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July 1, 2012

Less Money for the ‘Arsenal of Democracy’

The opportunity behind the headlines

ON DEC. 29, 1940, NEARLY A YEAR before the United States was pushed into World War II, President Franklin D. Roosevelt used one of his regular radio addresses to lay the groundwork for an unprecedented military buildup. Roosevelt said the United States could help its European allies beat back the axis powers, but only if it used its industrial might to build the world's biggest defense. “We must have more ships, more guns, more planes—more of everything,” he implored. “We must be the great arsenal of democracy.”

FDR's “arsenal of democracy” speech kicked off a national commitment to build and maintain what would quickly become the world's biggest military. Even today, the $614 billion that the United States currently spends on defense is more than the next 10 countries combined.

But the era of outsized procurement spending may be coming to a close, as the political pressure to reduce the federal deficit builds. Indeed, the contraction has already begun: The drawdown in the wars in Iraq and Afghanistan have prompted congressional budget-cutters to reduce projected military outlays over the next decade by $487 billion below previous plans. Another $500 billion in defense cuts will kick in automatically in January, unless the White House and Congress can pass a budget with at least $1.2 trillion in federal spending cuts.

As dire as the defense cutbacks may appear, many industry experts believe there is still plenty of opportunity for companies in the metals industry. Even as the domestic defense budget shrinks, the Pentagon's push for our allies to bear more of their defense costs should lead to an increase in exports of weapons, jets, trucks and other hardware. At the same time, the increased demand for lighter vehicles creates an opening for the most nimble and tech-savvy innovators who work with composites and other cutting-edge materials.

While Congress still has six months to avoid the $500 billion in additional cuts, fears are building inside the Pentagon—as well among defense contractors—that the two parties won't be able to bridge their ideological rifts enough to do so. But even if they do, Wall street analysts such as Credit Suisse AG's Robert Spingarn still believe about 16% to 24% of the $1.2 trillion in additional reductions would come out of the military budget. The Credit Suisse analyst believes Pentagon spending could easily drop to $500 billion over the next two years, and maybe even more in the future. “Fiscal reality will require further cuts later,” Spingarn says.

The Tough Hits: R&D and Procurement

And yet Spingarn warns that may not mark the trough. Given the budget deficit, Spingarn believes that what con- tractors care about most—the Pentagon's research and development and procurement budgets (see “shrinking Roots of Innovation,” page 24)—could shrink by as much as 35%, to just $147 billion, by 2017, “as Congress views defense as a cost center to pick at to reduce fiscal spending.” Washington insiders agree that the defense budget may prove to be an easy target for lawmakers demanding a peace dividend. “The question is not if, but how fast, defense funding correction occurs, and whether cuts are responsibly targeted or arbitrary,” says James McAleese, an attorney and defense analyst in Sterling, Virginia, who represents a number of contractors.

While a 22% reduction in military spending would be no different than what contractors saw when the Cold War ended, the prospect of deep cuts is already sounding alarms in the Pentagon and beyond. Already, Defense Secretary Leon Panetta has warned that the additional cuts could be “devastating.” Similarly, executives at the many companies supplying the Pentagon fear that the cuts could go too deep. “Clearly, as we wind down in Iraq and Afghanistan, the budget ought to be reduced,” says John Batiste, a retired major general in the U.S. Army who now serves as President and CEO of Klein Steel Service Inc., a Rochester, New York- based metal supplier. “But we ought to be careful about cutting defense too much.”

Typically during military cutbacks, weapons pro- grams get the worst of the axe, forcing contractors to trim production and lay off workers. But if there's any good news for the metals industry and other suppliers, it's that Pentagon officials have signaled their desire to apply more of the reductions to personnel costs to help preserve its key weapons programs. Pentagon planners acknowledge they are trying to avoid situations where “if you lost a particular part of the industrial base it would take you years and years and years to recapture it, if ever,” then-Undersecretary of Defense for Policy Michele Flournoy said in a speech in January. Instead, military officials have signaled their desire to cut troop levels and bases, as well as the benefits currently paid out to retirees.

One Solution: Slippage
 

At the same time, the Department of Defense has sig- naled its intent to realize some savings by “slipping” some procurement programs a few years out into the future, even if it costs more in the long run. Analysts note the Navy lost very little in the first $487 billion of Pentagon cutbacks, with vessels such as the new class of 12 ballistic missile submarines simply being deferred two years into the future.

As a result, the cuts are likely to ripple through the Pentagon supply chain—from the largest contractors to the hundreds of metals providers and suppliers that serve them. “There's no question that military demand for high-strength steel is going to decline in the years ahead,” says Loren Thompson, chief operating officer of the non- profit Lexington Institute, a defense-oriented think tank in Washington, D.C. Thompson notes that while submarine construction is scheduled to continue at the rate of two per year, the purchase of heavily armored vehicles—particularly trucks for overseas contingencies—“is largely complete,” he says. “There just isn't going to be much more production for MRAPs,” the Mine Resistant ambush Protected vehicles with armored steel that were built at a cost of $17.6 billion to survive Improvised Explosive Device (IED) attacks in Iraq.

For aluminum makers, the news is only slightly better, he says. Thompson notes that there is an expected surge in fighters, and the military is entertaining the production of 80 to 100 next-generation bombers. But in general, aluminum production “is likely to be weak too, because the annual production rates are not as high as expected.” What's more, Thompson notes that composites are being substituted more and more for metal in aircraft construction. “So it's a mixed bag,” he says. “The military will remain the largest customer for some makers of aluminum and steel products. But in general, demand levels are unlikely to be as high as they were in the last decade.”

