2012 Defense budget outlook: The new certainty

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Guest Article by Lou Crenshaw, Vice Admiral U.S. Navy (ret.)

The 2011 defense budget was characterized as a budget about uncertainty. Budget officials struggled to make ends meet in what seemed to be an endless stream of continuing resolutions (CRs), debt ceiling crises and impending government shutdowns. There was doubt about the continuing presence of U.S. forces in Iraq and Afghanistan, and planners were uncertain about what a post-Iraq war presence would look like. Given the lack of clear guidance, future force structure levels were practically impossible to predict. DoD officials were also concerned about the loss of supplemental funding and how to accommodate the migration of baseline expenses into supplemental funds. The newly appointed secretary of defense, Leon Panetta, had presumably been appointed to oversee a massive defense budget restructuring. Given his reputation as a tough but savvy budgeteer, DoD officials were uncertain about how aggressive he would be; they were still stinging from the relatively modest cuts mandated by Secretary Gates. In short, it was a very difficult year for Defense Department planners and budgeteers to put into place any sort of long-term plan that would adequately address the security challenges facing the nation and balance those challenges with the fiscal needs of Congress.

The good news is that unlike in 2011, the Defense Department can bank on quite a bit of certainty going into 2012…

• The New Certainty
  
• The good and bad
  
• The big picture
  
• Five Defense Trends for Clients
  
• Prepare now for a certain future
  
• Additional Readings
  

The New Certainty

The Good and Bad

The defense authorization and appropriations bills have been signed by the president, and funding levels for 2012 are locked. The positive effect of having the defense bills completed in the first quarter of the fiscal year cannot be overstated and frees planners to get on with the business of planning for the future rather than fretting about the present. There’s more certainty. In the end, the funding levels of $633.2 billion for the DoD were close to the president’s request of $656.2 billion. This amount is only about $38 billion less than in 2011. The level of troops remaining in Iraq is now well-defined at zero given the lack of a Status of Forces agreement with Iraq.

To be sure, certainty also comes with some not-so-good news: sequestration. With the congressional supercommittee’s failure to reach an agreement comes the baggage of sequestration — automatic across-the-board cuts that do not allow much room for interpretation. As of this writing, several members of Congress have stated their intention to propose legislation that reverses sequestration, but the president has vowed to veto any such legislation. For now, it is the law of the land. The Defense Department stands to lose a great deal of funding in the next 10 years, which will require some very difficult choices in the FY 2013 budget and beyond. Most sources say that despite the reality of sequestration, the DoD’s FY 2013 budget uses a 2012 baseline rather than sequestration targets. The Pentagon and White House reached an agreement on the future defense budget over the summer; the agreement trims $450 billion over 10 years, amounting to about 8%.

Under sequestration imposed by the Debt Reduction Act, the DoD is facing cuts from the baseline of $85 billion to $104 billion annually for the next 10 years, depending on whose scoring is used. That’s a lot of money, to be sure, but the DoD has survived sharper cuts in the past. According to McAleese & Associates, a well-respected source of DoD budget analysis, the current budget (adjusted for inflation) is $150 billion above peak funding during past defense buildups and at least $300 billion in excess of funding troughs. We have been there before. Also, budgeteers tend to take the largest cuts in later years, mitigating the short-term impact of cuts. The really bad news is that 2012 is an election year and the prospects of having the defense bills completed for 2013 are grim. We will most likely be back to the uncertainty of 2011, enduring more CRs, debt ceiling debates and government shutdowns. To add to the misery, CRs will be based on sequestration levels, not 2012 funding. This means 2012 is the year for the defense industry to prepare for a leaner future.

GT: Pentagon Total “Obligational Authority”, 1948 – 2012
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Historically, the DoD has met budget challenges in the “trough” years by disproportionately cutting procurement and to a lesser degree, O&M funding. The following chart clearly shows the procurement “holidays” after Vietnam and the Cold War. Current funding is skewed by supplemental funding, which is included in the chart, but I expect the trend to continue in the post-Iraq/Afghanistan defense budgets. Cutting the manpower accounts by the Pentagon has proven to be extremely difficult because of the aversion to reductions in force (RIF) in civilian jobs and large-scale reductions in military end strength. To add to the complexity of cutting uniformed and government personnel, the savings in manpower-related accounts tends to migrate into other O&M accounts as contractors are hired to fill the gaps. Savings in manpower therefore accumulate in later years of the budget, making dramatic cuts less attractive in the short term. It should be noted that most DoD government employees are funded from O&M accounts. Another factor influencing the O&M accounts is that since they have been skewed by a decade of supplemental appropriations, the drop in those accounts is likely to be dramatic in proportion to the rest of the budget. Throughout it all, the R&D accounts tend to grow constantly – a trend I expect will continue.

