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Playing Defense

CFOs of defense contractors are preparing their companies for a new era of austerity at the Pentagon.

So are other defense contractors like Exelis, L-3 Communications, Dayton T. Brown and Huntington Ingalls Industries, each repositioning their organizations not only to grab a bigger piece of an increasingly smaller pie, but also to generate revenues in nonmilitary markets. By and large, they are prepared as the industry’s cycle grinds into low gear.

“They know this stuff is coming because history tells them it will happen,” says Gordon Adams, professor of international relations at American University’s School of International Services. “Defense drawdowns are business as usual. Every time after combat operations cease, the defense budget declines, most dramatically in procurement. It’s an iron law that makes complete sense—you buy stuff when at war and stop when not.”

Peak to trough, the budget decreases historically have averaged 34% and the procurement declines alone about 50%, says Adams, who served from 1993 to 1997 as an associate director for national security in the White House Office of Management and Budget. The dollars started decreasing in 2010, when the wars in Afghanistan and Iraq gradually moved toward closure.

13Nov_PD_p39b“They went down again in 2011 and 2012, and even more than expected this year because of sequestration,” Adams adds. “They’ll go down again in 2014 and 2015, probably in 2016, and further than that the eye can’t see. We’ll have at least six years of drawdowns at the same historical rates, although sequestration speeds things up a bit.”

The automatic spending cuts have been closer to a slow boil. Although contractors prepared to suffer an automatic decrease of $42.7 billion in the Department of Defense’s fiscal year 2013 budget, a Congressional resolution in March eased some of the cuts, part of the DoD’s “damage limitation” plan sparing major spending programs.

“The industry to date has felt little impact from sequestration, with much of the actions taken by the government itself, in terms of its internal expenses,” says William Loomis, who closely follows the defense-contracting space as a managing director at Stifel, an investment banking firm and brokerage. “We’ve seen furloughs, pullouts from conferences, reduced travel and cuts for training.”

What haven’t been seen are base closings, layoffs and pay cuts, Dragelin notes. “The DoD wants to limit the budget impact on personnel,” he explains. “Consequently, defense contractors are expected to bear the brunt.”

Adams agrees. “The government will be forced to deal with their long-term contracts, which will prove difficult,” he says. “The specifics have yet to be quantified, and we won’t learn what they are until the FY 2015 budget comes out in February.” Adams notes that in September, Frank Kendall, U.S. undersecretary of defense for acquisition, technology and logistics, said that the burden of $52 billion in cuts for fiscal 2014 would fall on procurement, involving mostly contractors with big weapons programs. “Nevertheless, no hard­–and–fast commitments have been made as yet,” he says.

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