Defense contractors fine (so far) with cuts

But some impacts from federal budget reductions will be felt later
2013-07-28T00:00:00Z Defense contractors fine (so far) with cutsMarjorie Censer and Jim Tankersley The Washington Post Arizona Daily Star

WASHINGTON - Big defense contractors are weathering the federal budget sequester far more easily than they projected, in part because they have quietly eliminated jobs over the past few years in anticipation of spending cuts.

Raytheon Co., parent of Tucson-based Raytheon Missile Systems, posted a 3.4 percent increase in second-quarter profit last week and raised its revenue and profit forecast for the year.

Raytheon followed industry peers such as General Dynamics Corp., Northrop Grumman Corp. and Lockheed Martin Corp., which also reported second-quarter profits that exceeded analysts' estimates.

Contractors seem pleasantly surprised that the automatic spending cuts are not hurting nearly as much as the industry's lobbying arm warned they would in the months leading up to the sequester taking effect in March.

Waltham, Mass.-based Raytheon continues to expect that automatic federal budget cuts under a process known as sequestration will reduce sales by $400 million this year and bookings by $500 million, Raytheon Chief Financial Officer Dave Wajsgras said last week after the earnings release.

"We did see some delays in the second quarter relative to domestic awards that we now expect in the back half of the year," he said.

Lockheed had predicted that sequestration would wipe out $825 million in revenue this year, but no longer expects such a big hit. In fact, the company said, profits will be higher than initially projected.

"We're seeing less impact ... than we had expected to see through the first half of the year," Bruce Tanner, Lockheed's chief financial officer, said in a conference call with reporters last week. "It's somewhat hard for us to imagine that the full (anticipated) impact will be realized."

With the Pentagon only a few months into sequestration, analysts said they're not surprised that defense contractors' earnings are holding up. Many contracts are booked years in advance and it will take time, analysts cautioned, for the spending cuts to show up in companies' bottom lines.

Defense contractors "overhyped the immediacy of the sequester impacts, and I think that blew some if not all of their credibility," said Todd Harrison, a defense analyst at the Center for Strategic and Budgetary Assessments. "And the truth is there are going to be impacts; they're just not immediate."

Defense Department officials say they've approached this year's budget with a "damage limitation" strategy - looking for short-term ways to avoid pain and sparing major spending programs. But they warn that strategy will have to change if the sequester isn't reversed by next year, which could push some big weapons programs onto the chopping block.

The relative health of the industry also reflects the stealth cost-cutting major contractors embarked on over the past several years as the United States began to wind down wars in Iraq and Afghanistan.

In the past five years, Lockheed has cut its workforce to 116,000 from 146,000, a 20 percent decline. Falls Church, Va.-based Northrop's core workforce has dropped to 68,000 from about 81,000, a 16 percent drop; that doesn't include the thousands of workers who left when the company spun off its shipbuilding unit.

Raytheon has cut about 5,000 employees in the past five years, putting it at about 68,000 workers. Employment at Raytheon in Tucson stayed relatively steady, as the company reported staffing down about 200 in 2012 due to attrition. Several other large contractors have either shed a few jobs or kept employment flat after years of hiring.

"More than two years ago, every one of these companies started doing a series of things that are classic contractor adjustments to changes in the procurement market," said Gordon Adams, a professor at American University with expertise in national security. "Every contractor has been thinning its back office, it has been selling off divisions, it has been closing production capacity, it has been laying off workers."

There are signs that some parts of the contracting industry are beginning to see tightened spending. Contracts for services like engineering support or administrative help generally are not booked as far in advance as contracts for weapons systems like fighter jets and ships.

Lockheed's information technology unit, for example, saw sales drop about 7 percent in the second quarter. Raytheon's Intelligence, Information and Services division, which derives much of its revenue from training programs, posted a 2 percent decrease in second-quarter sales.

Meanwhile, sales rose for its F-35 fighter jet program, which accounts for 15 percent of Lockheed's revenue and is the Pentagon's largest weapons program. The program had been besieged by questions about cost overruns, but it has been largely shielded from budget cuts so far.

"I'd say that our customer really has not come out with a definitive position on how they're going to take into account sequestration," said Marillyn Hewson, Lockheed's chief executive. "One thing I will say is that they're very supportive of the F-35, and we'll just have to see how it comes out."

In the Washington region, a booming contracting job market has ground to a standstill. The government's usual labor statistics don't track contracting jobs specifically, but most of those jobs tend to fall under the professional, scientific and technical services industry.

That industry averaged 2.6 percent annual job growth from 2003 through 2011, adding nearly 100,000 net jobs in the process. But over the past 18 months, employment growth slowed to a trickle; the industry added just 1,200 jobs on net, a growth rate of 0.1 percent.

Still, the region and the industry are not yet experiencing anything close to the economic cataclysm that defense lobbyists warned about.

In the months before the sequester took effect, the Aerospace Industries Association warned that it would be devastating to both the defense industry and the broader economy. Sequestration will "be the second wave that overwhelms our floundering economic boat, likely sinking us back into a recession," the association said in a January statement. The association's chief executive could not be reached for comment Tuesday.

Industry analysts say the full effects of the cuts were always likely to take several years to materialize, and that contractors were wrong to suggest otherwise. The cuts will eventually ripple through the industry, they said.

"The biggest reason why sequestration isn't hurting earnings is because it takes a long time for legislation to turn into bottom-line results," said Loren Thompson, a consultant for the defense industry. "There's a lot of money that is coming out of the military procurement accounts, but the impact is only trickling down."

The Defense Department's short-term strategy is buffering contractors for now, other analysts said.

"The easier, less painful things are getting cut first from the DOD and the more painful (things) - including going to contractors, looking at long-term programs and potentially disrupting supply chains" will be "the last thing DOD is doing," said William Loomis, a defense industry analyst for Stifel Nicolaus.

But "if the cuts continue into '14, there's no choice."

Did you know?

Raytheon Missile Systems is Southern Arizona's largest private employer, reporting 10,300 full-time equivalent employees in the Star 200 survey of the region's major employers.

Assistant Business Editor David Wichner contributed to this report.

Copyright 2014 Arizona Daily Star. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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