The big picture

We can be sure that the new defense certainty will have a dramatic effect on firms in the A&D industry. Broadly speaking, firms can expect cuts across the board in DoD purchases of their goods and services. Midtier firms can expect the dominoes to fall as the large-scale integrators deal with program cancellations and restructurings, contract renegotiations, and general reductions in the DoD’s contractor workforce. The DoD will become focused on extracting maximum value from every contract and will be scrutinizing contractors’ business processes, IT infrastructure and profits as never before. To go along with this sharpened focus, new regulations intended to increase the authority of DoD inspectors and auditors to delve into corporate infrastructure are likely to be implemented. These regulations will mandate increased vigilance and investment in business systems and processes that are required for a company to do business with the DoD. Poorly performing programs across all domains will be on the chopping block, and even relatively healthy programs will come under intense pressure to improve. As a result, 2012 is likely to be a year in which the major defense companies will be looking to shrink or shed business units that are probable losers in the budget cuts, and to acquire companies that are winners.

On the bright side, there will be winners – those programs that the DoD considers vital to the success and relevance of future missions. Special operations, unmanned vehicles, cybersecurity initiatives, energy-efficient technologies, and health care and intelligence programs are likely to see investment at FY 2012 levels or higher. Firms that provide consulting services related to carrying out business process improvements, understanding and improving cost allocations, and maintaining performance and financial integrity (i.e., audits) will also continue to see investments as the DoD not only seeks to consolidate and strengthen its processes and infrastructure, but also to attain an unqualified audit opinion on its statement of budgetary resources (SBR) by 2014. A premium is likely to be placed on public-private partnerships in property development, construction, and efficient energy use and generation as well. Firms in all these areas can expect modest growth throughout the Future Years Defense Program (FYDP).

Since the DoD is likely to depend on cutting the major weapons systems procurement accounts to pay for a large share of the expected savings, those firms with troubled or expensive weapons systems programs will be under the gun as well. DoD will be taking a hard look at vehicle and heavy armor programs, searching for opportunities to cancel and consolidate. Likewise, the expensive Joint Strike Fighter program will be under more pressure. Debate will continue on how many and which variants to procure, informed by impending force structure cuts in land-based and amphibious forces, among other factors. The Navy’s shipbuilding program will likely be restructured and reduced as the necessity for a 313-ship Navy is questioned. Air Force programs that are likely to be reduced or canceled will be focused on support aircraft procurement in the nice-to-have category: i.e., VIP transport aircraft, search and rescue assets, electronic warfare and redundant classified programs, especially in R&D funds. Reductions in O&M funding will likely affect the armed services across the board, and reductions in depot maintenance, base and logistics support, flight and ground operations, and spares can be expected. Also at the forefront of O&M reductions will be a large effort to reduce all types of contractor support. Contractor reductions have traditionally been very difficult for the DoD because the funding for contractors is not clearly itemized as such, nor is it classified uniformly. It is generally agreed that most funding is in research, development, testing and evaluation (RDT&E); O&M; and procurement accounts, but funds that pay for contractors can be found in almost every appropriations category. Given the inability to specifically identify contractor funds in those accounts, reductions are typically done by assigning bogeys – unspecified arbitrary cuts – to those accounts. This practice will likely continue.

Although the DoD tends to avoid large-scale manpower RIFs when attempting to deal with budget cuts, we can nevertheless expect to see significant reductions in Army and Marine Corps uniformed personnel and the civilian employees and contractors who support them. The additional contractor cuts will most likely surface in the O&M and procurement accounts of the Army and Marine Corps, putting additional stress on those appropriations. These cuts will be in addition to the O&M and procurement reductions common to all branches of the U.S. military, ensuring that the Army and Marine Corps will feel the most impact. There will likely be a demand for more sophisticated manpower management resources and tools as a result.

