After a Tumultuous Year, Can Defense Industry Get Back to Business in 2014? | National Defense Blog

By Sandra I. Erwin

Defense industry is happy to bid 2013 adieu. It was the year when the hits just kept on coming. The dreaded sequester that everyone predicted would never happen, happened, as well as a government shutdown to boot. Government workers were furloughed, and Congress allowed them to recover lost pay. No such break was afforded to contractors. The industry had anticipated the Pentagon would pare back spending following the end of two wars, but CEOs were not prepared for business to grind to a halt as Washington crawled through the gridlock.

For an industry that always could count on bipartisan support, 2013 brought home the reality that those days are over, at least until the military is sent to fight another war.

The passage of the Bipartisan Budget Act of 2013 has given the defense sector a temporary reprieve. After turbulent cycles in 2012 and 2013, federal appropriations in 2014 and 2015 will stay relatively flat, and Congress is signaling that it will not allow the government to be shut down by acts of brinkmanship.

For the Pentagon, the future looks a bit brighter now than it did before Dec. 10. Instead of facing a 6 percent drop in 2014, the budget bill trims 2014 spending by 1.2 percent from 2013. Under the agreement, the 2015 and 2016 budgets will drop slightly in real terms, although at about the same pace as every recent year other than the 2013 sequester cut, according to budget analyst Russell Rumbaugh, of the Stimson Center. From 2017 on, the Budget Control Act caps keep the defense budget in lockstep with projected inflation.

But any hope for the end of sequester must be buried. By all accounts, no sweeping budget agreement that would roll back sequestration is on the horizon, at least until the next administration. One of the key negotiators of the budget deal, Rep. Paul Ryan, R-Wisc., pointed out that 92 percent of the sequester will remain in place.

“The budget deal is only for two years and we still have seven more years of sequestration beyond that,” said Christian P. Marrone, vice president of national security and acquisition policy at the Aerospace Industries Association.

Some budget analysts have dubbed the deal a defeat for the Pentagon, considering that civilian and military leaders had been pleading for Congress to undo the sequester in its entirety.

In 2015, the Defense Department gets back $10 billion, but the $520.5 billion top line is still $40 billion less than the funding levels for which the Pentagon had been planning up until a year ago. Between now and Jan. 15, Congress has to pass a 2014 defense budget that is $30 billion less than the president’s request, noted Rob Levinson, senior defense analyst at Bloomberg Government. It has been more than a decade since lawmakers have had to put together a budget that cuts the president’s plan to that extent, Levinson said during a Dec. 17 Bloomberg webinar. The 2015 budget, he said, will provide the first signpost of the Pentagon’s strategic choices as it downsizes its ranks.

The Pentagon and its contractors now have some breathing room to plan for life after 2016. To be able to live within the Budget Control Act spending caps through 2023, the Defense Department civilian bureaucracy, the military services and the industry will have to be smaller and leaner than they are today. How precisely that will be done is still to be decided.

Return to Stability?

Military leaders have cautioned to not see the budget compromise as a cause for celebration, although they are grateful for any semblance of fiscal normalcy. The two-year agreement “does not eliminate the impact of sequestration,” said Air Force Chief of Staff Gen. Mark Welsh. “It will mitigate it for the first couple of years and maybe allow us to do a better job of staying ready as we transition to the new reality.”

Even with this respite, Defense Department leaders recognize they have a small window of time to come up with a politically viable plan to take unpopular steps to thin the ranks and eliminate excess infrastructure. “The sooner we can get on that path, the sooner we can get to a new normal,” said Air Force Undersecretary Eric Fanning.

The budget compromise creates a risk, though, that the Pentagon will become complacent and assume it can keep pushing off austerity, observers have warned. Indecision would be bad news for defense CEOs as they plan for the future, said Charles F. Wald, head of the Deloitte defense practice. Because the Pentagon is not going to have the budget it used to have, it behooves Defense Department leaders and Congress to ease the transition by setting budget priorities, jettison questionable programs and fund key technologies that will give the U.S. military an edge in future wars, Wald said.

Procurement Budgets

What happens over the next two years will have major implications for the industry’s lifeline — the procurement, research and development budgets. The concern is that these accounts will become a piggy bank to pay for less negotiable expenses such as personnel benefits and healthcare. Procurement of equipment and weapons topped out at about $130 billion in 2010 and has dropped to $105 billion in 2014. Under the Obama budget, procurement was scheduled to grow to $123.2 billion between fiscal years 2014 and 2018, a scenario that is now regarded as overly optimistic. Todd Harrison, of the Center for Strategic and Budgetary Assessments, estimated that during the two previous defense downturns, procurement bottomed out at $62 billion in 2014 dollars.

