The Defense Industry Dilemma

By Sandra I. Erwin

The Defense Department and its contractors begin 2013 with hope for a March deal that will shield the Pentagon from a 10 percent budget cut. But even if Defense is spared from the sequester, the business climate for Pentagon contractors will be bleaker in 2013, analysts predict.

Whereas the defense budget top line peaked in 2010 and has only dipped slightly, projected spending on new equipment already has declined by one-third since 2008 and is on a path to go down another 10 to 15 percent, says Erich Fischer, a partner at the consulting firm Booz & Company.

The reductions in procurement spending have not yet hit home for many companies because the actual outlays of funds lag behind budget projections by two to three years. The budget began to come down in 2008, outlays peaked in 2010 and companies are now starting to feel the effects of a drying funding stream, Fischer says.

Another trend that bodes badly for defense firms is that weapon acquisitions budgets continue to be squeezed by rising military personnel, health and operations expenses.

“Some businesses are seeing decline up close and personal for the first time,” says Fischer.

The reality for industry is likely to be a 40 to 45 percent plunge in procurement spending since 2008, which is consistent with, or even less severe than, the previous defense downturn, Booz analysts estimate.

As a result, “2013 is when you will see industry begin to take real action” to cope with a shrinking market, Fischer says.

The largest Pentagon contractors have moved aggressively over the past two years to shed overhead, mostly by eliminating staff. The industry overall, however, is still saddled by huge fixed costs in unneeded facilities. “The head count reductions we have seen are emotionally difficult but the easiest to address. You’ll see more,” Fischer says. About 40 percent of industry overhead is in facilities, he says. Assuming that procurement spending falls by 40 to 45 percent from its peak, industry still needs to shed $20 billion to $25 billion of fixed overhead, he says….

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