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9-2011 Military Metals Outlook
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Metal Suppliers Barely Nicked by Budget Cutters’ Ax...So Far

Republicans and Democrats in Washington are at war over where to make cuts in federal spending. Regardless of whose view comes out on top, the Department of Defense will not go unscathed.

By Dan Markham, Senior Editor

After months of contentious negotiations, Congress and the Obama administration reached an agreement this summer that calls for $900 billion in cuts to discretionary spending to be implemented over the next 10 years. How will that affect spending on defense and the metal suppliers that sell to government agencies and contractors? It’s way too soon to tell, say defense experts.

The initial round of budget negotiations, and the deal it produced, will slice $350 billion from defense spending over the next decade. That much is certain, and came as no surprise to defense watchers. Industry analysts had already factored in a cut of about that size in their projections for the coming years. In fact, the $350 billion was $50 billion less than the president had called for back in April.

But the initial round is just the first step in the process. From the perspective of the defense community, the important phase has yet to take place. As part of the budget deal, President Obama created a special bipartisan super committee to trim billions more from the federal budget. That committee must cut spending from its current level of 24 percent of GDP to a historically low 22 percent.

The 12-person committee will meet in the second half of the year to put together its recommendations for the House and Senate. If the committee is unable to provide a recommendation, or if Congress rejects the plan, additional spending cuts will trigger automatically—and that’s bad news for defense, say the experts.

Under the trigger mechanism, an additional $500 million would be cut from the defense budget. Defense analyst Jim McAleese of the law firm McAleese & Associates, McLean, Va., says the worst-case scenario would result in annual cuts of $85 billion to $104 billion, down 15 to 19 percent from the most recent spending levels.

The defense budget is set to flatline at $532 billion in 2011, with a $526 billion base in 2012 and a $529 billion base in 2013. If the trigger mechanism is activated, the base would fall to $472 billion in 2013, McAleese says.

Much like with the previous budget negotiations, the fallout from not reaching a deal on defense is severe enough that a compromise is expected to be reached. “If the fiscal committee took no action, the deal would automatically add nearly $500 million in defense cuts on top of cuts already made. At the same time, it would cut critical programs like infrastructure or education. That outcome would be unacceptable to many Republicans and Democrats alike, creating pressure for a bipartisan agreement without requiring the threat of a default with unthinkable consequences for our economy,” stated a White House press release. 

Still, even if the super committee reaches an agreement, further cuts to defense spending are inevitable. McAleese expects to see those future cuts in the $700 million range, or double the initial cut. However, the committee will be able to target waste and excess more effectively than cuts made by the more indiscriminate trigger mechanism, he says.

Under scrutiny for cuts will be a broad “Security” department, which encompasses Department of Defense spending, veterans’ programs, homeland security, diplomatic operations, foreign aid and some energy department projects. The vast majority, at least 77 percent of any cuts, must come from the Department of Defense, “given the sheer size of DoD and the political sensitivity of potential cuts to the departments of energy, homeland security, state and the Veteran’s Administration,” McAleese says. Defense officials have made it clear the committee should target “entitlements and revenues,” while protecting “force structure spending,” he adds.

Any force structure cuts will take four to six years to implement, McAleese says, therefore operations and maintenance readiness and procurement are the “short-term bill-payers by default.”

Historically, the level of defense spending is at record highs. McAleese notes that the current level of spending, adjusted for inflation, is more than $150 billion above prior defense funding peaks. Additionally, it’s more than $300 billion above post-conflict troughs. “The question is not if, but how fast, defense funding correction occurs, and whether cuts are responsibly targeted or arbitrary,” he says.

While the long-term defense spending outlook is uncertain, heavily dependent on the whims of Washington, those serving the market see less cause for concern in the immediate future. Demand for metal to service the military’s needs continues to be robust.

“In the short-term, we haven’t seen any real effect (of the recent budget cuts),” says Patrick Able, general manager for the government business unit at TW Metals, Carol Stream, Ill. “And this is the time of the year, at least within the DoD activities, where we see an increase in buying levels. They either spend it or lose it, so it has been kind of busy.”

That comment is echoed by other distributors, for varying reasons. In the case of Standard Metals, a red metals distributor, it’s simply a matter of timing. Submarine builders have just started work on the Virginia class of subs, resulting in strong demand for copper and brass. “It isn’t because we’re building an inordinate number of subs. This just caught us in a good period of time,” says Steve Buzash, president of the Hartford, Conn.-based Standard Metals.