The political paralysis and ensuing budget crises that began in 2011 have taken a toll on procurement programs, and it could be a long time before predictability returns to the defense business. Even with a flat budget, the military services will have to cut weapon programs unless they are allowed to shed force structure.

The Air Force finds itself in such logjam. To protect funding for its top priority projects — the F-35 Joint Strike Fighter, the KC-46A refueling tanker and a new bomber — it has sought to retire aging aircraft and cancel less pressing programs but it has faced congressional backlash, Programs are at risk in the Army, too, as the service struggles to fund major acquisitions. A Bradley replacement, known as the Ground Combat Vehicle, is in danger, noted Shaun McDougall, defense budget analyst at Forecast International. A non-developmental armored multi-purpose vehicle has a better chance to survive, he said. Planned purchases of new helicopters also face an uncertain future.

In the Marine Corps, it is still not clear if it can afford a new amphibious combat vehicle while simultaneously upgrading existing platforms, as is envisioned in the current plan, he said. The Marines have already put their new personnel carrier program on hold. “The requirement could disappear altogether if the Marines decide to pursue a larger ACV fleet,” said McDougall.

The Navy has reduced the minimum number of ships it says it needs from 313 to 306. It is clear that the Navy cannot afford its shipbuilding plan, he said, and it remains to be seen how budget cuts will affect the future fleet.

Government-Industry Tensions

Before defense industry can return to a more predictable business environment, officials said, buyers and sellers will need to repair fractured relationships. Tensions have worsened over the past several years as spending plunged and mistrust ensued.

Lt. Gen. Charles R. Davis, military deputy at the office of the assistant secretary of the Air Force for acquisition, said fences must be mended. “We are very poor on the military acquisition side about understanding the drivers in the business discussion,” Davis told a Credit Suisse conference of defense investors. “The process for getting a proposal out of industry and for our teams to negotiate and sign a contract is just unbearable,” he said. Most of the disputes are over expenses that industry bills the government. “Negotiation timelines are unsustainable,” said Davis. “We are losing money every time we drag these things out.” That partly explains why so many programs are being delayed, said Davis. When programs take longer than planned, the Defense Department risks losing the funds from that year’s appropriation. The Air Force on average loses between $200 million and $600 million of its annual appropriated budget because of “under execution,” said Davis. That means a contract wasn’t signed, milestones were not met or bad performance did not warrant the funding. That money ends up going back to the Treasury.

Every program these days draws high-level scrutiny because of the budget environment, he cautioned. “Everyone is second guessing the programs that are out there.”

Contractors can expect more reviews and more oversight, Davis warned. The current reviewing, however, is a case of too much of a good thing that ends up being counterproductive, he said. “In some case we achieve the opposite of what we are trying to achieve.”

At the core of government-industry mistrust is a belief among contracting officials that prime contractors and their suppliers overcharge for overhead expenses. Overhead rates generally account for 30 to 60 percent of a Defense Department contract, according to Davis. In most Air Force contracts, prime contractors pass on 50 to 70 percent of the work to subcontractors. “That is generally where our contracting officers just run into a brick wall in terms of trying to understand” subcontractor costs, said Davis.

Who Should Take Risks?

Industry executives, meanwhile, have complained about being on the losing end of a “war on profits.” Davis said it will take efforts on both sides to do business in ways that benefit both buyers and sellers. “If we can decrease the cost of a program and increase the profit for the company, we’d be all for that, he said. “Unfortunately we are seeing costs rising year after year and the request for profit goes in the same direction. If we could work those in different directions, I think you would see a different type of acquisition process.” Davis called the current policies “arcane” because they reward contractors for adding cost to a program.

At the root of these problems is the perennial question of who should bear more of the risk in a defense program. Contractors worry that if they bid too low, they will lose money so they price the work to compensate for the risk they take, said Joe Chenelle, managing director of Accenture’s defense and intelligence portfolio.

Each party tries to push more risk on the other, and that is a manifestation of a lack of trust, Chenelle said. “We are not for low-cost bidding,” he said. “We are for shared risk and incentives.” The Defense Department and industry must develop “trusted relationships.”

More Acquisition Reforms

Also to the chagrin of defense industry, lawmakers have become increasingly disenchanted by the performance of defense acquisition programs despite piles of new rules that have been imposed over the past decades to help lower costs and speed up deliveries.

House Armed Services Committee Vice Chairman Mac Thornberry, R-Texas, will be leading a new effort to revamp defense acquisition. This is significant as Thornberry is expected to succeed current HASC chairman Rep. Buck McKeon, R-Calif.

