Editor’s note: In this special report, Microwave Journal looks at the recent economic and political events that led to the budget cutting program known as sequestration, how the cuts are implemented with regard to defense spending, the projected and realized impact on the economic fortunes of defense contractors six months into sequestration and how forward-thinking contractors are adjusting their business plans to succeed in a shifting landscape of tightening government budgets.
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It was five years ago this fall that the financial crisis responsible for the great recession set off a chain reaction of Federal Reserve monetary actions and government stimulus programs which, along with plummeting tax revenues, led to unprecedented U.S. budget deficits, alarm among deficit-conscious fiscal conservatives and the birth of a political movement known as the Tea Party. In the 2011 fight over raising the debt ceiling - the amount the government can borrow in order to meet its existing fiscal obligations - Tea Party activists emboldened by their wins in the 2010 congressional elections forced the Republican majority in the House to reject a compromise with Democrats to raise the debt ceiling unless acceptable cuts in spending could be met.
At the time, the imminent failure to raise the borrowing limit threatened to shut down the government and would have resulted in a default of its fiscal obligations, presumably creating new panic among financial markets as the world’s largest debtor stopped making payments on existing loans. Despite negotiations between the White House and the congressional leadership to impose deep targeted cuts to the federal budget’s largest items (entitlements and defense spending), individual members of Congress, fearing a backlash from their constituents and the resulting political fallout, could not muster up the will to accept draconian cuts to specific programs.
As a result of the impasse, the credit rating agency Moodys downgraded the U.S. Government credit rating from AAA to AA, citing increased lending risk due to the lack of political leadership in dealing with the pending crisis. The rating downgrade conceptually would make it more expensive for the government to borrow money. In actuality, investors continued to pour money into U.S. bonds, a sign of how the global economy remained at considerable risk of falling back into recession or worse.
To resolve the immediate crisis, lawmakers needed to devise an acceptable plan that would satisfy a highly divided and partisan Congress. In general, Democrats would fiercely protect entitlement programs, Republicans would do the same for defense programs and the Tea Party caucus would not compromise on reducing the size of the cuts they hoped would shrink the deficit. In addition, the “kick-the-can-down-the-road” approach of deferring problems through legislative wizardry was unacceptable to these new hard-line congressional members who had been elected on the platform of ending business as usual in Washington. And so the Budget Control Act of 2011 was devised to allow the president to raise the debt ceiling in exchange for debt reduction levels (budget cuts) acceptable to Tea Party members of Congress.
The remaining issue of how to reduce the budget would be handled by a legislatively-engineered “fiscal cliff.” The fiscal cliff, which many felt would plunge the country back into recession, called for simultaneous increases in tax rates and decreases in government spending starting on January 1, 2013. Under the fiscal cliff scenario, select programs such as Social Security, Medicaid, federal pay (including military pay and pensions) and veterans’ benefits would be exempt from spending cuts. Discretionary spending for federal agencies and cabinet departments would be reduced through broad cuts referred to as budget sequestration. Reductions in defense spending would make up half of the spending cuts called for under sequestration.
Before reaching that cliff, the Budget Control Act called for the creation of a Joint Select Committee on Deficit Reduction, known as the super committee, which was tasked with developing a deficit reduction plan to cut at least $1.5 trillion over the coming 10 years. The super committee recommendation would be subject to a simple vote by the full legislative bodies without amendment in order to bypass congressional debate and pass a bill by the December 23, 2011 deadline. However, in late November the committee issued a statement that it would be unable to make any bipartisan agreement before the deadline and the committee was disbanded on January 31, 2012.
With 2012 being an election year and the fiscal cliff set to occur shortly thereafter, politicians held off resolving the budget issue and focused on campaigning for office based on their positions on how to address revenue (what to do about expiring Bush tax cuts) and spending. The selection of the president and members of the House of Representatives and Senate would serve as a referendum on the country’s priorities, although the meaning of the results would still be open to interpretation.
After the November election, intensive debate and media coverage over the looming fiscal cliff and its projected short-term fiscal and economic impact drew widespread public attention. The Washington interpretation of the election results swayed lawmakers to enact the American Taxpayer Relief Act in the final weeks of 2012, making the lower tax rates for the lower and middle class established under the Bush tax cuts permanent, while retaining the higher tax rate and eliminating various deductions for upper income levels. The act did not tackle the spending cuts issue, but did delay sequestration for two months (March 1st).
