While the Pentagon and its suppliers have gone through plenty of Defense spending downturns before, they say this one is different and poses risks the earlier ones didn’t, both for the companies themselves and for future military capabilities.

Military spending has ebbed and flowed on an ongoing basis for most of the nation’s history. But in the past, the cycles have followed a certain logic. The buildups tended to happen when wars start, and the drawdowns tended to happen once wars were over.

What makes the current cycle different, DoD and industry officials argue, is the cuts started long before the end of the war and were the product of political stalemate, not a policy consensus about national security priorities.

A little more than two years after sequestration’s formulaic budget cuts first took hold, Congress has acted around the margins to add more money to the government’s domestic and Defense budgets, but no one quite knows where things are headed.

That uncertainty makes the Pentagon worried about the health of the defense industry, particularly small suppliers, Elana Broitman, the deputy assistant secretary of Defense for manufacturing and industrial base policy, told a Bloomberg Government conference on Wednesday,

“The cuts are precipitous, and they aren’t tied to any long-term policy explanations,” she said. “That makes it very difficult for us to plan, and it makes it very difficult for industry to plan. The defense industry is unlike a lot of other industries in that if a defense company comes up with a new product and we don’t buy it, literally no one else is allowed to buy it. If we can’t fund that research and development and provide that certainty, it’s very difficult to see how we’re going to be able to get the best products for our warfighters. The other thing that’s been happening over the last decade is that we can no longer guarantee that the U.S. product is always the best product. If we aren’t investing in our industries in the way that those countries with more government-owned industries are able to invest, that’s also going to be detrimental.”

Further mergers, acquisitions not advised

Another complication compared to past downturns is the defense industry simply looks a lot different than it did at start of the last spending dip, Broitman said.

When the Cold War was ending, Defense procurement budgets were falling dramatically, but DoD had a sufficient abundance of “top tier” vendors. The department urged them to merge with one another, in order to make the industrial base more efficient.

They did, and today, the Pentagon doesn’t think it’s in the government’s interest for its prime contractors to consolidate any further, since mergers and acquisitions have left only a handful of “heritage” vendors, whose business is still focused mainly on defense.

“We’re very concerned about continuing competition in industry, and it’s just a market truism that competition leads to better quality and better pricing,” she said. “That’s something we worry about quite a bit, because it also means there are going to be fewer entities around to fund some of the innovation that we’re worried about.”

Even though the biggest trough in procurement spending under sequestration still is two fiscal years away, the Pentagon already sees fewer competitors bidding on its requests for proposals, said Frank Kendall, the undersecretary of Defense for acquisition, technology and logistics.

That’s in spite of the department’s Better Buying Power initiative, which has emphasized the need to increase competition for contracts.

“Competition across the board is the best thing we can do to reduce cost, period. But our numbers are not up. They’re down a little bit,” Kendall told the National Defense Industrial Association’s annual logistics forum last week. “I’ve got to look deeply into that and figure out what’s happening there, but I think part of what’s going on is that the budget cuts and constant changes in plans mean we’re basically doing fewer new things, which is where you’re most likely to get competition. And given the way we treated the government workforce last year, we were lacking in the basic resources we need to run our competitions.”

DoD officials say at least during the short term, sequestration hasn’t created a crisis within its industrial base. The department’s biggest contractors’ last few quarterly earnings reports have wowed Wall Street investors.

Earnings are up

Lockheed Martin, the Pentagon’s largest single vendor, said Thursday that its first-quarter profits were 23 percent higher than what the company experienced a year ago.

DoD’s other large suppliers are also doing quite well. General Dynamics, Northrup Grumman and Boeing reported earnings that beat investors’ expectations this week.

Kendall said the Pentagon is much more worried about its small business vendors.

“We’re watching the industry very carefully. We’re letting market forces work, but we’re paying attention. We’re prepared to intervene in some cases, and those cases generally are going to involve key capabilities we can’t live without,” he said. “The greatest risk is with our small manufacturing companies that build very specialized parts in low quantities. They are very sensitive to changes in our market. They don’t have the access to the capital that the big primes do. We’re watching them very carefully, and there are cases where we’re prepared to step in and help people.”

But even the biggest defense firms won’t be able to weather the storm forever, said Linda Hudson, a board member at BAE systems who retired as the company’s CEO three months ago.

She said while prime defense vendors like hers are riding high in investment markets right now, that’s mostly because they’ve dramatically downsized their workforces over the last few years and engaged in large buybacks of their own stock.

“But you can only buy back so many shares. While this model is working well at the moment, it is not sustainable over the long haul,” she said. “This time period of extraordinary financial performance for the large companies is limited, and the small companies are not weathering it nearly as well, because they don’t have the ability to adapt and adjust. I think we’re on the precipice of an industry readjustment like we saw in the last major downturn.”

But the characteristics of the current downturn are very different from the last few, said Hudson, who has been working in the defense industry since the Vietnam drawdown.

During those spending cuts, and the next round that accompanied the close of the Cold War, everyone understood the basic rationale for a cutback in Defense spending, she said. Even if her industry didn’t like those cutbacks, it was pegged to a national policy rationale, around which it could build its own corporate strategies.

“It was difficult for industry, but government and industry actually worked together to create a consolidated, more cost-effective, slimmed-down industry,” she said. “What we have now is a reduction in Defense spending that’s not tied to any kind of peace dividend. The policy, the budget and where we’re headed is not clear, and so you have companies saying, ‘I’m not going to bet my future on something I can’t see and that I don’t understand.’ And so very little research and development is happening, and very few products are being taken forward into even a pre-production stage. It feels very disjointed and misaligned. During the past downturns, we didn’t like it, but we pretty much did it in a collaborative way with the government.”

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