Is the Sky Really Falling?

Let’s get this straight: the Defense Department and the defense industry survived the sequester. But you’d be forgiven for thinking otherwise, given a year of dire forecasts from the aerospace industry that 2013 would see the decline and fall of the economy — and with it America’s military capability.

The forecasting failure of the Aerospace Industries Association (AIA) notwithstanding, the industry has not given up. Facing a second round of the sequester this coming January, the halls of Congress and the media are once again ringing with forecasts of doom. AIA CEO Marion Blakey is back on the hustings, telling the Senate Defense Appropriations subcommittee that another round of sequester could cut $147 billion in defense acquisition over the next five years, calling into question "our industry’s ability to deliver these capabilities in the future."

Here we go again; the industry never gives up, despite some lobbyists whining to National Public Radio that they are somehow incapable of defending their interests before the Congress and the public. And some members of Congress, especially those on the defense committees, remain ever susceptible to the pitch.

In reality, the defense industry is surviving the sequester mighty well, anticipating a downturn in the budget, making corporate moves that lock in profitability, and ensuring they remain in the game, whatever the level of the budget.  

Let’s start with the basics: Is the defense industry hurting as a result of the budgetary sequester? Not really. Keep in mind that the decline in defense spending preceded the Budget Control Act by more than two years. Defense budgets started coming down after FY 2010, three years before the sequester of FY 2013. What the industry is dealing with is a long-term drawdown in the defense budget and America’s military forces, something that happens after every war. In every drawdown since Korea, moreover, it is procurement — buying things from the private sector — that goes down most deeply and most quickly.

The big guys in the industry — Lockheed Martin, Northrop Grumman, General Dynamics, Boeing, L-3, Raytheon — have been coping for several years now with a decline in defense buying, and coping rather well, in fact. The last quarterly results are a testimonial to their hardy survival. Lockheed Martin’s net earnings were up 16 percent from last year; they generated $115 billion in orders, raising their backlog to nearly $79 billion. Northrop Grumman also did well, reporting an 18 percent increase in earnings per share. And General Dynamics reported net earnings up $50 billion over the prior year. Sounds like defense continues to be not only good business, but profitable, as well.

How do they keep this fiscal success up, in the face of AIA’s doom-and-gloom scenario? At a conference I attended at the Naval War College last week, savvy industry analyst Byron Callan of Capital Alpha Partners pointed to part of the reason: unlike the 1990s, the big guys have their fiscal house in order. Their debt-to-capital ratios are healthy (low debt), the margins are great, profit rates are steady, and they have a lot of generated cash in hand.

While sales may go down (and all the companies are reporting projections of lower sales in the future), they aren’t disappearing. And the Defense Department has a big stake in keeping profits up at a rate that makes it worthwhile to stay in the business. Unlike commercial players, these big guys stay out of the private market (except for Boeing, which is nicely positioned with military sales and commercial jets). When the defense giants wander into the commercial world, their record is, as Martin Marietta CEO Norman Augustine once said, "unblemished by success." Just ask Grumman how their bus business fared in the 1970s, for example.

So, how have they managed to survive so nicely? Turns out that the big defense companies are what I like to call "canaries in the coal mine" of defense budgeting. They know earlier than anyone that a drawdown is coming and, rather than die like the proverbial canary, they start doing the things they need to do to survive. They may squawk in public, but they are pedaling fast behind the closed door.

First, they started long ago to reduce their wage bills. While AIA cried havoc about job losses from the sequester, the major contractors started laying off people long before the Budget Control Act (BCA) was a gleam in Congress’s eye. Lockheed, for example, reduced its workforce from 146,000 to 116,000, starting back in 2008 — when defense budgets were still growing.

Second, they have been selling off parts of the company they figured would not do well in a declining market, like Northrop Grumman did with its shipbuilding business in 2011, months before the BCA was passed.  

Third, they have been buying companies and technologies they think will do well even in a declining defense market, like small cybertechnology firms with big upward potential, thanks to the roughly $10 billion government investment in cyber offense and defense.

Fourth, they are refocusing their efforts on the international defense market — those places where the budgets are growing — to make up for some of the lost sales to the Pentagon.  The market for defense sales in India has been hot with competition and Asian defense budgets are offering new sales opportunities to a U.S. industry that already dominates international arms markets.

Fear not, even with sequester, the big companies in the defense industry are thriving. Knowing your market, hitting your financial targets, shrinking the workforce, finding the niches — these strategies usually work well.

But these are the giants of industry, the companies that integrate the components of big hardware like aircraft, missiles, tanks, and ships. How about the "little guys" — the companies that make the components (landing gear, switches, dials, joy sticks, windshields, etc.) that the big aerospace boys put together? Are they more vulnerable to a draw down? Will their technologies and the work they do disappear, along with the jobs they create, when sales fall?

According to several experts I’ve spoken with, the little guys are actually often more flexible than the big aerospace firms, working back and forth between the commercial and the defense world. The landing gear they build turns out to work for commercial aircraft. Same for the canopies and windshields. In fact, a lot of what goes into a final defense product is connected in some way to the commercial market. As Peter Dombrowski of the Naval War College put it, "There’s always somewhere where there is a permeable barrier between defense and commercial" when you look at an aircraft, ship, tank, or missile.

And the truth is that some of the little guys are pretty
big — Microsoft, Apple, Hewlett Packard, even Google have all entered the defense market, bringing commercial technology into the defense world ("spin on") instead of drawing technology out of the defense world ("spin-off").

If anything, the closer integration between defense and commercial technologies and parts is even more advanced today than it was when I was looking at this question more than 25 years ago. Even then, however, subcontractors in defense reported that they were pretty agile when defense dollars from the big boys dried up. They kept their hand in commercial markets, husbanded their cash, and worked at turning to new opportunities quickly.

Way back in the good old days of the 1950s, the old "defense industrial base" was more of a hermetically sealed box, but not today. As the drawdown proceeds, the emerging data suggest that the whining and fear-mongering coming from the industry is more of a false alarm than a description of reality. The big contractors whose names everyone knows are actually surviving well. And the subcontractors are more adaptable than we think.