What Actually is “Sequestration?”
The word sequester comes from the Late Latin word sequestro, meaning to set aside or to take something away until a debt has been repaid. In the context of funding federal programs, sequestration is intended to implement broad automatic spending cuts in “particular categories of federal outlays” as mandated by the Budget Control Act (2011), thereby lowering government spending by approximately $1.2 trillion over a 10-year period. The $1.2 trillion reduction in spending (from 2013 to 2021) would come from $984 billion dollars in sequester split evenly over nine years ($109 billion/year) and $216 billion dollars in saved debt servicing (interest payments).1
The total annual spending cut of $109 billion would be divided equally between defense and nondefense spending, roughly $55 billion. Generally speaking, these cuts are divided proportionately between the discretionary and nonexempt direct spending within each broad category. Since much of direct spending is exempt, sequestration would primarily affect discretionary spending ($813 billion of the $984 billion in non-interest savings).2 Defense spending is largely discretionary.
The mechanics of how sequestration works can be divided into two parts. The first part calculates the dollar amount of the required defense reduction ($55 billion/year). The second part of the Budget Control Act sets a cap on discretionary defense spending. For FY 2013, this cap starts at $546 billion. Funding is then reduced by $55 billion, making the effective budget for the FY 2013 discretionary national defense budget equal to $491 billion. The budget caps for future years would in turn be reduced by an identical amount of $55 billion.3
Budget caps apply to the amount of money appropriated by Congress in a given year. The DoD has multiple years to spend its budget authority depending on the type of funding appropriated. Defense acquisitions often take multiple years to award contract, obligate funding, and provide the vendor time to develop and produce the system/platform being acquired. When money is transferred from the U.S. Treasury to the vendor, it becomes an outlay. Sequestration will cause overall defense outlays to drop by roughly 4.6 percent in FY 2013 in addition to a 2.5 percent reduction already associated with the decline in war-related funding.4
Since the yearly forced reduction of $55 billion is a fixed number and the defense budget cap will actually continue to increase yearly, the sequestered amount as a percentage of the overall defense budget will decrease. The Congressional Budget Office (CBO) estimates that sequestration will produce cuts ranging from 10 percent in 2013 to 8.5 percent in 2021. Between now and 2021, sequestration of new defense discretionary appropriations will result in a total cut in budget authority of $492 billion, which is estimated to yield $454 billion in outlay savings.5
Impact on Defense Spending
The FY 2013 DoD budget calls for $620 billion, which includes $525.4 billion in discretionary funding and $6.3 billion in mandatory funding with an additional $88.5 billion for ongoing military operations, primarily in Afghanistan. Total defense-related spending also includes $19.4 billion in discretionary and mandatory funding for defense-related atomic energy programs, $7.7 billion for defense-related activities in other agencies, and $137.7 billion for veterans’ benefits and services. The Treasury must also set aside $67.2 billion to cover unfunded liabilities in the Military Retirement Trust Fund. Together these expenses total $852 billion, or 23 percent of the total federal budget.3
So while sequester cuts may seem daunting, they only represent a 7 percent cut of total federal spending for FY 2013, which pales in comparison to the 54 percent loss in stock market value from 2007 to 2009 and the 33 percent loss in the housing market from 2006 to 2009. Additionally, starting in 2014 and for the next seven years, discretionary limits will actually increase 1 to 2 percent per year, offsetting some of sequestration’s impact. The immediate outlook for vendors is further improved by the billions of contract dollars currently obligated.
