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Playing Defense

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

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.

13Nov_Subhed_p36An 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.”

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.

Loomis and others say most defense contracts are prepared. “In the past when the defense cycle came down, like in the late ’80s to early ’90s, it came down fast,” he notes. “This one is more of a slow train wreck—in a good way. Defense spending peaked in 2008 at the height of the Iraq and Afghanistan wars, and has trended down modestly since. This means that defense contractors have had a lot of time to get ready. For the most part, they haven’t wasted this time.”

Adams concurs: “Their CFOs have really stepped up their game.” Here is a look at how the finance chiefs of five defense contractors are preparing for a new era of austerity at the Pentagon.

13Nov_Subhed_p37Lockheed Martin: Eyeing New Businesses
So far at least, the impact of sequestration on Lockheed Martin has been light. Earlier in the year CFO Tanner had projected a possible $825 million reduction in revenue for fiscal 2013—less than 2% of the defense giant’s 2012 revenues—but he has since backed off that estimate climate.

But Lockheed isn’t taking Pentagon cuts lightly. Over the past five years, the company has downsized its workforce by 20%, from 146,000 employees to 116,000, and introduced a supplemental executive retirement program targeting senior leaders, who accepted buyouts and were not replaced. Lockheed also optimized manufacturing capacity, closing a Minnesota manufacturing facility in 2010 that made communications systems used on military ships and aircraft. The same year it moved manufacturing at another facility in Maryland to Arkansas. And it shortened the terms on its lease agreements, given the favorable real estate climate.

Trimming expenses are one thing, but what about generating revenue? CFO Tanner concedes that reductions in government business, which represented 82% of revenues in 2012, are discomfiting. “When you have a customer that large and proportional to your portfolio, and it is projected to shrink its business, you need to look for other areas to grow or at least maintain that business,” he says.

In this regard, Lockheed has been eyeing adjacent new businesses like cyber security and cyber protection. “Companies have the same systems and networks that relate to the same Internet and the same threats and need for protections that the government has,” Tanner says. “For the right company and the right deal, we will commercialize the products we’ve provided the government.”

He adds that Lockheed has already sold such systems to several Fortune 500 companies, “but our clients don’t like to be named.”

Other adjacencies presenting new or additional sources of revenue include energy conservation, particularly in the area of smart grids for sale to utilities. For instance, Lockheed can make digital technology with two-way communications controlling appliances at consumers’ homes to save energy. “We’re also looking internationally for opportunities in our core markets that align with the security needs of our global allies,” Tanner says.

13Nov_Subhed_p38Exelis: Strategic Investments
Exelis, a McLean, Va.-based diversified global aerospace, defense and information solutions company spun off from ITT in 2011, has been undertaking a “fairly aggressive” restructuring this year, says Peter J. Milligan, senior vice president and CFO. “We’re leaning out the cost structure with the assumption things will get worse from sequestration and the shrinking government budget,” he says.

The contractor (2012 revenues: $5.5 billion) is cutting its 20,000-strong workforce by 6%, partly through a voluntary early retirement program. It’s also reducing its real estate footprint by 10% in 2013 and another 10% in 2014. All told, restructuring is expected to cost the company between $70 million and $80 million this year.

13Nov_PD_p38At the same time, Exelis is sharpening its business focus. By selling off noncore businesses like fiberglass reinforced pipe manufacturing, Exelis can plow more money into strategic investments extending its capabilities in mission-critical networks, ISR (intelligence, surveillance and reconnaissance) and analytics, and electronic-warfare systems. The latter supports the detection, defense and defeat of threats on the electromagnetic battlefield (bursts of electricity that render technology devices useless).

Exelis is also strengthening its nonmilitary and commercial businesses. The company’s recent acquisitions include C4i, an Australian provider of advanced communications software used in air traffic systems; Space Computer, which makes real-time signal processing systems and software used in satellites and unmanned aerial vehicles; and Applied Kilovolts Group, a maker of precision high-voltage power supplies for medical, scientific and food safety instruments.

“We are spending more money on fewer things, and making sure we concentrate on our true competitive advantages,” Milligan says.

13Nov_Subhed_p39aL-3 Communications: Shifting Resources
L-3 Communications (2012 revenues: $13.1 billion), a New York-based prime contractor in command, control, communications and ISR, also is effectively managing through sequestration, says senior vice president and CFO Ralph G. D’Ambrosio. “We’re being vigilant about how we manage our various businesses, being sure they’re properly sized to what we anticipate the demand will be,” he explains. “We’re always trying to stay ahead of the curve, which requires making projections and assumptions about what might happen to the volumes. Obviously, in a cyclical downturn, the assumption is our defense business will be declining.”

In response, L-3 is seeking to grow its nondomestic defense revenues, with special focus on its commercial businesses and foreign military sales. (About 70% of the company’s 2012 revenues came from government business, primarily the DoD.) Regarding the former, L-3 has a leg up on competitors, D’Ambrosio claims. “We have more commercial, nonmilitary revenues in our business base, which will help us offset the declines in our military business,” he says.

