Defense 2015 Preview: Downturn Ends but Industry Troubles Not Over
Pentagon contractors are entering the new year with a mix of caution and optimism. Military spending is about to hit bottom and is projected to inch up over the next several years. With Ashton Carter as defense secretary, the Pentagon gains a leader who has been an ardent critic of budget cuts and will again be on the front lines of that fight.
But industry CEOs still face a rough road ahead as the Pentagon slows down arms purchases and military spending remains caught in the crossfire of partisan battles on Capitol Hill.
The industry heads into the fifth year of the defense downturn with some assurance that the “worst is behind,” said defense analyst Robert Stallard, of RBC Capital Markets. “We are seeing the trough in U.S. defense spending, and the next step is a return to growth,” he told investors. It remains to be seen, though, whether modest growth in the budget will boost contractors’ bottom lines. Investors also will be watching the Pentagon’s other budget, the “overseas contingency operations” fund that pays for ongoing wars.
Fiscal year 2016 is the last year of the trough according to the profile laid out in the 2011 Budget Control Act. The cap is scheduled to inch up in 2017 by about 2.6 percent, from $499 billion to $512 billion. But despite projections of 1 to 2 percent growth starting in 2017, “We think the fiscal situation will require the Department of Defense to live within its current means,” Stallard said.
The realistic view is that Congress will not lift the spending caps of the Budget Control Act. It likely will keep defense funding for fiscal year 2016 at the BCA level of about $496 billion. The administration is expected to request a higher amount of about $535 billion to $540 billion. A $535 billion request would represent a stunning 8 percent increase, said Stallard, “so even if the DoD asks for it, we would be very surprised if the Congress appropriates this much money." To avoid a civil war between fiscal and national security hawks, the new Republican leadership might keep the base budget within the caps while allowing “flexibility” in OCO spending. Similar dynamics played out last year leading up to Congress passing a $1.1 trillion “cromnibus” bill for fiscal year 2015, with about $490 billion for defense base budget funding and $64 billion for OCO.
For fiscal year 2016, the Obama administration put a $30 billion “placeholder” for OCO, but the rising cost of operations in the Middle East could drive up the request to at least $40 billion. Industry investors anticipate the Pentagon will use OCO funds to pay for items that would otherwise have been in the base budget, Stallard said, such as munitions, aircraft upgrades, equipment losses or attrition, spare parts, services and force “readiness.”
Prime contractors could see a much improved environment, said Roman Schweizer, industry analyst at Guggenheim Securities. “A budget above the caps will put the onus back on a newly seated Republican Congress to cut down the budget to the BCA level, or sequester would kick in. This would be a positive for defense primes in the near term because major programs would not sustain long-term cuts that would be difficult to reverse later if spending were to increase beyond the caps.”
The final outcome of the 2016 budget won’t be known until the fall, at the earliest. Congress could find a way to raise the budget caps in the Budget Control Act as it did in fiscal years 2014 and 2015 but this time it will be harder because of $45 billion in tax extenders that add to the deficit, noted Byron Callan, defense industry analyst at Capital Alpha Partners. Although lower than forecast interest rates for 2015 may give Congress some breathing room.
Compared to a year ago, the defense sector faces less uncertainty, but it is still “not out of the woods,” according to a new report by Bloomberg Government. “While pressure is increasing for greater defense spending, major increases in budget are unlikely. … Because the budget caps are unlikely to change soon, prospects for defense revenue growth are limited.”
The outlook is far more positive for the Pentagon’s top defense contractors. Despite a 15 percent decline in defense contracting from fiscal 2010 through 2013, the largest publicly traded defense contractors have fared well and outperformed the market, Bloomberg analysts said. “Top companies have pursued a variety of strategies to adapt. … They have cut employees and reduced research and development expenses.” The defense industry still faces challenges, and incumbents will be fighting for shares of a shrinking market.
Tough Times for Many Contractors
While military spending may have hit bottom, contractors are not going to see an immediate increase in business. “You have programs that continue to be stretched out or canceled, and that is driving the primes completely nuts right now,” said Jeffrey Sorenson, a retired Army lieutenant general and industry consultant at A.T. Kearney.