Across the DoD, allocated budget is spent at different rates. The majority of military personnel funding and more than two-thirds of Operations & Maintenance (O&M) funding is spent in the year it is appropriated. There is more of a delay between budget authority and outlays when it comes to procurement (up to three years) and Research Development Test & Evaluation (RDT&E) funding, which have a two year obligation period. Only 22 percent of procurement funding and 49 percent of RDT&E funding become outlays in the year in which they are appropriated. The delay between budget authority and outlays means that the impact of sequestration on vendors has been less immediate. Moreover, because budget authority becomes outlays at different rates in different accounts, the reduction in outlays will not be uniform across all parts of the budget. Due to the lag between procurement appropriations and outlays, this year’s outlays should experience only a 3.5 percent reduction ($120.2 billion vs. pre-sequestration outlays of $124.5 billion), according to “Analysis of the FY 2013 Defense Budget and Sequestration” by Todd Harrison. Because more O&M funding (maintenance, logistics, and other support functions) is spent in the same year it is appropriated, the reduction in outlays for these funds will be higher at 6.9 percent.3
That sequestration acts on budget authority rather than outlays provides some insulation for defense companies as it allowed more time for adjustment. Because sequestration does not affect funding that has already been obligated, defense firms were able to continue working on contracts already awarded. However, sequestration is expected to affect the DoD’s ability to award new contracts and exercise options on contracts. If allowed to continue long term, sequestration will result in a decline in revenues for defense firms, but it will be three or four years before defense companies feel the full impact.
This has given industry more time to adjust employment levels through natural attrition and early retirements rather than forcing immediate layoffs. In addition, RDT&E funding was only reduced by 3 percent (~$7 billion) compared to the previous year. The smaller reductions in O&M and RDT&E relative to other accounts are consistent with two of the priorities highlighted in the new strategic guidance: maintaining “a ready and capable force” even as overall force structure is reduced, and continuing investments in science and technology “to sustain key streams of innovation that may provide significant long-term payoffs.”
Speculation, Reactions and Reality
Last fall, there was a consensus among many analysts that sequestration would have a disastrous impact on U.S. jobs and gross domestic product (GDP). The CBO initially projected that sequestration would reduce 2013 economic growth by about 0.6 percentage points (from 2.0 percent to 1.4 percent or about $90 billion) and affect the creation or retention of about 750,000 jobs through its first year.6 The National Association of Manufacturers (NAM) and Aerospace Industry Association (AIA) painted more dour predictions in two separate reports. NAM projected that budget caps and across-the-board cuts in defense spending would result in:
- The loss of over 1 million jobs in the private sector, including 130,000 manufacturing jobs
- A 1 percent drop in GDP
- A 0.7 percent increase in the national unemployment rate
- The loss of 3.4 percent of aerospace jobs, 3.3 percent of jobs in the ship and boat industry and 9.3 percent of jobs in the search and navigation industry.
The projected loss of over a million jobs involves a “multiplier effect,” according to NAM president Jay Timmons, “since the job losses, including workers in the defense manufacturing supply chain and those employed in the military and as defense contractors, will result in lower disposable income and reduced consumer demand — creating a ripple effect across the entire economy.”7
In their study for the AIA (July 2012), Dr. Stephen S. Fuller and Dwight Schar, faculty chair and director for Regional Analysis at George Mason University, projected a loss of 2.14 million American jobs with nearly half of all sequestration job losses coming from small businesses. The report predicted that 2013 would “constitute the greatest one-year reductions in GDP, personal earning and employment” with the GDP taking a $215 billion hit and unemployment rising to above nine percent. The study went on to report that cuts in DoD procurement would lead to over 130,000 direct job losses to the professional and business sector including contractors who provide scientific, engineering and technical services.8
Fortunately, these predictions failed to materialize. Despite the cutbacks, the U.S. economy has not imploded. The stock market reached record highs and the housing market continues to rebound. By the end of August, the Commerce department announced that the GDP actually rose at a 2.5 percent annualized rate, up from the initial estimate of 1.7 percent. As a result, the CBO predicts the deficit will shrink this fiscal year to $642 billion, or just four percent of GDP. Thanks to sequester, coupled with higher tax revenue and improved economic growth, the deficit has been shrinking by about $42 billion a month for the past six months.9
Contractors have been pleasantly surprised that the automatic spending cuts were not hurting nearly as much as the industry’s lobbying arm warned in the months leading up to the sequester. Defense contractors have been reporting solid earnings and dividends and their stocks are on the rise. Teledyne Technologies, Boeing, Northrop Grumman and United Technologies have hit record highs. Lockheed Martin, General Dynamics and Rockwell Collins are within 10 percent of their all-time peaks.
In late July, Lockheed Mar-tin reported that its profit rose 10 percent to $859 million during the second quarter, despite a slight dip in revenue. According to Lockheed’s chief financial officer, Bruce Tanner, the company is “seeing less impact than we had expected to see through the first half of the year, it’s somewhat hard for us to imagine that the full [anticipated] impact will be realized.”
