Let me take you back, back to last year, in the midst of a presidential campaign, when the Aerospace Industries Association was working itself, the industry, and some members of Congress into a lather about sequestration -- particularly about the devastating impact it would have on the economy, on the defense industry, and on the labor force that works in the defense sector.
Fast-forward to the quarterly reports from the major defense contractors. Oops! Seems Lockheed's profits rose 10 percent. Northrop Grumman was up 2 percent over the last year. General Dynamics was slightly up with an operating margin of 12 percent, Boeing earnings up 9 percent, blah, blah, blah. To quote Lockheed's chief financial officer, "We're seeing less impact ... than we had expected to see through the first half of the year."
Almost every contactor's defense revenues were down, but margins were good and earnings were up. What happened to the Doomsday machine that would hit the defense sector and boomerang into the American economy?
Can I say I told ya so? I could, but it is more fun to say why this is true. Defense contractors are the canaries in the coal mine -- they see a drawdown coming before anyone else is prepared to admit it. And, believe me, these guys started preparing for a drawdown way before the sequester was a gleam in John Boehner and Barack Obama's eyes.
For the last three years, the big guys have been doing everything a smart contractor should do to prepare for a declining budget: Sell off things that won't be profitable in the drawdown, buy things that will (IT and cyber businesses, especially), lay off workers (something that started way before the sequester), streamline production. They have been getting ready for a long time.
Then there are the peculiar features of sequestration, which were transparently clear last year during all the breast-beating and garment-rending. It really didn't hit the contractors. Military personnel were exempted, so they were untouched. But so were any Pentagon dollars already tied into contracts, which meant anything the industry was working on this year, anything already under contract, was funded with what are called "obligated" dollars. They weren't sequestered.
AIA and then-Lockheed CEO Bob Stevens assured us that there would be massive layoffs -- Stevens was preparing to send out notices to much of his workforce. He was either misinformed or disingenuous -- I'll let you decide. He did (or should have) known that existing contracts were not touched, and that the bulk of sequestration cuts would hit DOD's civilian workers (now furloughed a day a week until September 30) and the other kind of contractors -- those doing the dishes, cooking the food, and putting guards at the gate -- but not his business.
Now, some folks still see fear and loathing on the horizon -- the bad news wolf is not at the door, but coming down the path. That could be; the defense budget is going down and dollars for hardware always go down deepest in a drawdown. In fact, procurement dollars are already down around 20 percent, while the overall budget is down only 10 percent (pre-sequester -- which, as I said, didn't do much damage to procurement).
In fact, that's why contractor revenues are down -- we are in a drawdown, and revenues for defense contractors and subcontractors will definitely go down. And their workforce will shrink -- that's what happens in a drawdown, and it has been underway for three years now. Lockheed has cut its workforce 20 percent over the past five years; Northrop Grumman has laid off 5,000 over the same timeframe.
But those margins will stay healthy because that's how you manage a drawdown. The contractors and their shareholders will probably be OK. Oh, sure, as Loren Thomson of the Lexington Institute said the other day, 10-12 percent margins are not so good compared to fully private sector companies raking in over 20, 30, 40, even 50 percent (e.g., Dunkin Donuts).
And he is absolutely right. But what he didn't say, and the reason these big guys stay in the defense business, is that defense margins are very steady over time. Defense is a very stable business, with regular returns even when volume is down. It doesn't have very sharp swings in profitability, unlike the full-risk private companies. Sales go up and sales go down; the workforce grows and it shrinks. But the return is regular and risk stays low.
So let's not lose too much sleep over the future market or the profitability of the big guys in defense. Getting the Pentagon's defense plans in line, streamlining their back office, controlling costs -- those are the real priorities.
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Last year the Aerospace Industries Association took aim at the budget sequester on behalf of its members and mounted a visible and expensive campaign to prevent it. They ran out a study done by Steven Fuller showing that sequestration would lead to a million jobs lost and trigger a recession in some regional economies, like Virginia.
AIA issued alarmist statements and press releases about the coming economic doom. Their chorus was joined by Senators campaigning hard against the sequester, like Sen. John McCain, Kelly Ayotte, and Lindsey Graham. It was quite a road show.
In the front of the cheering section last year was Lockheed Martin CEO Bob Stevens, who warned, at the time, that sequester would lead to 10,000 layoffs at his large defense contracting company. He announced the intention of issuing WARN Act notices, which would let employees know their jobs would soon be in jeopardy.
Stevens left at the end of 2012, having withdrawn the WARN threat, but the recent comments that the new CEO, Marilyn Hewson, made to Politico suggest that the apple of corporate leadership has not fallen far from the tree.
So far Lockheed and Hewson say 50 employees have been affected by sequestration, and their major programs -- the F-35 and the Littoral Combat ship, among others -- have not been much affected. Hewson argues there could be worse to come, but DOD has still not provided detailed guidance for the industry.
It seems that CEO Hewson lives in the same echo chamber Stevens created last year. According to the Politico story, it is still the same scary world out there, with the same budget uncertainties and threat to the future of her industry that her predecessor described.
The world, she tells Politico, is a frightening place: "Abroad, new threats are rising, even as old threats become more menacing. Iran, we know, edges closer to nuclear statehood, and North Korea has already achieved it. The list of threats goes on and on."
