In ‘15 Budget, Red Flags for Contractors

If defense industry CEOs can draw any conclusion from the Pentagon’s 2015 budget proposal it is that, except for the too-big-to-fail joint strike fighter, most of the military’s modernization plan is on shaky ground.

The most illustrative example is the Army’s fruitless quest to modernize its combat vehicles. The budget terminates the Army’s ground combat vehicle, which was conceived as a replacement for another failed program, the future combat systems. The budget also kills the Army’s tortuous modernization plan for its Vietnam-era scout helicopters.

A similar story unfolded in the Marine Corps, which has long sought to replace its aging armored vehicles that swim from ship to shore and serve in land combat roles. In both cases, Army and Marine leaders fought for their vehicle programs and named them “top modernization” priorities, but ultimately had to cut their losses. The conventional wisdom at the Pentagon now is that the safer course is to fix, rather than buy new. The services will have to try again when the budget climate improves.

Navy shipbuilders, meanwhile, are trying to discern the consequences of the Pentagon’s decision to truncate the littoral combat ship program to nearly half the number originally planned. Navy leaders spent the past decade championing the LCS as the linchpin of the future fleet, and gave shipyards assurances that they would be building vessels for decades. It turned out the LCS cannot survive a missile strike and is ill-equipped to go into hostile waters, so the Pentagon told the Navy to go back to the drawing board.

Doubts about future weapons also abound in the Air Force, which is gambling the bulk of its modernization dollars on the F-35 and a new refueling tanker, but is still unsure where it will find the money for everything else. Like the Army, the Air Force expects to live with what it has and wait for the fiscal storm to clear. When it comes to “new starts, whether for helicopters or airplanes, we’re in an environment now where we are having to be very careful about starting anything new, and we’re looking very carefully at what the tradeoffs are between something new versus extending what we have,” said William LaPlante, assistant secretary of the Air Force for acquisition.

The latest round of military acquisition flameouts caps a decade of procurement misfires that has left the Pentagon billions of dollars poorer, but without the modern equipment to show for it.

“The substantive increases of the defense base budget after 9/11 have not resulted in equivalent gains in purchasing power, primarily because of escalating compensation, operation support and procurement costs,” said Acting Deputy Defense Secretary Christine Fox. “The result has been relatively little recapitalization of our military’s inventory.”

One of the big messages of the 2015 budget is that the Pentagon has no desire to invest in bold, risky ventures. At least for the foreseeable future, the strategy is to minimize full-scale development projects and instead fund “prototyping” projects that keep engineers employed but cost less than traditional programs.

“It’s all about risk management,” said Undersecretary of Defense for Acquisition, Technology and Logistics Frank Kendall. The Pentagon is considering prototyping initiatives to retain “critical parts of the industrial base” in areas such as air superiority and space, he said.

For the majority of defense firms, however, prototyping projects are not going to cut it. Executives insist that to stay financially viable, they need production contracts and some predictability on future Pentagon requirements.

“We need stability and certainty,” said one executive who did not want to be quoted by name because he works for a Pentagon contractor. The Defense Department is asking industry to invest in new technology, “but in order to do that we need to be relatively sure that we’ll have the opportunity to compete for sufficient quantities of systems,” he said. “We see a lot of uncertainty in the procurement area. … They advertise lofty numbers and then they buy one-third to one-half of what they advertised,” the executive said.

Kendall gave notice that the uncertainty will continue as long as the Pentagon and Congress remain at odds over funding levels. The 2015 budget that the Pentagon put forth, like the 2013 and 2014 requests, exceeds congressionally mandated spending caps set in 2011. Defense officials said they will continue to push back, and believe they can convince Congress that the restrictions are unreasonable. Until that dispute is settled, the clouds will continue to hang over weapons programs.

The sequester chopped $16 billion from defense procurement and research and development in 2013. For 2014 and 2015, those accounts will be $37 billion smaller than what the Pentagon had proposed three years ago. The overall annual budget for technology investment is about $160 billion.

Fox said investments are being “squeezed by stubbornly high operating and personnel costs.” As a result, the “scrutiny will only get more intense on individual programs.”

Defense contractors have to brace for more pain, she said. “Strategic priorities may in some cases require weapons programs to be delayed or even canceled outright, with commensurate loss of jobs, revenue and shareholder value.”

Industry analysts wonder whether it is time for executives to stop whining and come to grips with fiscal and political realities. At least through the remainder of the Obama administration there is no chance of bipartisan consensus on any major issue, let alone the defense budget. Many lawmakers have been dependable supporters of the defense industry, but if the choice is to increase funding for weapons at the expense of military benefits, contractors will come out on the losing end.

When industry CEOs complain that they have no “visibility” about the future, what they are really saying is that they wish the Pentagon spent more money on the stuff they want to build, said James Hasik, a defense industry fellow at the Atlantic Council.

A more plausible explanation for the Pentagon’s indecisiveness regarding future weapons is that the building is more focused on the budget fight than on its potential enemies on the battlefield. The 2015 budget “fails to provide any meaningful picture of where the United States is going and of the defense posture it is trying to create,” said Anthony Cordesman, of the Center for Strategic and International Studies.

Defense Secretary Chuck Hagel said the Pentagon is “repositioning to focus on the strategic challenges and opportunities that will define our future: new technologies, new centers of power and a world that is growing more volatile, more unpredictable. … Fine, but how? Where? When? And to what end?” Cordesman asked. “The secretary’s plans and sense of direction seem to go no further than getting through fiscal year 2016.”

Topics: Business Trends, Doing Business with the Government, Defense Department, Defense Watch, DOD Budget, Procurement, Defense Department