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Aerospace and Defense Channel

A “Post Fiscal Cliff” Defense Budget Environment-An Industry View

Will our new Fiscal austerity environment begin to enforce a change in DOD spending priorities for our high technology Equipped Air, Space, Land, Sea, and Cyber Forces

January 16, 2013
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Deal or No Deal?
Welcome to a “Post Fiscal Cliff” budgetary world, where the pressure to reduce Federal spending, increase taxes, and cutting our National debt has our Government almost at a complete standstill.  Even with the last minute New Year’s Eve deal worked out in Congress to solve the “Fiscal Cliff” problem, not that much has really changed.  And some have even suggested the situation we now face is worse than it was before.  Good work Congress!  The policy disagreements between the stakeholders have been exploited, exaggerated, and embellished by both sides of the aisle for political purposes.   Now, by kicking the can down the road with a delay for two months in the implementation of Sequestration cuts, we actually have not made any real progress in cleaning up our Federal Budget/Fiscal affairs in general, and our Defense Budget spending levels in particular.  Companies are frozen in place on investment decisions—hiring of additional personnel, IR&D plans and Capital Expenditures-- as uncertainties for what Defense program will survive or be cut/eliminated are all on the table.  The specter of draconian sequestration cuts to all federal programs—including an across the board cut of 9.3% in Defense Programs regardless of importance or priority—lie ahead of us if a deal is not worked out.  This is in addition to the $460 billion in Defense cuts made last year in the ten year planning cycle.  Let's take a look at this complex situation and try to make “some sense out of the (continuing) non-sense”--- that seems to be how we govern ourselves these days.  And as always, we will try to provide some insight into the “game within the game” that is being played out in Washington, DC and provide some navigation vector headings for companies in the Microwave Industry.

Democracy “In-Action”
Can the US Congress actually function anymore as a governing body?  As envisioned by our founding fathers, we live in a Jeffersonian Constitutional Democracy.  That means the Congress is an elected representative body of the people, whose sworn duty is to act in the best interest for all the American people.  Is that what is really going on in Congress these days?  I would dare say, no.   Is the failure to collaborate and compromise a lost skill set?  Yes, unfortunately.  Congress has gone from a contact sport to a blood sport.  It’s not about doing the right thing—it’s about winning and losing.  So why then does our government seem to be incapable of getting anything done?   Unfortunately this is not a straightforward question with a simple and easy to understand answer.   Considering the debacle we just went through over the “Fiscal Cliff”, it clearly was not Washington's finest legislative hour played out under the watchful eye of the electorate.  The “schoolyard antics” of both sides came into play and it got ugly.  And the painful outcome yielded no real winners on either side as there were causalities (revised policies, new regulations, Earmarks/Pork, and questionable legislative regulations) lying all over the landscape in its aftermath.  How did we fail in getting the most basic things accomplished when so much was riding on its outcome? 

Complex Situation
Whatever side you are on in this debate, this process was clearly driven by the hardening of Partisan Political Party Lines, a worsening fiscal environment and a weakened US economy.  In addition, we are facing increasing National Security Challenges around the globe.  None of these are going away anytime soon.  Yes, we went over the Fiscal Cliff in January, but what did that really mean? As it turns out, it does not mean very much.  It was mostly a debate about increased tax rates on wealthy individuals, and holding the line on middle class tax cuts.  There were no spending cuts, entitlement reforms, and nothing was done on Defense and Sequestration. What did Congress and the President really do in their deal?   They postponed all the tough issues until later. Are we worse off than we were in December?  Yes, decidedly so.  The Federal Budget, Defense Spending and Sequestration issues are still on the table with both sides dug in even deeper.  As we go forward, who is going to blink in this ongoing game of political brinksmanship inside the Washington Beltway?   That is not very clear yet.  The situation is further complicated as both Houses of Congress have passed and  President Obama has signed the final FY 2013 National Defense Authorization Act into law.  So there is in place a FY 2013 legislative Budget blueprint for Defense pending.  However, it was done without any consideration for sequestration cuts, and any anticipated budget deal.  So is it a worthwhile document or a worthless document? Does it carry any weight? More importantly, we need to come to grips on how these drastic Sequestration cuts will affect the Services, their Missions/Programs.  Aerospace and Defense Companies  are stuck in place as all this has yet to be figured out by the Congress, the Pentagon and the Administration.   

