There are cyclical industries, and there’s the defense industry. In wartime, billions of additional dollars flow to defense contractors from the U.S. government, and in peacetime, Congress tightens the money spigot. It’s a cycle that all contractors are used to, except this time around there’s an added dimension: the Budget Control Act of 2011 and sequestration.
By itself the act was bad enough for the industry, requiring the Pentagon to cut $487 billion from its budget over the next 10 years. But the automatic spending cuts triggered under the act’s sequestration provisions could shrink the budget by an additional $500 billion during the same period, unless Congress steps in.
Taken together, the measures could slow defense spending by nearly $1 trillion over the next decade. And the current transition from war to peace will make things worse. “It’s not just sequestration that’s taking a toll on the industry,” comments Tim Dragelin, senior managing director in the corporate finance practice of FTI, a West Palm Beach, Fla.-based global advisory firm. “It’s the other projected losses of revenue from traditional government budget drawdowns that really hurt.”
Those drawdowns include a 37% decrease in the federal budget for operations and maintenance-related projects over the next three years, and a 400% reduction for Overseas Contingency Operations, from $162 billion in FY 2010 to $40 billion by FY 2014. “Those are the two areas of largest impact,” says Dragelin.
Dragelin expects that Congress will make exemptions to the automatic cuts. “Don’t get me wrong, it’s a big number, but we’re still not sure where the government will actually reduce expenditures,” he says. “Some companies, because of their services or products, will either not be affected or be dramatically affected.”
Still, the double whammy of drawdowns and sequestration is a powerful challenge to an industry that has been riding high for the last decade. The winners will be those companies that can best trim costs, reallocate capital and invest resources—actions that fall squarely in the domain of the CFO.
An Iron Law
At the world’s biggest defense contractor—Bethesda, Md.-based Lockheed Martin, with 2012 net sales of $47.2 billion—CFO Bruce Tanner has been preparing for the drawdowns for the last three years, consolidating various facilities and investing capital in acquisitions. He’s been there before.
“I’m fortunate that I have the benefit of history in making these decisions,” Tanner says. “Both myself and our CEO [Marilyn A. Hewson], as well as most of the other business heads, have been here for more than a quarter century. We’ve been through a few ups and downs in the past.”
That said, he acknowledges that this time around the stakes are higher. “Sequestration adds a bit more amplitude to previous cycles, but we are prepared nonetheless,” he says. “We don’t wait for downturns [to take action]. We’re constantly assessing our portfolio and the shape and size of our business.”