The cancellation of the Army’s new ground combat vehicle is a case in point, Sorenson told National Defense. “We visited 75 suppliers that are being affected. When you make a major decision, the ripple effect through the supply base is extraordinary.”
The Pentagon has sought to close excess military bases, reform benefits programs and shift money from aging weapon systems into procurement of new equipment, but Congress has rejected most of these proposals. The political back-and-forth keeps the Pentagon from committing future funds, said Sorenson. “This constant churn on the budget process is maddening.”
He is not confident that Congress will go along with Air Force bids to retire older aircraft like the A-10 and the U-2, or with Army plans to mothball combat helicopters and shift a portion of the fleet from the National Guard to the active-duty force. “I don't think that they're going to get relief,” said Sorenson. “There are grand expectations that with Republicans in charge they are going to be able to work through a number of contested issues.”
Congress’ rejection of the Pentagon’s recommended cuts in fiscal year 2015 will add $70 billion in costs over the next five years. Critics on the right and left have blasted Congress for failing to bring fiscal discipline to the Pentagon. For the defense industry, Congress’ inability to tackle Pentagon bloat means future spending on equipment will be squeezed. Government watchdogs, while cheering defense cuts, worry that Congress continues to play political games with the nation’s defense. The 2015 defense budget is proof of that, said Angela Canterbury, executive director of the Center for Arms Control and Non-Proliferation. The budget provides “unsurprisingly more funding of last century’s weapons, more budget gimmicks for the Pentagon, and more stuff military leaders don’t want or need.”
Industry Headed for Further Consolidation
With a somewhat clearer picture of what lies ahead, the defense sector is emerging from a “mergers and acquisitions” hibernation, Stallard said. He noted that 2014 has seen a notable pick up in defense M&A, with more than 60 defense-related deals announced in 2014. Most of these acquisitions were small and involved privately owned companies.
“As the defense sector becomes more comfortable in the improving outlook, we expect M&A to gather momentum.” Companies in the business of cyber security, intelligence, surveillance, electronics and unmanned systems are likely to be sought after.
Although many equity investors would prefer companies to keep up their share buybacks and capital return to shareholders, eventually they will expect to see real growth, Stallard said. “Some of the major defense primes have significant financial firepower that could be deployed on M&A.”
The Defense Department does not support mergers of top prime contractors, but it is open to vertical and horizontal integration down the defense supply chain. In some areas where there is perceived over capacity, such as in land systems and services, Stallard said, “DoD could actually encourage consolidation to strengthen the remaining players.”
Bloomberg predicts companies will seek to acquire niche technology specialties, rather than “empire-building.” General Dynamics made 13 acquisitions, and only two had more than $100 million in federal contract obligations the year they were purchased.
“M&A will gain more momentum in services and prime portfolio shaping,” said Callan, of Capital Alpha Partners.
Is There a Future in Foreign Markets?
After every defense downturn, the industry predictably turns to overseas markets for opportunities. And great expectations usually results in disappointment, said John Stack, aerospace and defense analyst at The McLean Group.
Although several U.S. arms makers have scored big-ticket sales in the Middle East and Southeast Asia in recent years, foreign markets generally have been difficult, Stack said. “The same players are going after the same business, competitions drag for years, and other governments have the same fiscal issues as the United States.”
International defense ambitions also could be tempered by currency, elections and energy trends, Callan noted. “We see exchange rates, the price of oil and non-U.S. elections as greater factors for defense in 2015 than in recent years.” The drop in the Yen relative to the dollar is the most significant currency trend, and if the Euro weakens further, that also could be something to watch, he added. In Middle East markets, a weaker Euro would help European contractors in competitions against U.S. firms.
Oil prices are another wild card. “Some of the world’s largest defense spenders also are major oil producers,” Callan said. As prices fall, some countries may have to choose between defense modernization and domestic programs. Upcoming elections in the United Kingdom and Canada could shape defense spending in those countries and their future plans to invest in U.S. weaponry, notably the F-35 joint strike fighter.