Nevertheless, the company also is in the thick of determining which businesses it wants to compete in. “We’ve taken some dramatic actions over the last year and a half, such as spinning off a sizable part of our company [now called Engility Holdings] to shareholders,” D’Ambrosio says. The spin-off of the $1.7 billion government services subsidiary was completed in July 2012.

13Nov_PD_p39a“But we’re also growing the company, too,” adds the CFO. Recent acquisitions include the civil aircraft simulation and training business of Thales Training & Simulation ($130 million) and the electro-optical unit of Danaher ($210 million).  “We’ll continue to make such niche buys, seeking out opportunities that align with our existing core organizational competencies,” he says. “We’re looking for businesses similar to the defense industry, characterized by generally few customers, customized solutions and a bid and proposal process. We’re not ramping up and down here—we’re shifting resources.”

13Nov_Subhed_p39bDayton T. Brown: Deepening Relationships
Smaller defense contractors, too, are revising their plans in the face of shrinking DoD outlays. “We’re deepening our relationships with the OEMs [original equipment manufacturers] to get a bigger share of their wallets,” says Steve Marini, vice president and CFO at Dayton T. Brown, a Bohemia, N.Y.-based subcontractor with annual revenues of $40 million. The fortunes of the family-owned company, which focuses on engineering, technical and testing services, are hinged to those of its major customers, like Lockheed and Raytheon.

“A year ago, things looked worse for us than they look now because of all the uncertainty [around sequestration],” Marini says. “The government was delaying programs and otherwise dragging its feet. We didn’t know whether specific programs would be cut or everything would be trimmed across the board. That slowed down orders from the OEMs, but now we’re seeing something closer to a normal order flow.” He adds, “It’s not boom times, but at least people aren’t afraid to make decisions.”

Since its revenues derive primarily from services, the largest expense at Dayton T. Brown is payroll. Unlike other contractors, it couldn’t sell off a product line or consolidate factories. This made it difficult for the company to get leaner than it already is.

“There wasn’t much fat left to cut, so we had to go after the top line,” Marini says. “One way we’re building deeper customer relationships is by investing in highly specialized testing equipment that most of our competitors don’t have. For instance, we recently spent $1.3 million on a T5500 vibration shaker, which can be used to test how long a bomb rack holds up before it breaks. Customers know if they need something big to be shaken, they come to us.”

13Nov_Subhed_p40Huntington Ingalls Industries: Projects in the Pipeline
Other defense contractors are riding the down cycle well, thanks to long-term manufacturing contracts with the government. This is the case at Huntington Ingalls Industries, which inked a 30-year contract with the U.S. Navy less than a decade ago to build aircraft carriers, nuclear attack submarines and other ships. “That gives us some stability and security,” says Barbara A. Niland, corporate vice president and CFO. “It takes four to eight years to build a ship, and we’ve got a backlog of $21 billion in contracts that were awarded.”

13Nov_PD_p40Spun off by Northrop Grumman to stockholders in 2011, Huntington Ingalls is not biding its time counting the future revenue. Like other contractors, it is maximizing its competitiveness by closing noncore enterprises and pursuing adjacent market opportunities. The Newport News, Va.-based company ($6.6 billion in annual revenues) recently announced the closure of its Gulfport, Miss.-based composites facilities, which made deckhouses for guided-missile destroyers. And in February, it opened an office in Houston to pursue opportunities in the energy infrastructure market. “We’re in discussions with several companies in the oil and gas infrastructure market to build modular structures comparable to what we do in shipbuilding,” Niland says.

Another nongovernment project in the pipeline is the possibility of building ocean carriers to move products between U.S. ports. “There is a need for Jones Act commercial ships right now, but we are being very cautious in exploring this avenue,” the CFO says. “We’d need support from the Navy, as well as a credible partner in commercial shipbuilding or the energy infrastructure business that understands this market, pricing structure and risk.” (The Jones Act restricts the carriage of goods or passengers between U.S. ports to U.S.-built and -flagged vessels.)

These and myriad other efforts by the nation’s defense contractors are predicated on remaining profitable if and when the top line falters. So far, pricing has held in the industry. “Contractors have not been terribly aggressive in their pricing to drive revenues up,” says Stifel’s Loomis. “The focus has been on operational excellence and cost cutting, as opposed to playing the market-share game. As long as margins aren’t moving much, most seem comfortable with shrinking revenue. As we go through the next few years and a tougher budget environment, we’ll see the [pricing] pressures intensify.”

Those next few years remain hard to call from a budgeting standpoint, as the recent shutdown of the federal government underlined. “At the moment, we don’t know where the cuts will be the sharpest, so diversification of portfolios, the development of specialized capabilities and investing more money into R&D make sense for defense contractors,” says Dragelin. “These small investments could have some significant legs propping up the rest of the business.”

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