Wait, "on and on"? So far she has listed two "threats," both old and well-known, and neither of which is more threatening to our security because of anything the sequester might cause in the Defense Department. I am curious to see what the "on and on" is about.
Does she mean China, toward which we are supposedly already pivoting and whose capabilities are far below ours? Does she mean "cyber warriors," who may be a problem, but are irrelevant to 95 percent or more of our military capability? What's the list? And is it real?
Or is a defense industry CEO whipping up a fervor encouraged by the community that lives in that fear stovepipe, but doesn't have a grip on what is going on in the rest of the world?
And then, there is that budget world, equally, if not more threatening, according to Hewson. Her predecessor, she said, was just campaigning for clarity last year, not playing politics. Let that rest; it was an election year and there is no such campaign going on this year.
But calling for guidance today suggests that Hewson is out of touch with what has actually happened as sequester has been announced and implemented. Someone should brief the CEO. Last year OMB provided two sets of guidance, making it clear that the major impacts of sequester would be felt in the operational accounts at DOD. Not in the acquisition accounts, which is where the vast bulk of Lockheed's business lies.
The reason Lockheed has only laid off 50 people is because its programs are not experiencing the hurt. Federal employees are, as the secretary of defense made clear on May 12 -- nearly 700,000 of them will get 11 unpaid days between now and the end of September (and maybe next year, too, if there is no budget agreement).
But the "memo" to industry about the sequester has always been that contract dollars are not affected as quickly, because the dollars already committed to contracts were not sequestered under the law. Makes sense the near-term impact would be minimal, although the defense industry and Bob Stevens were screaming louder than anyone.
Maybe what she is really worried about is not the sequester, but what is happening to the defense budget in general. We are in an obvious drawdown, long-term, and drawdowns affect everyone, including industry, because procurement dollars go down even more deeply than the overall budget. (They are already down more than 20 percent since FY 2010, while the overall budget, pre-sequester, is down only 10 percent in constant dollars.)
Industry leaders should get with this program, and many (even Lockheed) have begun to do so. But instead of wasting valuable time complaining about guidance and arousing fear, it would be good for long-term business to focus on this reality and plan accordingly.
We are near the end of the 17-month drama of sequester and the defense industry's special pleading, and its special planning, are in the highest gear. The theater has moved along nicely.
We have been through the Sequester Prologue -- the Budget Control Act of 2011.
Act 1 was the Super Committee, a terrifying, cliff-hanger drama with a predictable outcome: failure.
Act 2 was the primary campaigns for the Republican Party and, especially, the adjunct campaign conducted by the Aerospace Industries Association and their political travelling side show: the McCain-Graham-Ayotte tour of America's most loved defense locations. But the industry failed to scare Americans away from fiscal discipline for the Department of Defense. Predictable outcome, since defense was not an issue in the primaries: failure.
Act 3 was the general election campaign. The industry backed off its warning of layoff notices four days before the election when a savvy administration pointed out that they, of all industries, would be most protected from sequester because they have existing government contracts, already funded, that ensure business would continue. (And as a sweetener, the administration also said the legal costs for any contractor sued because no layoff notice was sent, would be allowable cost under the contract.) Predictable outcome: the political side show sponsors felt undercut when the industry pulled back from playing politics; the president carried all but one of the states in which the side show had opened a tent.
Epilogue: where we are today. Defense budgets are a residual item in a much bigger main event over revenues and entitlements. Likely outcome: the defense budget will go down below the level Panetta proposed last February, to make a deal on everything else happen.
The defense industry has not given up the fight, though. And they are also ready for what may come, because they anticipate the market for defense goods better than anyone. Still girded for battle, defense industry chief executives such as Wes Bush, CEO of Northrop Grumman, and David Hess, president of Pratt and Whitney (United Technologies), will make their case on December 3 at the National Press Club. Perhaps no threat of layoff notices, but doom and gloom likely to be the message.
At the same time, the defense industry has been preparing for a defense drawdown for two years -- a realistic move because the defense budget has already come down for two years. Layoffs at large contractors have already happened. Less promising businesses have been sold (including CEO Bush's spinning off its shipyards last year). And companies are searching for acquisition opportunities in niche businesses that may prosper in the defense downturn: equipment servicing, drones, information technology, and cyber research and development.
Best of all, the industry has been churning up large piles of cash to finance these activities. Brendan McGarry of Bloomberg reported this week that the five largest defense contractors (Boeing, Lockheed Martin, Northrop Grumman, Raytheon, and General Dynamics) have had operating margins that are at a record high, thanks to the generous defense budgets of the last ten years. More to the point, they used these margins to grow their cash holdings by 71% in the final quarter of the 2012 fiscal year, bringing their total cash holdings to more to nearly $21 billion. The average cash holding of the five was over $4 billion, nearly double what it was a year ago. These funds can be used for acquisitions, dividend payments, or held for a rainy day.
Smart thinking, corporate-wise. The rainy day is already on its way. The defense budget is headed down, even with a sequester-preventing deal, and, as Bloomberg's Kevin Brancato put it "Defense companies are likely to see cuts even if there's an agreement to avoid it." That doesn't stop the last-ditch epilogue battle we will see this month -- the show must go on!
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Gordon Adams tracks the budget and the national security establishment for FP.