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March 1, 2014

Defense Budget Bumbling

The biggest impact of the much-hyped cuts may be the aggravating uncertainty.

Chris Gash

“Defense contractors talk about it all the time” at industry conferences, says Joe Homko, senior director of manufacturing at Liberty Ammunition, a Clearwater, Fla.-based ammo maker that has sold to the military but mainly markets now to other buyers.

He’s talking about sequestration. Specifically, the $500-billion-over-10-years of military budget cuts that were to result from Congress’ inability three years ago to agree on a comprehensive plan to reduce the federal budget deficit. The effects of what is officially known as the Budget Control Act started kicking in last year. The prospect of sequestration had the entire range of defense contractors, prime clients of the metals industries, in full battle cry about the damage that would be done to the nation’s military—and to their businesses.

To date, however, the impact of sequestration has been as much psychological as economic, if not more so. Even after the sequestration talk and U.S. military pullbacks from Iraq and Afghanistan, defense spending adjusted for inflation is still way above what it was at the time of the 9/11 attacks in 2001. It is also higher than in the mid-1980s Star Wars buildup during Ronald Reagan’s presidency. Indeed, data from the Stockholm International Peace Research Institute (SIPRI) tells the story (see chart below). SIPRI figures that in inflation-adjusted 2011 dollars, military spending went from about $570 billion in 1988, Reagan’s last full year in office; to about $400 billion in 2000, the year before 9/11; to $668 billion in 2012.

 

Fear of the Unknown Future

Yet, despite the substantial and even increased funding, fear of the unknown future prevails. “The big problem,” says Dorothy Coleman, vice president, tax and domestic economic policy at the National Association of Manufacturers, “is the uncertainty.” Sequestration, she adds, leads to “a hesitancy to invest and hire.”

The uncertainty is surely increased by the Obama administration’s proposed defense budget for fiscal year 2015, which begins on October 1, 2014. The budget, which was proposed in late February, would produce the smallest U.S. Army in decades. Technically, the budget as presented would follow the modified-downward sequestration rules for FY 2015, while telegraphing the possibility of far bigger cuts in FY 2016 and beyond.

“You have fewer troops, fewer ships, fewer planes,” Defense Secretary Chuck Hagel told reporters. Army troop levels would fall from 520,000 to as low as 420,000, while an entire class of attack jets would be eliminated.

Since it’s only a proposal, the budget is subject to all kinds of political horse-trading as it goes through Congress. Some observers see this opening salvo as posturing by the administration to force Republicans into supporting tax increases or canceling automatic sequestration with their mandatory bigger cuts. 

Larry Farrell, president and CEO of the National Defense Industrial Association, another trade lobbying group, made the same point as Hagel about sequestration at a U.S. Senate Committee on Appropriations hearing late last year. “If left in place,” he said, “sequestration will deliver a defense industrial base that is smaller than the investments taxpayers make in it, less agile than our military needs it to be, that makes fewer investments in research and development on its own dime, and is much more at risk of losing critical capabilities we will need in the future. … Neither our military nor defense industry can cope with the levels of uncertainty we have faced for the past few years.”

 

Softening the Impact

On the ground, though, a variety of factors has so far softened sequestration’s harsher impacts. These factors are rooted in the law, in later congressional amendments, and in accounting fashioned by canny Pentagon bureaucrats who have considerable experience at jiggering budgets. They have included such devices as using money left unspent from prior budget years as well as tapping vast “contingency” funds earmarked for overseas operations. In addition, the compromise budget deal signed by President Obama as 2013 ended gave the Pentagon $22.5 billion more to spend than it would have had if sequestration had remained in place. Sequestration allegedly capped national defense spending at $498 billion in 2014. Now, it will get more than $520.5 billion, though that’s still below the pre-sequestration cap of $552 billion. In the Washington game of budget roulette, agencies rarely get everything they ask for.