The business-as-usual outlook for the moment is reinforced by Richard Aboulafia, vice president of analysis for the Teal Group, Fairfax, Va. “Procurement spending is not going down by a huge degree. We’re still riding a crest of high defense spending.”

That’s true even with the expected drawdown in troops in both Afghanistan and Iraq. While a sustained slowdown in active campaigns will almost certainly lead to smaller defense spending commitments, the immediate effect of the slowdown will be to allow time for much needed repair and replacement to equipment that has been used almost nonstop for the past decade.

“The current force is in terrible shape,” says Aboulafia. “It’s been in constant use.”

That’s what suppliers such as Metals USA are seeing. The Fort Lauderdale, Fla.-based service center is a large supplier to the military. Earlier this year, the Defense Logistics Agency, the DoD’s combat logistics support agency, extended its existing vendor contract with Metals USA in the Southeast region, one of three such contracts the distributor holds.

“We are very involved with maintenance work,” says Lourenço Gonçalves, president and CEO. “We have an existing backlog we’re counting in years. The wars have been fought for a long time. It’s not like it started yesterday.”

Moreover, the recent unanticipated flare-up in Libya, and America’s subsequent commitment of support there, serve as a reminder that stability can be fleeting. “If it’s not Afghanistan or Iraq, it’s somewhere else,” says Able. “There’s always the element of unrest in the Middle East. We have to stay positioned and prepared.”

“It’s still pretty tense out there,” Aboulafia says, pointing out that the U.S. and British governments were absolutely committed to drawing down in the Middle East when suddenly, “Libya happened.”

Even distributors seeing continued healthy demand from their defense customers know the new tune being sung in Washington may result in changes down the road. John Batiste says it stands to reason that priorities will have to change to accommodate the greater emphasis on frugality.

“I think it’s going to change with respect to the armored vehicle. There’s a good chance it will be replaced with something lighter,” says Batiste, who was a major general in the army before joining Rochester, N.Y.-based Klein Steel, where he is now president and CEO. “The prototypes for the joint light tactical vehicle weigh twice what they need and cost twice as much as they should. The industry will be forced back to the drawing board.”

That emphasis on getting leaner will filter back to the suppliers, he adds. Service centers will need to be far better and more efficient to keep their defense business.

Able says the defense industry will become more cognizant of the issues of fraud in the new environment. He also sees a trend toward less sole sourcing of material and shorter contracts, both of which will give the defense industry greater flexibility and leverage with its supply base.

Aboulafia believes that keeping a healthy defense supply chain is imperative to the government. The last time defense spending experienced a downturn, the number of defense contractors consolidated to an unhealthy level. “They believe the number of current players is the right one to ensure competitiveness,” he says.

As for pricing power, that largely depends on the overall economy. If the economy continues to grow, and demand for materials is solid in most end markets, then metals suppliers will have a lot of power. But if a double dip is on the way, resulting in softening demand from other markets, the defense industry will be better positioned to dictate pricing, experts say.

While political and combat changes may shift some aspects of defense spending, the process of doing business with the government has become far more steady and predictable. “There’s a lot of new coding that takes place, so neither we nor our major suppliers get hacked,” Buzash says. “Other than that, the specifications aren’t really changing daily the way they did 20 years ago.”

He says the key to being a supplier in good standing is to simply make sure your work is error free, as that’s the quickest way to fall out of favor. “If you’re quality approved and you haven’t made any mistakes, it’s easy.”

Able notes that with his company already being qualified as a defense supplier, it opens the doors to serve some of the smaller governmental units such as the Department of Energy, the Army Corps of Engineers and the federal prison system.

“We’re investing all of the other agencies within the federal space. Once you have people and systems in place and processes to understand the statutes, a lot of the requirements do transfer outside the DoD,” he says.

Regardless of the stressful political and economic environment, defense suppliers say it is still good to do business with the people who print the money. Gonçalves notes that despite any recent downgrade in credit rating, the government remains one customer that never fails to pay its bills.

“I can deal with AA+ customers. We’re very serious about collecting our money,” he says.

The question for defense industry suppliers remains how serious the government will become about not spending that money. n

  
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