Conservative Partisan Positions
Republicans are now more conservative than they've been in 100 years. This is particularly true in the House, where the GOP is dominated by what has been called "the 'hell no'' caucus." The implications of this voting block are that they can put a hold and halt any legislative actions are enormous and hold the potential for disastrous outcomes in any legislative battle. The last-minute deal to avoid the "fiscal Cliff" was almost certainly not a true signal of cooperation and collaboration.  Instead of building on that compromise, the reverse is happening. Lines are growing harder, and heels are digging in much deeper. Republican lawmakers who backed the deal are being the scapegoat as sellouts by their own colleagues. In addition, some that voted for it have been threatened by their fellow conservatives that they will curse the day they voted for the Fiscal Cliff deal.   In the weeks ahead, Congress is facing three major fiscal decisions: raising the debt limit, funding the government and dealing with the drastic budget cuts postponed for two months on New Year's Eve. But all the signs are ominously negative that anything good is going to happen.

Senate Republican leader Mitch McConnell has said additional revenues are off the table; House Democratic leader Nancy Pelosi says they're definitely on. President Barack Obama says he won't negotiate on the debt ceiling; House Speaker John Boehner says he won't negotiate with Obama on anything.  And the new Republican Whip, Sen. John Cornyn of Texas, threatens to shut down the government if Republicans don't get their way. There's a lot of blame to go around. Democrats have certainly become more liberal, adding to the paralysis. But it's also true, that the blame is equal, as most believe that Republicans have moved further to the right than the Democrats have moved to the left. At this point does it really matter who moved the most—what matters is can they come together and do something.

Three More Fiscal Cliff-Like Battles
Congress and President Barack Obama have prevented a potential recession with the fiscal cliff  bill in early January, but in doing so put off, yet again, many difficult decisions necessary to get the nation's fiscal house in order. In a couple of months, three more fiscal cliff battles lie ahead -- Sequestration, the debt ceiling, and a new Federal Budget.

Sequestration - As part of the Budget Control Act (2011), about $1 trillion of automatic spending cuts were supposed to begin going into effect in 2013 if Congress did not replace them with an equivalent amount of deficit reduction. About half of those cuts are in defense and the other half are in other discretionary spending.  The cuts, known as sequestration, were intended to provide the incentive for the bipartisan super-committee, also created by the Budget Control Act (BCA) to complete its task of creating a deficit reduction bill. The super-committee was supposed to replace the Sequester with long term deficit reduction through tax reform and entitlement reform. The super-committee, though, failed to reach an agreement. The Fiscal Cliff bill, officially called the "American Taxpayer Relief Act of 2012," will delay the Sequester for two more months. This means that Congress will have two months to agree to a long term deficit reduction plan to replace the Sequester, or the cuts will begin about the same time as the Debt Limit.

The Debt Limit - The U.S. Treasury has already surpassed its debt limit ceiling by mid-January. Treasury Secretary Timothy Geithner announced that he will use "extraordinary measures" that will allow the government to pay its bills for about two months. After that, if Congress does not increase the limit at which the Treasury is allowed to borrow money, the U.S. government will begin defaulting on promised payments and other obligations. Republicans have said they will not vote for a debt limit increase without spending cuts equal to or greater than the amount of the increase. It was this position that led to a showdown in the summer of 2011, the last time the debt limit was increased. That battle resulted in the creation of Budget Control Act. In July 2011, Speaker of the House John Boehner and President Barack Obama came close to agreeing to a grand bargain deficit reduction package that would have included tax reform and entitlement reform. In order to bring some stability to the federal budget and the financial markets, Congress and Obama still need a grand bargain agreement. They will have just a couple of months to do that before the Sequestration begins and the debt limit is reached. About the same time, though, there will also be a fight over the Federal Budget.

