Defense firms weathering budget cuts more easily than expected

July 23, 2013

Big defense contractors are weathering the federal budget sequester far more easily than they projected, in part because they have gradually eliminated jobs over the past few years in anticipation of spending cuts.

Bethesda-based Lockheed Mar­tin, the world’s largest defense contractor, reported Tuesday that its profit rose 10 percent, to $859 million, during the second quarter even as revenue dipped slightly. Northrop Grumman and General Dynamics, two other large contractors, are scheduled to report results Wednesday.

“Lockheed’s setting the tone,” said William Loomis, a defense industry analyst for the financial services firm Stifel Nicolaus.

Contractors seem pleasantly surprised that the automatic spending cuts are not hurting nearly as much as the industry’s lobbying arm warned they would in the months leading up to the sequester that took effect in March.

Lockheed Martin had predicted that sequestration would wipe out $825 million in revenue this year, but it no longer expects such a big hit. In fact, the company said, profit will be higher than initially projected.

“We’re seeing less impact . . . than we had expected to see through the first half of the year,” Bruce Tanner, Lockheed’s chief financial officer, said in a conference call with reporters Tuesday. “It’s somewhat hard for us to imagine that the full [anticipated] impact will be realized.”

With the Pentagon only a few months into sequestration, analysts said they’re not surprised that defense contractors’ earnings are holding up. Many contracts are booked years in advance and it will take time, analysts cautioned, for the spending cuts to show up in companies’ bottom lines.

Defense contractors “overhyped the immediacy of the sequester impacts, and I think that blew some if not all of their credibility,” said Todd Harrison, a defense analyst at the Center for Strategic and Budgetary Assessments. “And the truth is there are going to be impacts; they’re just not immediate.”

Defense Department officials say they’ve approached this year’s budget with a “damage limitation” strategy — looking for short-term ways to avoid pain and sparing major spending programs. But they warn that their strategy will have to change if the sequester isn’t reversed by next year, because some big weapons programs could be pushed onto the chopping block.

The relative health of the industry also reflects the stealth cost-cutting major contractors embarked on over the past several years as the United States began to wind down wars in Iraq and Afghanistan.

During his commencement address at the U.S. Naval Academy, the president urged Congress to pass a budget that would fund the military and “middle class priorities.” (The Washington Post)

In the past five years, Lockheed has cut its workforce to 116,000 from 146,000, a 20 percent ­decline. Falls Church-based Northrop’s core workforce has dropped to 68,000 from about 81,000, a 16 percent drop; that doesn’t include the thousands of workers who left when the company spun off its shipbuilding unit.

Raytheon, based in Waltham, Mass., has cut about 5,000 employees in the past five years, putting it at about 68,000 workers. Several other large contractors have shed a few jobs or kept employment flat after years of hiring.

“More than two years ago, every one of these companies started doing a series of things that are classic contractor adjustments to changes in the procurement market,” said Gordon Adams, a professor at American University with expertise in national security. “Every contractor has been thinning its back office, it has been selling off divisions, it has been closing production capacity, it has been laying off workers.”

There are signs that some parts of the contracting industry are beginning to see tightened spending. Contracts for services such as engineering support or administrative help generally are not booked as far in advance as contracts for weapons systems such as fighter jets and ships.

Sales at Lockheed’s information technology unit, for example, dropped about 7 percent in the second quarter.

Meanwhile, sales rose for its F-35 fighter jet, which accounts for 14 percent of Lockheed’s revenue and is the Pentagon’s largest weapons program. The program had been besieged by questions about cost overruns, but it has been largely shielded from budget cuts.

“I’d say that our customer really has not come out with a definitive position on how they’re going to take into account sequestration,” said Marillyn A. Hewson, Lockheed’s chief executive. “One thing I will say is that they’re very supportive of the F-35, and we’ll just have to see how it comes out.”

In the Washington region, a booming market in contractor jobs has ground to a standstill. The government’s usual labor statistics don’t track contracting jobs specifically, but most of those jobs tend to fall under the professional, scientific and technical services industry. That industry averaged 2.6 percent annual job growth from 2003 through 2011, adding nearly 100,000 net jobs in the process.

But over the past 18 months, employment growth slowed to a trickle; the industry added just 1,200 net jobs, a growth rate of 0.1 percent.

Still, the region and the industry are not experiencing anything close to the economic cataclysm that defense lobbyists warned about.

In the months before the sequester took effect, the Aerospace Industries Association warned that it would be devastating to the defense industry and the broader economy. Sequestration will “be the second wave that overwhelms our floundering economic boat, likely sinking us back into a recession,” the association said in a January statement. The association’s chief executive could not be reached for comment Tuesday.

Industry analysts said this week that the full effects of the cuts were always likely to take several years to materialize and that contractors were wrong to suggest otherwise. The cuts will eventually ripple through the industry, they said.

“The biggest reason why sequestration isn’t hurting earnings is because it takes a long time for legislation to turn into bottom-line results,” said Loren Thompson, a consultant for the defense industry. “There’s a lot of money that is coming out of the military procurement accounts, but the impact is only trickling down.”

The Defense Department’s short-term strategy is buffering contractors for now, other analysts said.

“The easier, less painful things are getting cut first from the DOD, and the more painful [steps] — including going to contractors, looking at long-term programs and potentially disrupting supply chains” will be “the last thing DOD is doing,” said Loomis, the Stifel Nicolaus analyst. But “if the cuts continue into ’14, there’s no choice.”

Jim Tankersley is the editor of Storyline, where he explains complex public policies and illuminates their human impact.
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