Weapon systems are moving in the wrong direction, lawmakers have griped. In 2012, the Defense Department obligated $360 billion worth of contracts, or 10 percent of the entire federal budget and 52 percent of the department’s total commitments. From 2008 to 2012, development and production cost overruns accelerated, and delays worsened. Congress has to “do a better job watching for cost growth but also understanding why it happens,” Thornberry said.

Marrone, of the Aerospace Industries Association, predicts 2014 will be an eventful year in the defense acquisition world. Of note is an expected new draft rule that could increase the Pentagon’s purchases of products from commercial vendors, as opposed to buying customized products from defense contractors. Purchasing commercial technology makes more sense in times of tight budgets, Marrone said. The cost savings could be huge because buying commercial items does not require the onerous auditing that is associated with Pentagon-developed products. “You don’t need a huge bureaucratic infrastructure … and you don’t have to spend research-and-development money,” said Marrone. The Pentagon sought to move in that direction in the 1990s, but it steadily shifted back in the other direction out of concern that it was overpaying for products from vendors it could not audit. New rules could make it easier to do business with commercial suppliers, said Marrone.

A potential rub in the Pentagon’s relationship with vendors — the control of intellectual property — also needs to be addressed, he said. “Companies are loath to turn over their data rights, especially if they paid for the majority or all the R&D,” said Marrone. The Defense Department must do a better job explaining why it needs data rights, he added. “We should be able to work through those issues in a rational way.”

The acquisition policy agenda will be packed this coming year, said Marrone. Besides decisions on commercial items, there could be progress in other areas such as how contractors should deal with counterfeit parts and how they can better protect their networks from cyber attacks.

Brain Drain

To prepare for the future, the defense sector soon has to find ways to stem the brain drain, a crisis that has been predicted for years.

“Smart young people don’t want to work in an environment filled with inertia and no ability to stay current and on the technical edge,” said A.J. Clark, CEO of Thermopylae, a small information-technology contractor that works with defense and intelligence agencies.

Young IT engineers, he said, “see little future in the defense industry and are looking to other industries to flex their technical muscle.” In his own company, where about 40 percent of the business comes from federal contracts, “our challenge is to keep the innovative engineers interested in solving problems for the government,” Clark said. Because the government is late to embrace the latest technologies in hot areas — such as mobile, cloud computing and data analysis — the brighter and more skilled employees get frustrated, he said. For contractors, one solution is to capture commercial work to keep engineers motivated and up-to-date with technology.

Many high-tech firms are dismayed to see the Defense Department getting away from the cutting edge of technology, said Clark. “People [in government] are more careful, and concerned about taking any kind of risk.” But there is still hope that innovation eventually will make a comeback eventually, said Clark. “I foresee decision makers having a strong appetite to catch back up. There will be opportunities once resources break loose. It takes money to transition from one technology to the next.”

What’s Next?

With a budget agreement in place and the prospect of two drama-free fiscal years, defense industry has reason to be optimistic. But the sector is still in for painful retrenching. Defense and aerospace firms have shed at least 160,000 jobs over the past five years, and an anticipated wave of corporate mergers and acquisitions could increase the pink slip toll.

The Pentagon’s top suppliers have been preparing for a downturn for several years. Lockheed Martin Corp., the nation’s largest defense contractor, shrank its workforce from 146,000 employees to 116,000 since 2008. More layoffs are scheduled for 2015. The nature of federal contracting is such that the repercussions of program cancellations and delays take years to trickle down to the industrial base.

Industry advocates worry that the Pentagon and Congress have not yet fully grasped the perilous state of the defense sector. Just because the stock prices of a handful of defense companies are at historic highs does not mean companies are “sitting here, fat, dumb and happy,” Marrone said. “There has been an enormous amount of effort to scale down operations, doing things that the Defense Department has been talking about doing but hasn’t done in an effective way.” The job losses are real, he said. “The industrial base is not made up of six companies.” There are thousands of small companies whose fate is uncertain.

The newly signed budget agreement certainly softens the decline in defense spending. For industry, one bright spot in the agreement is that it stabilizes defense spending above historical levels. Another is an attempt by legislators to push forward politically tough spending reforms that could benefit industry in the long run. To offset some of the sequester rollbacks, the budget deal calls for cost-of-living adjustments to military pensions to be reduced to 1 percent below inflation for retirees under the age of 62. Supporters of the hugely politically unpopular measure argue that these are moderate reductions considering that, since 2000, military personnel costs have doubled while the active-duty force has shrunk by 10 percent.

Even this relatively small adjustment to military benefits is remarkable, Rumbaugh noted, because it constitutes a transfer of spending from personnel costs to operations and modernization. This budget deal, he said, is a “heck of a holiday present for the defense establishment.”

via After a Tumultuous Year, Can Defense Industry Get Back to Business in 2014? | National Defense Blog.