The Agony of the Contractors

Let me take you back, back to last year, in the midst of a presidential campaign, when the Aerospace Industries Association was working itself, the industry, and some members of Congress into a lather about sequestration — particularly about the devastating impact it would have on the economy, on the defense industry, and on the labor force that works in the defense sector.

Fast-forward to the quarterly reports from the major defense contractors. Oops! Seems Lockheed’s profits rose 10 percent. Northrop Grumman was up 2 percent over the last year. General Dynamics was slightly up with an operating margin of 12 percent, Boeing earnings up 9 percent, blah, blah, blah. To quote Lockheed’s chief financial officer, "We’re seeing less impact … than we had expected to see through the first half of the year."

Almost every contactor’s defense revenues were down, but margins were good and earnings were up. What happened to the Doomsday machine that would hit the defense sector and boomerang into the American economy?

Can I say I told ya so? I could, but it is more fun to say why this is true. Defense contractors are the canaries in the coal mine — they see a drawdown coming before anyone else is prepared to admit it. And, believe me, these guys started preparing for a drawdown way before the sequester was a gleam in John Boehner and Barack Obama’s eyes.

For the last three years, the big guys have been doing everything a smart contractor should do to prepare for a declining budget: Sell off things that won’t be profitable in the drawdown, buy things that will (IT and cyber businesses, especially), lay off workers (something that started way before the sequester), streamline production. They have been getting ready for a long time.

Then there are the peculiar features of sequestration, which were transparently clear last year during all the breast-beating and garment-rending. It really didn’t hit the contractors. Military personnel were exempted, so they were untouched. But so were any Pentagon dollars already tied into contracts, which meant anything the industry was working on this year, anything already under contract, was funded with what are called "obligated" dollars. They weren’t sequestered.

AIA and then-Lockheed CEO Bob Stevens assured us that there would be massive layoffs — Stevens was preparing to send out notices to much of his workforce. He was either misinformed or disingenuous — I’ll let you decide. He did (or should have) known that existing contracts were not touched, and that the bulk of sequestration cuts would hit DOD’s civilian workers (now furloughed a day a week until September 30) and the other kind of contractors — those doing the dishes, cooking the food, and putting guards at the gate — but not his business.

Now, some folks still see fear and loathing on the horizon — the bad news wolf is not at the door, but coming down the path. That could be; the defense budget is going down and dollars for hardware always go down deepest in a drawdown. In fact, procurement dollars are already down around 20 percent, while the overall budget is down only 10 percent (pre-sequester — which, as I said, didn’t do much damage to procurement).

In fact, that’s why contractor revenues are down — we are in a drawdown, and revenues for defense contractors and subcontractors will definitely go down. And their workforce will shrink — that’s what happens in a drawdown, and it has been underway for three years now. Lockheed has cut its workforce 20 percent over the past five years; Northrop Grumman has laid off 5,000 over the same timeframe.

But those margins will stay healthy because that’s how you manage a drawdown. The contractors and their shareholders will probably be OK. Oh, sure, as Loren Thomson of the Lexington Institute said the other day, 10-12 percent margins are not so good compared to fully private sector companies raking in over 20, 30, 40, even 50 percent (e.g., Dunkin Donuts).

And he is absolutely right. But what he didn’t say, and the reason these big guys stay in the defense business, is that defense margins are very steady over time. Defense is a very stable business, with regular returns even when volume is down. It doesn’t have very sharp swings in profitability, unlike the full-risk private companies. Sales go up and sales go down; the workforce grows and it shrinks. But the return is regular and risk stays low.

So let’s not lose too much sleep over the future market or the profitability of the big guys in defense. Getting the Pentagon’s defense plans in line, streamlining their back office, controlling costs — those are the real priorities.