Schweizer, of Guggenheim securities, said foreign military sales should continue to be a “solid driver for the major platform primes.” There are a number of pending international procurement decisions for air and missile defense systems in Germany, Poland and Turkey that could go in favor of U.S. firms, he noted.
The Stockholm International Peace Research Institute, which tracks global arms sales, said sales by U.S. and Canadian companies decreased in 2013, while sales by Russian-based companies grew by 20 percent. “The share of global arms sales for companies outside North America and Western Europe has been increasing since 2005,” said SIPRI analyst Aude Fleurant. Also, the number of U.S. producers in the think tank’s top 100 rankings dropped from 42 companies in 2011 to 38 in 2013, he added. “These trends underline the modest yet continuing relative erosion of the domination of the U.S. and Western European producers.”
Concerns About U.S. Defense Technology
Pentagon officials have expressed increased frustration by the relatively low level of internal R&D investment by the U.S. defense industry. According to Bloomberg Government, Boeing, Raytheon, Northrop Grumman and BAE Systems cut R&D by more than 10 percent.
Many industry CEOs are not yet ready to shift corporate cash from share repurchases and dividend payments to R&D investments until they see a more predictable picture of the future, said industry consultant James McAleese, of McAleese and Associates. “There is clear disparity in responsiveness of industry CEOs to increasing contractor-funded R&D,” he said. “Some CEOs will not significantly invest.”
Callan attributes this to the mantra of “shareholder value” and lower tolerance for risk taking among top Pentagon contractors. “These firms are run differently today, with different expectations for returns, risk, allocation of cash flow and management incentives,” he said. “There isn’t an easy solution to DoD’s demand for more innovation and investment. DoD could fund more R&D programs, but in a tight budget environment, budgets would likely have to be cut in some procurement programs.”
To counter this trend, the Pentagon could seek to reform acquisition policies to encourage non-traditional defense contractors to enter the military market, Callan wrote in a recent report. “It could hope to attract firms run by managements and boards that are more willing to invest and take risk” such as startup SpaceX. Heritage firms are likely to resist these moves, he added, “but if the U.S. is losing its military technology advantage, efforts to block change could be dashed by national security interests, particularly if this loss of advantage is manifested in a very public way.”
The problem for the Pentagon is that private investors do not see it as an attractive customer, said Eric Sobota, managing director of BDO's Government Contracting Advisory Services. “There is little profit margin on government contracts.”
Considering the large investment that is required to develop advanced technology, the returns will not please investors unless it involves technology the government will help the company develop and allow the firm to sell commercially.
What’s Next for Acquisition Reform
The incoming congressional leadership — particularly the chairmen of the defense policy committees: Rep. Mac Thornberry, R-Texas, and Sen. John McCain, R-Ariz. — has made acquisition reform a high priority for the coming legislative season. But what specific actions Congress might take is anyone’s guess, said Sobota, of BDO.
“Acquisition reform really is a wild card at this point,” he told National Defense. With Carter as Pentagon chief, contractors should anticipate some regulatory changes. “He's more likely than past secretaries to get into the weeds of these things.”
Increased oversight and auditing should be expected, said Sobota. Future reforms could bring more regulations, he said. The Pentagon introduced new rules in July to tighten oversight of contractors’ accounting systems. The measure requires triennial audits of prime contractors by outside firms. Although this measure will only affects large, cash-rich companies, it will create a substantial expense for them, said Sobota. New regulations are being proposed in response to criticism of lax supervision of contractors’ expenses that are billed to the government.
Contractors also should prepare for tougher competition as the government comes under greater pressure to lower costs. A trend in recent years, to select bids based strictly on price, will intensify, Sobota said. Choosing the lowest-cost bid, though, comes at a price, he added. “Frankly, I don't think there's any thing wrong with it. But it's inconsistent with what the government is trying to do from an efficiency perspective.” In this environment, contractors are motivated to merge or buy competitors, which over time could make the entire market less competitive and make it harder for the government to get lower prices.
The low-bid mentality has created a cutthroat environment where an incumbent might lose a re-compete in a multimillion-dollar contract by a $10,000 difference. “The government is telling contractors: ‘We are going to take the risk of training a whole new company to do this to save $10,000.’ That couldn't be more contentious.”