So what happened? The long lead up to sequester allowed many large contractors to insulate their businesses as much as possible. Some manufacturers rushed to get contracts signed before the sequester went into effect and are in the process of fulfilling those contracts now, which means the cutbacks haven’t hit their balance sheets yet. Others have diversified their portfolios by making acquisitions in areas such as unmanned aerial vehicles (UAV), computer security, health care IT, and C4ISR (command, control, communications, computers, intelligence, surveillance and reconnaissance).
“Cuts to the defense budget are part of the overall reductions in government spending necessary to address the nation’s debt issue,” said Steve Brecken, a spokesman for Honeywell’s aerospace division. “We have been anticipating and planning for sequestration for over a year, and to date, the impacts have been largely as we expected. We do not anticipate any changes in our financial outlook nor any layoffs or furloughs due to sequestration, mainly due to our thoughtful planning and our large commercial aerospace businesses.”10
David Herr, executive vice president for services at BAE Systems, speaking to the National Journal Daily,shared his beliefs that big firms such as Lockheed Martin, Northrop Grumman, BAE and General Dynamics would do some “portfolio-shaping” to strengthen their ability to go after new business. In the service business, Herr is predicting a lot of consolidation that will probably create some very big players interested in the IT business, maintaining hardware and space systems. According to Herr, “If you look at the history, in the last downturn those companies that sat back and did nothing fared the worst. There will be consolidators and those that will be consolidated. BAE would like to be one of the consolidators.”
The company is also diversifying into more commercial markets and opportunities outside the U.S. BAE is developing next-generation cabin electronics for commercial aircraft. It is not alone in pursuing opportunities in commercial and international markets. Earlier this year, General Dynamics announced a partnership with Samsung to deliver enhanced security to that company’s mobile devices.
What About the Small Companies?
Dan Stohr, a spokesman for the Aerospace Industries Association (AIA), told lawmakers that his association was concerned that smaller suppliers might feel the pain more acutely than large contractors, despite the minimal impact on their bottom lines. One concern is that small firms do not have access to the kind of capital and credit the larger firms do, and they are far less likely to be diversified. Many of these smaller companies rely on large DoD contractors for 25 to 50 percent or more of their business. On the other hand, small companies have the advantage of agility and willingness to innovate.
According to the Small Business Administration (SBA), 20 percent of Defense Department prime contracts and 35 percent of DoD subcontracts in 2011 were awarded to small firms. In 2011, 18 percent of NASA prime contracts went to small businesses and 38 percent of its subcontracts to small companies. Additionally, between two-thirds and three-quarters of defense industrial purchases are directed to small suppliers, many of which are the only source of specialty parts and technologies for the U.S. military.
The SBA says that small firms employ half of all private sector employees. According to the U.S. Census Bureau, small businesses create 90 percent of all new jobs on an annual basis. “From a national security perspective, letting the avoidable occurrence of sequestration force small businesses to exit the defense industry or go out of business altogether would not only hurt our economy but taxpayers,” said Mackenzie Eaglen, resident fellow at the Marilyn Ware Center for Security Studies.
In turn, hits to small companies may eventually trickle upward and be felt on a national scale, resulting in layoffs, mergers and further industry consolidation among aerospace companies. According to Herr, BAE has brought some smaller subcontractors to visit policy makers and discuss concerns over losing certain skills and preserving capabilities within the supply chain. One fear among prime defense contractors is that they will muscle through this sequestration and budget downturn, and when they put out a request for bids, there won’t be anyone there to fill them. This is a network of thousands of small and midsize businesses spread across all 50 states.
Several lawmakers in Congress are concerned for the plight of small businesses under sequester, among them U.S. Senator Mary Landrieu (R-La.), chairwoman of the Small Business and Entrepreneurship Committee. “Small businesses are going to be the ones that feel the most immediate effects as these government budget cuts come down, because contrary to popular notion, government spending does affect private-sector jobs,” Senator Landrieu told Politico this past April.
Landrieu held a roundtable event entitled, “Sequestration: Small Business Contractors Weathering the Storm in a Climate of Fiscal Uncertainty,” to urge federal agencies to maintain their small business contracting goals. While the senator’s efforts may help small businesses that contract directly with the U.S. government, it will not directly provide support to companies far down the supply chain from the largest defense contractors. As budget tightening trickles down from top defense contractors, small companies will need to adapt.