Even as demand falls, Thompson expects the pace of change to accelerate even more for the Pentagon's contractors and suppliers. After decades in which the Pentagon largely subsidized the R&D costs of the next-generation products, the military is now asking those same contractors to bear much more of the development risk. and rather than paying contractors to build customized products—a practice that was the standard operating procedure for decades—the Pentagon says it may give preference to products that are already commercially available, which suppliers also say creates pressure for them to absorb the R&D costs.

New defense contracts force companies like Lockheed
Martin to take on more risk developing new projects,
like the F-35 Joint Strike Fighter.
One Result: Lower Profits

 

The new era of austerity is already creating uncertainty within an industry that, despite the buildup, has labored with lower profits in recent years. (According to a Deloitte study released in March, the average profit margin in the defense and aerospace industries is 10.5%, or a little more than half the average for all U.S. industry.) In a research report released in January, Morgan Stanley defense industry analyst Heidi Wood said that a review of recently signed contracts showed what she called “draconian” terms. In her report, Wood noted that Lockheed Martin Corp. had raised concerns about the level of risk that the Pentagon was making it bear on the F-35 Joint Strike Fighter. Boeing, she noted, had accepted a “near zero margin” fixed con- tract to build a new refueling tanker.

And with the Pentagon now under pressure to do more with less, it's pushing contractors for scores of design changes that make their products lighter and simpler to use. For instance, until now the Marines have used 38 amphibious ships to transport two Marine Expeditionary Brigades and the mountain of equipment, up-armored vehicles and aircraft they bring along on international missions. But the Pentagon's latest shipbuilding plan only provides for 33 amphibious ships. To squeeze everything onto five fewer ships, the marines are looking to reduce the extra weight of many of its vehicles, which have been loaded with extra communications gear and larger weapons to defend against iEDs in iraq. while the army has been looking at building the planned army marine Joint Light Tactical Vehicle in the 20,000-pound range, the marines now want a vehicle closer in weight to the 8,000-pound Humvee.

The Pentagon is expected to make sure that key con- tractors such as Boeing co. and Lockheed emerge OK, but even these big suppliers worry about a potential shakeout among the thousands of smaller suppliers that they rely on for critical components.

Richard Aboulafia, vice president of analysis for the Teal group corp., a fairfax, Virginia-based research firm, notes that the defense department's move to defer some big-ticket programs is of little help to smaller subcontractors without the financial resources of the giants. “A lot of these contractors are laboring under heavy debt loads,” Aboulafia says. Given these pressures, some experts believe the shrinking defense budget will lead to more consolidation as some firms opt to cash out and the remaining players look to spread their overhead across a wider revenue base.

Other Solutions: Diversify and Export
 

While some may sell, many other firms have taken steps to diversify more of their business away from defense and into the commercial market. Lockheed has established a cyber-security business servicing companies that operate power grids, and general dynamics paid $960 million to acquire Vangent, a healthcare IT firm. Sen. Claire Mccaskill (D-Missouri) has urged the federal aviation administration to certify a commercial version of Boeing's C-17 aircraft, most of which is manufactured in her state.

And the biggest contractors—those with the biggest marketing muscle and the broadest reach—have begun targeting international markets. Such efforts come with the blessing of Pentagon officials, who are working to revise export control regulations so U.S. contractors can sell more abroad. Loosening the rules for foreign sales not only allows U.S. allies to shoulder more of their own defense costs, but it also helps keep the production lines of key American contractors humming, even as domestic demand shrinks. Raytheon co. reports it is already generating a third of its military sales from overseas customers, while Boeing co. inked a hefty military deal in India.

Defense cuts mean the Marines will have 33
amphibious ships rather than 38 for
transporting equipment.

But the biggest deals are being made with our allies in the Middle East, given the Obama administration's desire to keep Iran in check as U.S. troops in that region are withdrawn. Last December, the administration agreed to sell 36 Lockheed martin f-16s to Iraq, while allowing Oman to acquire a dozen more F-16s. U.S. officials also brokered a $29.4 billion weapons deal with the Saudis that included 84 advanced Boeing F-15sa fighters.

The arms sales also help fulfill another Pentagon objective: helping tie key allies to the United states—allies the United states will need to provide technical and logistical support for the hardware they buy. Lockheed CEO Robert J. Stevens told reporters on a conference call in late January that such sales ensure “more cooperation on shared security objectives” with allies that use advanced U.s. technologies.

And yet, for all the certainty among lawmakers and Pentagon officials that defense spending will decline, that could all change with the next terrorist attack or Middle Eastern conflict. History has shown that every time the United States thinks it can collect a peace dividend, a new global shock occurs. From the bombing of Pearl Harbor to the Libyan conflict that resulted in Muammar Gaddafi's ouster last august, history is replete with crises that demanded a U.S. military response. As retired army general Tommy franks liked to say, when it comes to defense plans, the enemy inevitably gets a vote. For contractors, that may mean the United States remains the arsenal of democracy at a level that's determined by events rather than budget-deficit politics.

 


Dean Foust was a writer, editor and bureau chief for BusinessWeek for 23 years. He now produces thought-leadership content for corporate clients.