Defense Market Dodges the Budget Bullet
While government spending on weapons, aircraft and other metals-intensive equipment may moderate in the coming years, major cutbacks in procurement are not on the agenda for the Department of Defense.
By Dan Markham, Senior Editor
When Secretary of Defense Robert M. Gates began his summer-long campaign for more judicious spending by the Department of Defense, there was reason for concern throughout the metals supply chain. But once Gates started laying out the details of his Efficiency Initiatives, distributors in the defense supply chain could rest a lot easier.
|Production of Humvees and other Army trucks will dramatically drop in the coming years, as the war effort shifts from the urban settings of Iran to the more disbursed environment of Afghanistan. (Photo courtesy Department of Defense)
While Gates put certain areas of defense spending in his budgetary crosshairs, not only did he mostly exempt procurement from his targets, but he stressed the need for continued increases in that area going forward.
“It is important that we not repeat the mistakes of the past, where tough economic times or the winding down of a military campaign led to steep and unwise reductions in defense,” Gates announced in August. But Gates also believes an additional 2 to 3 percent annually in war-fighting capability can be funded without budget increases by identifying and eliminating unnecessary or redundant costs from the system.
“As a matter of principle, and political reality, the Department of Defense cannot expect America’s elected representatives to approve budget increases each year unless we are doing a good job, indeed everything possible, to make every dollar count,” he said.
Fortunately for metals suppliers, the areas where Gates sees the most inefficiencies do not involve procurement. The defense secretary’s primary targets are military headquarters, both in the number of facilities and their headcounts, and excessive operations and management growth, including administrative costs and contractor services. Neither of these areas would have any impact on metals distributors, analysts say.
“Everything Gates has been talking about in terms of cuts is designed to forestall cuts at the procurement levels,” says Richard Aboulafia, an analyst with The Teal Group, Fairfax, Va. “It looks like he’s trying to build a fence around the current level of spending and saying, ‘If you want cuts, take it out of operations and personnel, but don’t touch procurement that’s needed to replace what’s worn out.’”
Gates’ position drew praise from metals distributors serving the defense industry.
“The Department of Defense is too big, and Gates is doing some things to cut it, such as closing some headquarters and paring down staff,” says John Batiste, the president of Rochester, N.Y.-based Klein Steel Services and a retired major general in the U.S. Army. “It needed to be done.”
“The recent moves Gates made in dealing with the people side vs. the defense supply side is appropriate. We applaud that,” says Blain Tiffany, president of Paramount, Calif.-based Castle Metals Aerospace, a major supplier to the military. “He’s not cancelling programs, but looking at total cost of defense and where there are redundancies and inefficiencies. I was really encouraged by that.”
Analyst James McAleese of McAleese & Associates, Sterling, Va., recently sat in on a briefing with Gates and other outside experts following one of the secretary’s efficiency announcements. McAleese came away from the meeting convinced that Gates is committed to protecting both operating forces and modernization from cuts.
Still, procurement didn’t escape total notice in the remarks of Gates and Ashton B. Carter, undersecretary of defense for acquisitions, technology and logistics, who recently released his own set of recommendations. From Gates, a third area of efficiency initiatives targeted excessiveness of requirements, the desire for more and greater capabilities in weapons and equipment that may exceed what is necessary for combat.
“The message he was trying to deliver to the Navy was that their natural inclination is to buy more ships and better ships, but they’ve got to realize none of our adversaries are in a shipbuilding competition,” McAleese says of Gates’ earlier remarks to the Navy League. “Our adversaries are going to have much more finite resources. They’re going to do things to target our weaknesses. He was trying to get people’s attention about thinking differently, not a widespread call to reduce the size of the fleet.”
And Gates wasted no time putting this initiative into practice. The Department of the Army has already cancelled a previously announced request for proposals for its Ground Combat Vehicle program. The reversal was made after additional study revealed questions about the existing requirements “effectively and affordably meeting the needs of our soldiers,” a release from the DoD suggested. A new RFP is expected to be published sometime before October.
“The new requirements will be based on mature technologies that are more affordable based on unit costs. The original ground combat vehicles were estimated at $12 million a copy, but people outside the building were thinking they were going to be about $20 million per copy,” says McAleese, who will deliver a defense spending presentation at this month’s Metals Service Center Institute Forecast Conference.
In his Mandate for Restoring Affordability and Productivity in Defense Spending, Carter is also looking at changes that could impact the metals distribution business. Some of Carter’s suggestions include leveraging real competition instead of directed buys; phasing out award-fee contracts in favor of fixed-price or cost-type incentive contracts where government and industry share equally in overruns and underruns; and identifying and eliminating non-value-added costs, among others.