Five Defense Trends for Clients

What does all this mean for Grant Thornton clients in the A&D industry? Those companies that are prime contractors with the DoD, or that are suppliers to larger integrators, will obviously feel the impact of defense budget cuts given these companies’ position in the market relative to the effects mentioned earlier. However, there are some trends that are not so obvious that clients need to know about:

1: Cost. The first trend is a laser focus on cost reductions in everything the Defense Department buys. Accompanying this focus is an obsession with corporate salaries and profits — an obsession shared by Congress. The NDAA includes several provisions that have a direct impact on our clients. For example, the cap on allowable costs for defense contractor executive compensation has been extended to all management employees, not just the top five. DoD officials will publicly state that they do not care about corporate profits as long as the cost to the DoD is less than before, but their behavior does not support their rhetoric. The DoD will demand that companies reduce general and administrative (G&A) expenses, decrease non-value-added costs, cut down on marketing expenditures, and lower overhead rates in general. Contractors can expect increased scrutiny by the Defense Contract Audit Agency (DCAA) as it scours financial data for unallowable or improper costs, irregular time sheets, and other administrative violations. Clients should be ready for a comprehensive DCAA audit and should test their policies and procedures regularly. To bolster the DCAA’s authority further, new regulations allow contracting officers broad discretion in interpreting the results of DCAA audits, providing for the withholding of payments – or worse – until discrepancies have been resolved and re-evaluated by the DCAA, which may take a year.

2: Risk shift. The second trend is a shift in risk from the DoD to contractors. Recent direction from DoD procurement officials to contracting officers in the field is that the default contract type should be a firm fixed-price (FFP) contract, in which the contractor assumes all liability and risk for performance and delivery. While non-FFP contract types have not been eliminated, the procedures put in place to allow for other types of contracts are so onerous that contracting officers default to FFP even though other types are more appropriate. Meanwhile, some officials are beginning to use fixed-price incentive (FPI) contracts, which specify a target cost, a target profit, a price ceiling and a profit adjustment formula. For a company to execute the terms of an FPI contract properly, a cost accounting system is necessary. Cost accounting systems have historically not been required for clients dealing in FFP contracts, and implementation of these systems can be expensive. FPI contracts also open up the possibility of a more comprehensive DCAA audit.

3: Audits. The DCAA and the Defense Contract Management Agency (DCMA) are cracking down on deficient business systems, paying particular attention to them during audits. Huntington Ingalls Industries, a major shipbuilder for the Navy, has had millions of dollars withheld because of business system problems. At issue were violations of some of the 32 rules governing the earned value management system (EVMS), the main management tool used by the DoD to track the health of procurement programs. Traditionally limited to hardware contracts, the requirement to use the EVMS is expanding its reach. Increasingly, clients will be expected to adhere to these rules. Putting them in place and maintaining compliance with them will be an added pressure on profit margins.

4: M&As. During a recent interview, Jay Johnson, CEO of General Dynamics, told Reuters that declining defense spending could generate interesting acquisition opportunities and that the company is keeping sufficient cash on hand to pounce if it sees good prospects in cybersecurity, health care IT, intelligence or aerospace. Increased M&A activity is a fourth trend consistent across the industry, and clients in the winner areas can expect to be the targets of acquisitions by large defense contractors. Note: The use of the term pounce implies that these transactions will happen quickly. Clients should prepare in advance to play a role in these activities. They should also be prepared in the event that a corporate restructuring or divestiture affects their companies in a bad way.

5: New regulations. Finally, there are a variety of laws, regulations and rules that have been put into effect with the certainty of defense funding and focus on better business practices. One such provision included in the 2012 Defense Authorization Act is related to electronic parts supplied to DoD. If a firm delivers or repairs electronics for DoD, either directly or indirectly, that firm is responsible for ensuring that no counterfeit parts are used. Failure to do so will result in severe criminal penalties. The vendor is responsible for replacing any parts in violations of the act. Obviously any client involved in delivering electronic parts to DoD has now incurred significant liability and must have a mitigation plan in place to deal with the issue. Similar regulations are contemplated for conflict metals, requiring vendors to maintain the pedigree on these materials from source to service. Additionally, several new rules on the protection of DoD data, even unclassified information, on vendor networks have substantially increased their IT expenses and exposure to DoD inspection.

Prepare now for a certain future

In summary, despite the looming cuts, there is certainty in what the future holds for the Defense Department. There will be substantial cuts to the DoD budget in the next 10 years, but we have a good idea of where they will be made. While the numbers seem quite intimidating, keep in mind they are spread out over 10 years against a baseline of $5 trillion to $6 trillion. We know the areas of focus that will affect the aerospace and defense industry, and thus have an opportunity to address the issues. DoD has dealt with these types of cuts in the past and will continue to enjoy robust funding levels relative to the rest of government. This year is shaping up to be one of opportunity for those in the industry who are properly positioned to take advantage of the new certainty, and the A&D industry will lead the charge as a vital part of this nation’s economy.

Additional Readings

• DID (Feb 13/12) – How DoD Gets Money: A Primer on the US Federal Budget Process

• DID (Feb 13/12) – DoD Budget: Fiscal 2013 Highlights & Numbers