said.

Lobbying for defense jobs, however, has become a much harder job than it ever was. Industry consultant Loren Thompson, of the Lexington Institute, observed that the defense sector has lost its traditional political patrons. Contrary to the conventional wisdom that has the “military-industrial complex allied with conservatives, it is actually an orphan outside any political jurisdiction where it creates jobs,” Thompson wrote in Forbes.com. “Many Republicans view it as one more manifestation of big government, the closest thing that America has produced to industrial socialism.”

Carter agrees. The defense budget is an easier target for budget hawks at a time when 9/11 is fading in the public’s memory, the nation is tired of war, and politicians are unwilling to touch domestic health and retirement benefits, he said. “There was always a solid center of opinion that supported defense that you could count on, and it is much less so now.”

Topics: Business Trends, Doing Business with the Government, Service Contracts, Defense Contracting, Defense Department, Defense Watch