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Defense industry may see leaner times

A new administration and broad economic pressures are expected to mean cutbacks in military spending.

October 16, 2008|Stephen Manning | The Associated Press

WASHINGTON — There are few industries whose fortunes are so closely tied to government as military contractors, companies that provide the Pentagon with everything from fighter jets to janitors. And for the last eight years, business has been very good.

But with that government customer now ailing, the boom times are likely to end.

Long-term problems loom for the industry -- rising Pentagon costs for items other than weapons, calls for military contracting reform by both men vying for the White House and uncertainty over how massive government expenditures to prop up the economy will affect military spending, by far the largest discretionary portion of the federal budget. With the Treasury pouring hundreds of billions of dollars into rescue plans, there is suspicion that Washington's appetite for expensive military programs will diminish.

"No one really yet knows when or to what extent defense spending could be affected, but it's unrealistic to think there won't be some measure of impact," Boeing Co. Chief Executive W. James McNerney wrote in an Oct. 2 e-mail to company employees in which he warned that the plans could "crowd out" defense funding.

Major military contractors are scheduled to report their quarterly earnings next week, and with military spending still robust, there are few forecasts of an immediate downturn for the industry, which has enjoyed record profits in recent years. But analysts say leaner times are ahead.

"They see the writing on the wall that the budgetary environment is going to get tighter," said Michele Flournoy, president of the Center for a New American Security and a Defense official in the Clinton administration.

As President Bush's term ends in January, defense firms also face the prospect of greater scrutiny under either Republican John McCain or Democrat Barack Obama.

Both candidates have called for some measure of military contracting reform in the wake of a series of delayed or bungled awards. McCain has boasted of his role in scuttling an earlier Boeing contract for the planes, saying he has "taken on" contractors.

A new president also will be constrained by larger economic issues. Healthcare and other personnel costs for the military will consume a larger proportion of military spending, especially if the armed forces grow as both candidates envision.

The appetite for military programs and their huge price tags could diminish as Congress and the administration face tighter overall budgets.

"Both candidates will use the Pentagon as a bill payer for domestic priorities," said Mackenzie Eaglen, a national security analyst for the conservative Heritage Foundation.

Under Bush, military spending grew significantly. Including funding for the wars in Iraq and Afghanistan, 2009 fiscal year military spending is slated to be $612 billion, up about 40% during his eight years in office.

As military spending rose, so did military contractor profits. Companies such as Lockheed Martin Corp. and General Dynamics Corp. have consistently posted double-digit quarterly earnings growth and record sales. Lockheed, the nation's largest military contractor, had $42 billion in sales last year, most of it coming from government spending.

Having a stable government customer meant the defense industry was a relatively safe haven for investors. Although their shares have fallen with the broader market, many defense companies have large cash reserves and contracts stretching over decades to help weather the crisis.

"We believe our products and services will continue to be recognized as vitally important to the mission of our government customers and to our constituencies in Congress," Lockheed spokeswoman Cheryl Amerine said.

But Wall Street analysts say the government's $700-billion bailout plan, which includes $250 billion to directly buy shares in the nation's leading banks, can only pressure future military spending.

It seems "nearly impossible" that future military budgets "will remain unscathed by the current fiscal reality," Ronald Epstein, a defense analyst with Merrill Lynch, wrote in a recent investor note.

In a time of economic turmoil, some big defense programs that are behind schedule, over budget or still in development could prove a tempting place for Congress or a new administration to make cuts.

The Army's plan to outfit brigades with high-tech tools under its Future Combat Systems modernization program, led by Boeing and SAIC Inc., may cost as much as $200 billion, and some analysts say it could be scaled back to reduce costs. Air Force hopes for more of Lockheed's F-22 stealth fighter jets could be hurt by their price tag of $191 million per plane.

But industry officials argue that national security issues, such as the growing threat from insurgents in Afghanistan, would make it a mistake to slash support for defense.

"This is not a simple problem," said Fred Downey, vice president of national security for the Aerospace Industries Assn., a trade group representing contractors. "We can't afford to stop any of these programs."

Still, military officials have a cautious outlook.

At last week's annual Army conference at which contractors showcased their latest weapons, service leaders said that uncertainty over the Pentagon budget and national economic health made it difficult to predict how their priorities will fare.

"I don't know what the crystal ball is going to say for defense spending," Lt. Gen. Ross Thompson III, the military deputy to the Army's acquisitions secretary, told reporters. "We've got some serious issues the country has got to deal with."

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AP business writer Donna Borak in Washington contributed to this report.

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