These objectives are likely to have the most impact on service centers serving the defense industry and its primary contractors, McAleese says. “Presumably, what will end up happening is the amount of risk and cost will be placed increasingly on the prime contractor. And that presumably is going to cause the prime contractor to offload a significant portion, if not all, of the risk onto the subcontractors and suppliers. The desire to be more aggressive in terms of pricing is going to be pushed down the food chain, so the first- and second-tier subcontractors are going to be less flexible in terms of their pricing and be more demanding on deliveries.”
Thus far, the change in administration has not resulted in many changes in either the types or levels of materials the defense department is purchasing from suppliers. “It’s been slow, but I think that everything is starting to shake loose again,” says Steve Buzash, president of Standard Metals, Hartford, Conn. “The subs that were supposed to be released a year ago weren’t released until December, so that’s held things up.”
As far as doing business with the government, few modifications have been seen there either.
“We haven’t seen a lot of changes in the procurement structure,” says Tiffany, whose company recently renewed its contract to supply aluminum plate for the F-35 fighter, an enormous commitment that required Castle to put a management office at Lockheed to handle the program. The company has so many subcontractors globally that it needed a dedicated group to work on the contract.
Pat Able, general manager of the government business unit for TW Metals, Exton, Pa., says the only significant shift in procurement policies is an additional emphasis on subcontracting to small businesses. “It’s relatively stable,” Able says of the market. “There’s more emphasis on the Small Business Administration, and the government is doing everything it can to facilitate that market.”
Such stability is generally the rule, as an organization as large and bureaucratic as the federal government does not change quickly. Still, while the processes and the overall material requirements will remain steady in the coming years, distributors supporting certain programs may see significant increases or decreases in demand in the years to come. The biggest victim will be companies supplying the army truck market. Spending for all types of army trucks—light, medium and heavy—will fall off to nearly nothing in the coming years as production of such vehicles as the Humvee will end and the military will instead spend money on rebuilding and repairing the existing fleet.
The change in the war front from Iraq to Afghanistan will have an impact on some of the spending. “In Iraq, it was more of an urban environment, so it was all about MRAPs. Afghanistan seems to be more of a helicopter war, with a de-emphasis on vehicles. Now, every VFW hall in the country will have an MRAP out front, whether they want one or not,” says Aboulafia, jokingly.
On the other hand, the 2011 budget for aircraft procurement is on the rise for all branches of the military. The Air Force’s aircraft budget jumps from $14.6 billion to $16.7 billion, while the Army’s aircraft procurement budget increases from $6.0 to $7.6 billion in 2011, with even bigger increases expected in 2012. Naval aircraft procurement jumped from $15 billion to almost $20 billion in 2010, and will continue to climb in years to come.
The changing nature of the battlefront is driving some of the shifts in spending. Counterinsurgency battles are disbursed and distributed over a large area, which leaves them infantry intensive, McAleese says. “Once you get in these disbursed operations, it becomes a helicopter war.”
The most recent Quadrennial Defense Review revealed the need to add two combat aviation brigades to the active force. The first will be transferred from the reserve component into the active component, but the 2012 budget will likely call for a $6.5 billion investment to fund approximately 120 new helicopters.
One possible roadblock to the successful execution of Gates’ long-range plan for defense spending is a new political environment. In the past, Aboulafia says, the simple equation was that Republicans were good for defense spending and Democrats were bad. But the rise of the Tea Party movement has shifted some of the traditional defense spending points of view.
“You’ve got a significant part of the Tea Party crowd campaigning against defense budgets. That complicates things and increases the risk there may be political traction for cuts,” Aboulafia says. He doesn’t think such a scenario is likely, as political movements often play themselves out, but the possibility of a new rightwing that’s not as friendly to defense spending can’t be entirely discounted, he adds.
One thing is certain, say the experts. The great run-up in defense spending over the past decade has, at the very least, crested. While the DoD may be able to hold off on major spending cuts going forward, the hefty annual increases are likely a thing of the past, in light of the giant federal budget deficit.
In 2001, military spending in the U.S. totaled $432 billion, with $411 billion in the annual budget and $21 billion in supplemental war spending. Total spending has risen almost every year since then, and was at $720 billion for 2011, not counting war supplementals possibly to come.
“It’s tough to learn to live without growth,” Aboulafia says. “A high plateau isn’t so bad, but people were getting used to those nice high growth rates.”
Still, the ongoing activity in Afghanistan will ensure that spending will remain at lofty levels for the foreseeable future.
“As long as they continue with the conflict, anything that floats or flies or is on four wheels will have to be brought in from the theater for repair,” Able says. “That keeps [metals] demand high.” n