Sorenson suggested that any acquisition reforms should help simplify the system rather than make it harder for companies to do business with the Defense Department. “If they just quit making it so complicated and get back to simple basics,” he said. “A critical design review at the Pentagon requires as many as 40 documents. When you look at those documents, some are redundant. If they went back and looked at the documentation and think what's really necessary, it could be reduced by 75 percent. That would improve things.”
Many contractors would like to see a less adversarial business climate. Contract negotiations that used to take a month are now stretching to six or 12 months because parties disagree over issues like commerciality (whether a product is commercial in nature), intellectual property ownership and other sticking points. “The current state of procurement wastes everyone's time and money and should be more efficient so war fighters get what they need when they need it and not six months to a year later after the procurement process is completed,” an industry executive told National Defense on condition of anonymity.
New Opportunities in Healthcare
In a landscape of diminishing work for defense contractors, military and veterans’ healthcare services offer some of the biggest opportunities, said Joe Chenelle, managing director of the U.S. defense and intelligence portfolio at Accenture. One of the most lucrative is a healthcare records modernization contract that would be worth $11 billion over 11 years. Accenture has joined Leidos and Cerner to compete for the contract, which could be awarded this fall. The massive information-systems project would cover six million veterans and nine million active-duty service members.
Other industry players like Computer Sciences Corp., General Dynamics Information Technology and IBM are expected to submit bids.
Another project is to provide electronic technical work documents to replace paper-based instructions, references materials and technical drawings, said Chenelle.
Major IT contractors also are vying for business under the so-called Vista project, or veterans health information systems and technology architecture. “The whole point is interoperability between records from military to civilian doctors,” he said.
Companies like Accenture see future work, too, in “wellness” programs to help veterans transition to civilian life and prevent behaviors like substance abuse and suicides, Chenelle added. The company received a $95 million contract for the Army National Guard Bureau Wellness Program.
Economic Macro Trends Bad for Defense
The Obama administration in October hailed new estimates by the Congressional Budget Office that the 2014 federal deficit of $486 billion had fallen by $195 billion from a year ago. The deficit is at its lowest point since 2007 but the long-term fiscal outlook for the United States should worry any industry that makes its living from discretionary government activities. That includes everything from national security to education, transportation, science, veterans’ benefits, energy and environment. CBO noted that discretionary spending fell in 2014, but mandatory outlays for Social Security, Medicare and Medicaid rose. With the surging population of retirees living longer, the government will struggle to pay for discretionary activities. And even a modest rise in interest rates could be financially disastrous for a government that borrows heavily like the United States.
“We'll have some tough decisions to make as a country on spending. Higher interest rates eventually will kick in,” said Stack, of The McLean Group. “The country is in denial. Artificially low interest rates are not sustainable.” In less than a decade, the annual interest paid on the national debt alone will be bigger than the defense budget. The nation has yet to come to grips with this looming reality, Stack said. For the defense sector, interest rates are a “ticking time bomb.”
Washington talks a good game on fiscal discipline but has yet to take meaningful action on mandatory spending that today consumes more than two-thirds of the federal budget, Stack said.
“Everyone gets it at the theoretical level. At the implementation level, the devil is in the details. Congress is in a continuing standoff, divided by deep philosophical differences.”
The U.S. economy is forecast to strengthen in 2015, fueled by consumer spending and business investment that could offset higher interest rates and global weakness, according to a Bloomberg survey. Under a best-case scenario, more economic growth would allow the economy to absorb these rising costs even at higher interest rates, but the economy is not moving as quickly as it should, Stack said. “We're not in a good spot. We're kidding ourselves about the great job reports.”
In defense contracting, it is still a tough environment that is plagued by uncertainty and unrelenting pricing pressure, Stack said. “If you're not a specialized business, or minority or veteran-owned, you're having a harder time competing.”
The industry in 2015 will muddle through, but all eyes will be on the 2016 presidential election and whether a new administration will change course on spending and taxing priorities, said Stack. “That will be a real inflection point.”