Undoubtedly, the vigorous lobbying and public relations efforts mounted by the military industrial complex have borne considerable fruit. “Defense contractors have been screaming for a long time,” says Jeffery A. Green of J.A. Green & Co., a Washington, D.C.-based consultant and lobbyist with expertise in critical metals.

Many companies, especially the larger ones, have found replacement customers in the private sector or even new military patrons abroad. A report by research group IBISWorld said, for instance, that General Dynamics, the country’s largest defense contractor, avoided significant declines in revenue by focusing on its service segment (repairing and upgrading existing weapons systems) rather than its product segment (mainly selling new weapons systems).

 

Of Course, There Are Cutbacks

To be sure, there has been belt-tightening in the defense sector, especially where it concerns new products and upgrades. The Army, for example, says it has been forced to scale back many of its modernization programs, from the already-controversial Ground Combat Vehicle, the next generation of armored fighting machine, to upgrading programs for battlefield communications networks. Sales are also slowing for fighter aircraft like the F-15 and F-18 made by Boeing and the F-16 manufactured by Lockheed Martin, but that may have as much to do with sluggish foreign demand as sequestration.

Nevertheless, a December 2013 study issued by Market Connections Inc. and Lohfeld Consulting Group found that nearly two-thirds of all government military contractors “experienced moderate to significant revenue decline in 2013 as a result of sequestration and the government shutdown.”

But it’s a lot harder to find the kind of catastrophic business devastation that was predicted one or two years ago. There are examples, but they are difficult to pin exclusively on sequestration. GMA Cover Corp., a modest Port Huron, Mich., business that sold camouflage cover systems to the military, closed its doors in October 2013, blaming sequestration along with the government shutdown. But local press accounts say the firm had been having problems for years. More common than permanent closures have been regional media accounts of layoffs or temporary furloughs in particular companies.

And all of this was before that modest budget deal that Congress approved and Obama signed in December 2013, which canceled about half of the publicized defense sequestration cuts for this year and about 25% of the defense cuts for 2015.

The pact itself didn’t eliminate sequestration, which is supposed to play out over a 10-year period running through 2022. But because the legislation had few details other than defense versus non-defense, the exact outcomes remain unclear.

 

The Market Shrugs

Still, if financial markets are any measure, sequestration effects have been mild. Stock prices of many large defense-oriented, publicly traded companies are at or near record highs, even as U.S. military involvement in Iraq and Afghanistan is winding down. These developments only make it harder to sort out the impact of sequestration.

Dan Stohr, a spokesman for the powerful trade group Aerospace Industries Association, figures the 2013 hit to the military was about $37 billion.

Many experts say it’s clear that modest-size companies (with sales of $500 million or less) are feeling the brunt of the impact down the supply chain, where many metals service firms reside. “Small guys are going to be impacted the most,” says Bill Edgar, managing director, aerospace and defense consulting, at IHS Jane’s. Stohr agrees that there are “tighter margins the farther down you get,” due to such factors as inventory buildup and the inability to diversify.

The problem for the smaller players, as Liberty Ammunition’s Homko says, is that components of the supply chain simply can’t be turned off and then quickly back on like a faucet—which may prove to be one of sequestration’s lingering effects. “After you staff down,” he says, “it’s hard to build up.”

In earlier times, he says, the Department of Defense tended to give two to three years’ notice of a reduction in future purchasing, which gave a company some time to adjust its business or look for non-military customers. But the advance word for sequestration cuts often has been just months, he says.

The lesson here seems to be that it will be devilishly difficult, especially for smaller players along the military equipment supply chain, to predict, and therefore adapt to, any impact that sequestration might have on them. Relationships with contractors will be crucial for establishing an early warning system. But it also seems prudent, in these times of daffy congressional budget strategies, to diversify as much as possible to dilute the risk that haunts the business of military contracting.


William P. Barrett is a veteran business journalist. He can be reached at wmpb@aol.com.