So how are these companies weathering sequestration? Some small defense suppliers say sequestration already cut into their businesses, reporting that the Pentagon has been slow to place orders because of budget indecision, compounded by furloughs of civilian defense employees. Still, the Pentagon has worked hard to shield big weapons programs such as the F-35 jet, the military’s most expensive weapons system, from the mandatory cuts. According to Lockheed’s Bruce Tanner, “The Pentagon has done a fairly masterful job kind of deflecting” cuts to weapons programs.
As a result, much of the doomsday predictions have yet to materialize for small- to mid-size contractors. Sequestration may have cut some spending, but it may be an improvement over the budget uncertainty recurring since 2011. Sequestration has also changed priorities for a Pentagon looking to maintain its objectives to meet future threats with a more efficient use of its procurement and R&D money. As a result of these new priorities, contractors are finding new opportunities among its government and prime contractor customers.
Wall Street has taken notice. According to Bloomberg, investors are returning to many of the smaller government suppliers whose shares slumped during months of budget uncertainty leading up to sequestration. A Bloomberg index providing a sample of 17 small and mid-sized contractors, including API Technologies, Anaren and CPI Aerostructures, has gained 20 percent since March 1. It fell 14 percent in the five months before sequestration kicked in, partly reflecting concerns they would be more vulnerable to budget cuts. The surge comes as second-quarter profits and raised outlooks for the full year were reported from defense contractors such as Lockheed Martin, Raytheon and Northrop Grumman.11
There has been a nice bit of bounce back for small defense stocks, “because the sky is not falling and companies are not going out of business,” said Mark Jordan, a St. Louis-based analyst at Noble Financial Capital Markets. For example, the shares of API Technologies, which makes RF/microwave components and integrated microwave assemblies for defense and medical applications, have risen 16 percent since March 1 after falling four percent during the previous five months. API Technology, with a market capitalization of $167 million, hasn’t been “affected by any programs that were either eliminated or are to be eliminated,” commented Bel Lazar, API’s chief executive officer, during a conference call in July. According to Lazar, the Pentagon is now “more careful in terms of what they’re procuring and how much they’re paying.”
Executives at Anaren, a leading manufacturer of microwave passive components, assemblies and subsystems for telecommunications and military radar systems, “assumed the cuts would prevent sales from increasing more than roughly five percent. Instead, the company now projects a 10 percent boost in revenue from its defense and space businesses this year,” according to president Larry Sala. Anaren’s stock has jumped 19 percent since March 1, which Sala attributed mostly to a buyout offer from a private equity firm, which the company rejected in May. Apparently, Anaren isn’t the only one “pretty optimistic about growth. Right now, we’re planning on our business being even stronger next year than it is this year,” said Sala.11
Strategies for Surviving Sequestration
Defense contractors large and small need to utilize their core strengths to navigate the evolving nature of government spending and provide solutions that meet the DoD’s long-term objectives. These companies need to consider how to protect existing business, diversify into new markets, and look for ways to cut costs internally and for their customer. Now more than ever, it is important to maintain high visibility with existing and potential customers.
Jim Assurian, director of business development at Reactel, a leading manufacturer of RF/microwave filters, believes companies will react in a variety of ways. “For the larger guys [defense contractors], their best defense may be to let people go. On a much smaller scale (say for companies 100 employees and less), I think they are (or should be) redoubling their marketing and sales efforts. While they may lay off a few folks, I think there are opportunities out there to at least remain even in sales. We are mainly talking about companies with sales of $10 million or less, so it does not take much to replace the small share of programs they were on. These are really Business 101 type things, and should not be a revelation to anyone. However, with so many small companies in our industry, the thought of increasing spending to add sales guys and increase advertising in a down economy is counter-intuitive.”
To protect and serve the government, business consultants to the defense industry make the following suggestions:12
- Know your existing contracts: Take the time to do a full inventory and determine what types they are – indefinite delivery/indefinite quantity are increasingly common, time-and-materials less so. Understand what accounts are funding the contracts and how they will be cut, if at all.
