Pentagon Contracting Trends Paint Gloomy Picture for Defense Industry

There is a growing consensus in Washington that military spending — despite the looming threat of across-the-board federal budget cuts in 2016 — could be ticking back up. Stepped-up combat operations in the Middle East, an escalation of military efforts to contain the Ebola outbreak in West Africa and the possibility of Republicans winning the Senate have created upbeat expectations.

New data on Defense Department contracting trends, however, pours some cold water on these forecasts. Pentagon contracts did plunge as a result of the 2013 sequester, but the squeeze on contractors is likely to persist into the future, analysts from the Center for Strategic and International Studies predict.

Defense Department contract obligations dropped by 16 percent to $314 billion from 2012 to 2013, a decline four times as steep as was seen from 2009 to 2012, aCSIS study estimated. The reduction in Defense Department contract obligations under sequestration was nearly three times as steep as between 2011 and 2012. From 2009 to 2013, contracts plunged by 26 percent.

David J. Berteau, senior vice president of CSIS and director of the study, said the abrupt decline is not likely to be a one-year anomaly.

"I think that when we see the 2014 data, we are going to see the trends all across the board continue," he said.

The report provides overwhelming evidence that the sequester, which was designed to cut government spending across the board, has affected contractors far more dramatically, Berteau said. Non-contract outlays, by comparison, remained mostly flat from 2012 to 2013, an indication that when budgets fall, federal agencies target contract spending as a measure of first resort. The study, conducted annually by CSIS, looks at contracting trends from 2000 to 2013 drawn from the Federal Procurement Data System.

"Contractors are paying the largest share of the impact of the decline," Berteau said. As a percentage of total gross defense outlays, defense funded contract obligations have declined from 53 percent to 49 percent in 2013, the lowest share since 2002.

Berteau said the industry might not want to keep pretending that its defense sales have hit bottom and are going to come back up. World events and new contingencies such as the war on the Islamic State and the Ebola crisis might boost emergency spending, but will not immediately lead to a broad bipartisan agreement to increase the current caps on government discretionary spending, he added.

At the Defense Department, uncertainty and churn will continue to delay weapon modernization programs. "It is only going to get worse from a contractor point of view," Berteau said. "I do no see the votes to change those caps any time soon."

Many defense CEOs believed when sequester hit, that it would be a one-time event, that "Congress would come to its senses, that we'd get our money back in 2014, and the caps would be raised," said Berteau.

A big warning signal for contractors is the precipitous fall in Defense Department research and development spending. R&D contract obligations dropped by 21 percent from 2012 to 2013, and by 39 percent from 2009 to 2013. The Army's R&D contracts went down by 35 percent and the Air Force's by 27 percent, compared to only 10 percent for the Navy.

These numbers show that the Pentagon, contrary to the official rhetoric, is paring back investments in advanced technology and modernization of the force, said CSIS analyst Greg Sanders, one of the authors of the study. After Congress passed the Budget Control Act and military spending took a dive, Defense Secretary Chuck Hagel called for a smaller, but more technologically advanced force. The data contradicts that vision, Sanders said.

As shown by impressive gains in stock prices over the past two year, large primes have pulled through the sequester better than small firms. The study provides compelling proof that the largest contractors are more sheltered from cuts. From 2012 to 2013, contracts for the Pentagon's top six contractors — Lockheed Martin, Boeing, Raytheon, General Dynamics, Northrop Grumman and L-3 Communications — dropped by 9 percent. For everyone else, they fell by 19 percent.

The numbers in the CSIS study should not come as a surprise to industry investors, says analyst Byron Callan, of Capital Alpha Partners. "The data likely conforms to many investor perceptions of what’s happened in recent years," he writes in a research note.

"Investors and analysts need to keep in mind that the data is for contracts — this is not the same as outlays," he warns. Contract awards more closely track company orders while outlays are more closely related to sales. Of particular interest to investors, he says, is that foreign military sales contract obligations fell 20 percent between 2012 and 2013 — from $26 billion to $21 billion. "FMS should not have been impacted by sequestration, but the data is a bit surprising given general optimism surrounding international defense growth opportunities."

Retired Marine Corps Maj. Gen. Arnold Punaro, chairman of the National Defense Industrial Association, said the report should raise red flags about the Defense Department's investment priorities.

“The report makes clear that the bill payer for defense cuts and sequestration has been our technological edge. From 2009 to 2013, overall defense spending is down 20 percent, but research and development spending is down 40 percent,” said Punaro. “We should not cut investments in technology if we want to remain the preeminent global military power. Senior defense officials such as Undersecretary of Defense Frank Kendall have underscored this point repeatedly.”

Topics: Business Trends, Doing Business with the Government, Service Contracts, Procurement