U.S. Defense Industry Flees the Country

The defense drawdown is now well underway, and the defense industry is starting to pack up, if one is to believe what is being said this week at the Paris Air Show.

Defense budgets peaked in FY 2010, including war funding, and have been down about 10 percent in constant dollars. Factor in the budget sequester for this year, which looks like it will hang on through the rest of the fiscal year (and maybe make a repeat appearance next January), and the defense budget will have fallen 24 percent in constant dollars from their height.

The future does not look different. If the sequester remains, one can expect another roughly $500 billion to disappear from projected defense budgets over the next nine years.

Oddly, defense contractors seem to be doing OK, so far. Sales had declined a bit even before sequestration set in, but profit margins are holding strong for the big guys — Lockheed Martin, General Dynamics, Raytheon, Boeing, Northrop Grumman, L3.

This apparent fiscal health is actually an economic Potemkin village. Profit margins may hold, but U.S. sales are clearly headed down. The illusion stems from the reality that the major defense contractors are still working on programs funded in previous years, when budgets were higher.

But as the U.S. defense budget heads down, DOD’s dollars to buy stuff will drop more quickly than the overall budget, as they have in every drawdown since the Korean War. Between FY 1985 and FY 1998, for example, the defense budget declined 31 percent in constant dollars, while funding for research and purchases of hardware fell 53 percent.

This reality is already apparent today — budgets for weapons research and acquisition, before the sequester, were already down nearly 20 percent in constant dollars since FY 2010, and, with the sequester, could decline nearly 30 percent.

I like to see the major defense contractors as the canaries in the budgetary coal mine — they get the earliest signal of a change in fiscal direction, and they start to react well ahead of the policymakers and elected officials, many of whom think that the party is going to last forever.

The industry response to the coming decline began several years ago. Major contractors sold or consolidated business units, entered new markets (largely through acquisitions), and trimmed the workforce. Northrop Grumman, for example, sold its Newport News shipyard in 2011, leading to the creation of an independent business — Huntington Shipyards.

Boeing is reducing its management workforce by 30 percent and has closed defense production operations in Kansas and California. L-3 sold its consulting and government services businesses. Lockheed Martin already began consolidation and cutbacks in its missile and training operations in 2012. Overall, aerospace industry employment, which grew through the past decade, began a predictable decline in 2012, in advance of any implementation of the sequester.

As in the past, when the U.S. market tails off, the big contractors prepare to leave the country, hoping that international markets will make up for the loss in sales volume in the United States. The latest straw in the wind is an increasingly aggressive industry push to make up overseas for the sales that are declining at home.

And the U.S. defense industry has products it urgently wants to sell overseas. Lockheed hopes its F-35 will have a big export market. It is, after all, being built in partnership with Britain, Turkey, Italy, and Denmark, among other countries, which are expected to buy it — that was the whole point of cooperative agreements on F-35 development and production. For Lockheed and the U.S. aerospace industry, F-35 international sales are critical; this is the only fifth-generation fighter on the international market. If it sells, it would guarantee a leading position for U.S. firms in the international fighter market for years to come.

The Paris Air Show — on this week — has made this shift abroad abundantly clear. Fighters aren’t the only market U.S. companies are leaving the country for. Capital Alpha analyst Byron Callen reports from Paris that Lockheed anticipates 150-200 overseas sales of its workhorse C-130J transport plane, 300 of which have already been sold in the United States and overseas. This aircraft almost died in the Pentagon’s last drawdown, but industry pressure saved it and the Air Force has been buying it ever since.

The competition is heating up for shorter-haul aircraft as well. Boeing and Embraer announced that they are combining forces to market the Brazilian KC-390 competitor in Europe and the Middle East. And EADS/Airbus is still hoping for global sales of its long-awaited A300M. As the belt tightens at home, the sales effort is expanding abroad for everyone.

Even with defense budgets shrinking in the United States and Europe, the increasingly sexy drone market is another prime export target. General Atomics, maker of the Predator and Reaper drones — which have been on full display overseas in Iraq, Afghanistan, Pakistan, and Yemen — told the Paris crowd that it was heading into Europe. Predators and Reapers have already been sold to Britain and Italy, with French and German sales coming soon, according to Defense News. The industry drone push is spreading anxiety in the European defense industry. BAE (Britain), Dassault (France), and others have had joint drone research programs for about 20 years, as my colleague, the late Guy Ben-Ari, and I pointed out seven years ago. They have failed, so far, to produce a global competitor to the Predator/Reaper family. In desperation, Dassault, Italy’s Finmeccanica, and the continental European giant EADS combined forces at the start of the air show to appeal to European governments to put more money into indigenously developed drones, or risk losing the market to the U.S. firms. The three firms said they would join forces to build a medium-altitude, long endurance drone for the European market (they were silent on BAE’s role, maybe a side-effect of the failed effort to merge BAE and EADS late last year).

Spend more money, they said, so that "European sovereignty and independence in the management of information and intelligence… be guaranteed." A continental drone would "foster the development of high technologies and contribute to sustaining key competencies and jobs within Europe." Good luck with that as European defense budgets continue to fall.

The rush for the door marked "international sales" goes on and on. Boeing and Bell Helicopter companies are pushing the V-22 VSTOL transport plane into international markets, including Israel and the UAE, with prospects in Britain,
France, Canada, Libya, Saudi Arabia, Qatar, Italy, Colombia, Brazil, India, Japan, and Singapore. This for a program that has lived the perilous life of Pauline in the U.S. Marine Corps budget for more than a decade, but which the Marines now say has performed well in Iraq and Afghanistan.

The U.S. government has been lower key in Paris this year, arguing that sequestration prevented it from flying its fighters at the air show. And even Northrop Grumman, from whose pavilion I watched the Paris show back in 1999, skipped it this year. Perhaps everyone already knows enough about its Global Hawk drone. Japan, South Korea, and Australia have been interested, and NATO is already buying five for its Air Ground Surveillance system.

Global hope springs eternal for U.S. defense contractors — the same bum rush was on in the 1990s during the last defense drawdown. And maybe there are a few niche opportunities, especially in the Middle East and Asia. But there is a long history of competition in these markets, a natural tendency for others — especially the Europeans — to circle the wagons around national and regional industries, reflecting an inevitable uneasiness about relying on the United States as a defense supplier.

In the end, there is a mirage-like quality to the global market from a contractor perspective. Smaller sales is the likely trend across all markets. Jobs and corporate success are both at stake, which has generally led the U.S. government to support international sales.

But this trend begs some critical policy questions. Pursuing economic self-interest is one goal — a healthy defense technology base is part of national security. Strengthening alliance relations is another — cooperating with important allies and partners is part of the national security mission. Security is a different goal: Selling into regions with significant conflict issues may help allies and the technology base, but it can also exacerbate tensions (the Middle East) and stimulate arms races that are already gathering steam (Southeast and East Asia). The defense industry has the first goal at the front of its attention as the U.S. market declines. The administration needs to strike a balance with the other two missions. As the market shrinks, these are the issues that will move to the front of the discussion.