The Federal Budget - Congress never passed a FY 2013 budget. The federal government has been operating under a six month continuing resolution that will expire at the end of March. At the same time that Congress will need to agree to funding for the government for the rest of 2013, it will also begin working on the FY 2014 budget, which will begin in October.  President Obama will begin the process for the 2014 budget by submitting his budget to Congress. That budget is due the first week of February, but his office has already announced that, due to the fiscal cliff, his administration will be unable to meet that deadline

Implications of Defense Sequestration
United States defense budget reductions of $487 billion over 10 years have been agreed to by US administration and congressional constituents as part of the Budget Control Act of 2011. This equates to an estimated reduction of $25 billion of addressable revenue for defense contractors, or an estimated 12 percent of their 2012 estimated revenues.  As of now, the automatic “Sequester” budget reduction of an additional  $492 billion over nine years starting in January 2013 has yet to be resolved. If it occurs, taken altogether, that is likely to imply a reduction in force structure, (e.g., soldiers, sailors, airmen, etc.), as well as a reduction in investment accounts (e.g., research and development (R&D), new program starts, numbers of units ordered, etc.). Assuming that sequester cuts will be proportional and that the entire amount is cut, it is estimated that up to another 12 percent of defense and government contractor revenues are likely to be impacted, all else being equal. The impact on the industrial base is likely to be significant, given that essentially one out of four people in the defense contractor base within the US would be potentially impacted between both tranches of the Budget Control Act and the possibility of being downsized out of the workforce, should the additional $492 billion cut take effect. This could mean that the US defense industry may not be able to afford to keep certain technology capabilities alive in the industrial base. It might also mean that there may not be enough work to support two or more companies in certain technologies, thus potentially reducing competition.

FY 2013 Defense Budget Finalized
The Fiscal 2013 Defense Budget, Passed by both House of Congress, was signed by President Obama in early January.  The defense authorization bill, which has now passed for 51 straight years, sets Defense Department policy and authorizes $633 billion in defense spending. President Barack Obama signed the $633 billion defense bill for this year despite serious concerns about the limits Congress imposed on his handling of terror suspects and lawmakers' unwillingness to back the cost-saving retirement of aging ships and aircraft.  Obama had threatened to veto the measure because of a number of concerns, including saying that the bill calls for unnecessary spending on programs that the Pentagon does not want.  But he relented because he couldn't pick and choose specific sections as he doesn’t have a line item veto authority. However, in a statement sent out when he signed the bill, the president spelled out his concerns about restrictions on his ability to carry out his constitutional duties as commander in chief.  The president said his administration will interpret the bill's provisions and if they violate the constitutional separation of power, he will implement them in a way to avoid that conflict.

The president signed the 2013 National Defense Authorization Act (NDAA) after the White House had threatened to veto the legislation over a number of program reversals from the Pentagon’s proposed budget. "I am empowered either to sign the bill, or reject it, as a whole. In this case, though I continue to oppose certain sections of the act, the need to renew critical defense authorities and funding was too great to ignore," Obama said in the statement accompanying the sweeping Pentagon policy bill.  The bill includes new sanctions against Iran, an increase of 1,000 Marines to guard U.S. embassies around the globe, and plans to study a new East Coast missile defense site. The final conference committee report passed the House 315-107 and the Senate 81-14 in December. The law puts off the retirement of some ships and aircraft, and Obama warned that the move could force reductions in the overall size of the military as the Defense Department faces cuts in projected spending.  “Restrictions on the Defense Department's ability to retire unneeded ships and aircraft will divert scarce resources needed for readiness and result in future unfunded liabilities,” Obama said. The law includes cuts in defense spending that the president and congressional Republicans agreed to in August 2011, along with the end of the war in Iraq and the draw-down of American forces in Afghanistan. And it would authorize $528 billion for the Defense Department's base budget, $17 billion for defense and nuclear programs in the Energy Department and $88.5 billion for the war in Afghanistan.