- Know your contract/program lifecycle: When does it expire, what are the option periods? Contracts later in their lifecycle may be less flexible. Determine which are severable and which are non-severable: some will have to be carried over beyond the current fiscal year, but others may allow spending in fiscal 2013 for services carried out later. Also know the termination provisions and option expirations for their contracts and subcontracts.
- Strengthen ongoing performance: “Nothing will succeed in this area like a well-performing program.” Take preemptive measures to protect contracts from cancellation by working with clients on proactive approaches to reduce scope/cost of contracts and don’t give the government an excuse to cancel a contract by addressing any performance deficiencies immediately. Also, maintain relevant records – such as past performance – ensuring they are as accurate and favorable as possible.
- Engage customers, both at the contracting officer and end-user levels, to understand the importance of the work, the status, the performance, their plans and strategies going forward.
- Evaluate agency funding and spending priorities for both existing and new work. What must be saved, deferred or deleted? Perform an inventory of contracts based on their importance to fulfilling federal customers’ missions to assess areas most at risk for cuts.
- Agencies will be eager to use fixed-price contracts to shift cost risk to contractors. Companies should mature their processes quickly to improve their bottom line.
To find growth opportunities, contractors should look to utilize their current areas of expertise applied to the commercial sector and/or foreign markets. As an example, Anthony Sweeney, general manager of Mercury Systems RF and Microwave Component Group, points out, “While a significant portion of our revenue is aimed at the EW and radar markets, we also have a strong presence in the commercial telecom marketplace via base station power amplifiers, point to point digital microwave radio through our ferrite lines, and test and instrumentation through our control components line, as well as low noise and CNG test equipment lines. We also see several opportunities to leverage our technology into homeland security applications.”13
As in the Mercury System example, the commercial sector can actually help win new government business, especially when the Pentagon is looking for off-the-shelf commercial components to lower their costs. In addition, the Pentagon is working to maintain military readiness with existing defense assets, technology and operational support. With several major contracts in limbo, the electronics industry is the beneficiary of an increasing need for replacement parts or enhanced technology to improve current systems that are being kept operational longer.
“With sequestration lingering earlier this year, we saw a significant reduction in the bid solicitation from government sources,” says Julian Andrews, operations manager of Coaxial Components Corp., which manufactures RF connectors, attenuators, terminations and other microwave components. “With cuts now in place, we’re seeing a growing focus on maintaining or upgrading existing communication and defense systems.”
America’s future military will be defined as a globally agile force characterized by small, precision engagements that feature minimal violence applied with surgical precision. Over the coming decades, the U.S. military will look to “pivot from the past and a turn to the future.” The Pentagon’s new vision represents a shift from the types of missions and forces that dominated the wars in Iraq and Afghanistan, emphasizing “strategic flexibility” made possible through specialized, tailored capabilities, from cyber warfare tactics to special operations forces.
There will also be a rebalance of the global posture and presence to emphasize the Asia-Pacific region and the Middle East, building upon key alliances in all regions. Procurement and RDT&E plans will protect investments in key technology areas and advance new capabilities, as well as the DoD’s capacity to grow, adapt and mobilize as needed. These goals will lead to continued investments in intelligence, surveillance, and reconnaissance (ISR) and further developments in improved precision strike, cyberspace, and space capabilities maintained through funding for research and development (R&D) of technologically advanced capabilities.14
In Washington, Congress is expected to pass another stopgap bill, known as a continuing resolution, to fund government operations for fiscal year 2014, but it is unclear whether such funding will stay at current levels or shrink. Earlier this year, the House and the Senate passed spending bills for the 2014 fiscal year, which began on October 1, that were about $90 billion apart, but never settled on a final figure. The fate of the sequester, scheduled under current law to continue through 2021, is uncertain in the next round of budget and debt ceiling negotiations.
As Jim Fallon, president and CEO of Fallon and Associates LLC, advised last year in Microwave Journal, companies should, “keep looking for growth opportunities in defense and commercial markets by focusing on the technology trends and programs that will survive. Look for platform upgrades, electronic warfare systems, low cost SATCOM terminals, and IP based tactical radios, to name a few applications. Develop new customer relationships in emerging applications like UAV data links, autonomous vehicular guidance, and electronically scanned arrays.” As the country asks lawmakers to trim waste from the budget, look for government dollars to flow to companies willing to help them get lean and mean.