Defense Contractors Brace for the Big Squeeze

In recent rounds on Capitol Hill, Defense Secretary Robert M. Gates has delivered a tough message to contractors: The age of ultra-generous Pentagon budgets is about to end. The latest reminder of the Pentagon's new austerity came from Admiral Michael G. Mullen, chairman of the Joint Chiefs of Staff, who warned on Feb. 17 that debt is the "greatest threat to our national security."

After a decade of record defense spending increases—powered by military operations in Iraq and Afghanistan—contractors now must contend with budget-cutting zeal from Gates, liberal Democrats, and conservative Republicans, all looking for ways to trim deficits. The companies "should be concerned," says Michael H. Herson, president of American Defense International, a lobbying and consulting firm. "They need to adapt to the changes that are coming."

Gates—who has announced he will step down this year, possibly as early as this summer—has targeted $78 billion in cuts through 2016 for deficit reduction and an additional $100 billion in savings from hoped-for efficiency improvements, including in weapons procurement and Pentagon overhead. The Defense Secretary already has slated for cancellation some high-profile contracts, including General Dynamics' (GD) amphibious vehicle for the U.S. Marine Corps, Raytheon's (RTN) advanced surface-launched missiles for the Army, and a NATO air defense system developed by Lockheed Martin (LMT).

The Obama Administration's $703 billion defense spending plan for 2012—the second-largest item in the federal budget, behind Social Security and ahead of Medicare—is an attractive target as Congress starts a months-long debate over what to cut and what to fund. The request, adjusted for inflation, is 23 percent higher than what the Pentagon received in 1985, the peak of the Reagan-era military buildup. Years of slashed defense budgets followed under Presidents George H.W. Bush and Bill Clinton, who reaped a so-called peace dividend from the end of the Cold War. A similar contraction may be coming, says Herson, whose clients include General Dynamics, Raytheon, and United Technologies (UTX).

A telling example came on Feb. 16 when the U.S. House, including more than half the chamber's 87 GOP freshmen, voted to cut $450 million from this year's budget for a Joint Strike Fighter backup engine that General Electric (GE) and Rolls-Royce are developing. GE reported in October that it had spent $8.2 million to lobby Congress to fund the alternate engine starting in mid-2009. The pitch: About 2,500 jobs are tied to the development of the engine, and that number could swell to 4,000 at peak production of 114 engines a year, according to GE Aviation spokesman Rick Kennedy.

Yet even the threat of job losses couldn't save the program in the House. The Senate might still rescue it, but that's not likely. (In the past, it's the House that has insisted on the backup engine.) "This is about the deficit," says Representative Lynn Westmoreland (R-Ga.), an opponent of the alternate engine. Now, adds Robert Stallard, an analyst with RBC Capital Markets in New York, "politicians can call for defense cuts and not fear for their jobs."

The deficit isn't the only threat to contractors. Late last year, the Pentagon's chief weapons buyer, Ashton Carter, announced that his office would seek fixed-price contracts to replace so-called cost-plus deals, which cover all expenses and pay an extra incentive fee, even for troubled programs. Under the new arrangement, the Pentagon and contractors would share cost overruns. Companies would have an incentive to deliver weapons below the agreed cost, though such deals can also "wipe out the profit" or cause a loss, says Todd Harrison, an analyst with the Center for Strategic and Budgetary Assessments. That's a novel concept for many weapons contractors.

The bottom line: Defense contractors may be in for cutbacks similar to the squeeze that occurred after the end of the Cold War.

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