The new defense authorization law contains multiple changes to the Pentagon’s previous plans for weapons programs. It bans the pentagon from funding the Medium Extended Air Defense System (MEADS) program with Germany and Italy in FY 13, stops the retirement of some Air Force aircraft, an blocks the cancellation of the Global Hawk Block 30 spy drone. --- It authorizes added funding for M1 Abrams tanks, and allows the Navy to use special incremental funding for the Virginia class submarine. The measure is about $29 billion under the current level, largely due to smaller amounts for Iraq and Afghanistan.  The measure tightens penalties on Iran to thwart its nuclear ambitions and bulk up security at diplomatic missions worldwide after the deadly Sept. 11 raid in Libya.

Challenges in Defense
Defense contractors in 2013 are likely to be challenged in a far greater context to execute programs of record on schedule and on budget. There is no room for error. For those programs experiencing significant delays and cost over-runs, there is potential for scale-back or even termination. Nunn-McCurdy breaches will likely be treated far more seriously than in the past, due to the inability to absorb cost over-runs due to budget limitations.  One reason that defense cuts look as scary to the industry as they do is that service personnel costs have ballooned, to sustain recruitment and retention through the longest and largest combat deployments ever attempted without a draft. Consequently, budget cuts will fall heavily on procurement, military end strength/personnel, and R&D accounts.

No matter the outcome of the budget Sequester action, there is likely to be continued pressure to reduce defense expenditures over the next ten years. And there is likely to be continued debates on several important questions and challenges to US defense and security policy and investment priorities. These include, how will the US President work with Congress to meet the security requirements in response to a nuclear armed Iran, instability in the South China Seas, continued threats from North Korea, the continued violence in the Middle East, and increased cyber-attacks. 

All these matters are expected to be very important in 2013, as it relates to the financial performance of the defense industry.   The formulation of a finalized, funded U.S. defense strategy, coupled with the resulting war fighter requirements, and ultimately the multi-year Defense Budgets/Planning Guidance, will likely provide the blueprint and plan for going forward and guidance necessary for defense contractors to size their workforce appropriately, to understand what revenues they can count on, and therefore what their financial performance will be in 2013 and beyond. 

We in the Microwave Industry/Defense Sector can expect our advanced technology innovations and products to continue to be created and drive the global A&D industry into the future. In the defense segment, some of the science and technology being developed/enabled by our technology include directed energy and high powered microwave weapons, hyper-sonic missiles, long-range/ high-altitude unmanned aerial systems with covert data links, satellite-based high resolution full motion video cameras. The challenge is how do we get there from here?

In response to declining sales to the US government, A&D companies in the US, will likely strengthen their marketing and competitive positioning in emerging markets, particularly in India, Brazil, South Korea, Japan, Saudi Arabia, Taiwan, Singapore and UAE. These countries, with their increasing wealth and growing security concerns, are expected to increase their purchases of sophisticated weapons systems, where US companies have competitive strengths. European A&D companies also will likely increase and intensify competition for these foreign military sales opportunities. However, the US has to update our ITAR/Export Control regulations to enable growth in this arena.

Summary
Between now and the end of March many events will occur which could drastically affect the DOD budget and will impact positively or negatively on the Defense Industrial Base.  The FY 2014 budget could be delayed because of the unknown of Sequestration. The FY 14 budget was to include the continuation of the $487 billion 10 year cut, and any potential Sequestration cuts should be included in the budget. Sequestration could take up to $55 billion annually from the DOD budget, causing many changes to the present plan. There are a lot of unknowns, and where a large segment of revenue for Microwave Companies comes from DOD, we will need to be vigilant, engaged and aware of the actions of Congress and the administration as they continue to fight over these important issues and come to a conclusion we all can stand behind as Americans.

Recent Articles by Jim Fallon President and CEO, Fallon & Associates LLC

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