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Defense Market Outlook

Big Spend Still on the Horizon

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MCN Editor Dan Markham Donald Trump has made improvements to the nation’s defense a cornerstone of his presidency, but political realities are forestalling a major boost to spending.

Of all the metals sector participants enthused by the 2016 election of Donald Trump to the presidency, few had more reason for optimism than suppliers to the defense industry. Throughout the campaign, and into the first months of his administration, Trump has repeatedly championed the nation’s defense, and the need to support it.

While Trump has vowed to cut funds from many departments and agencies, his plans for the Department of Defense have called for significant spending boosts. In February, he proposed a $54 billion defense spending hike, to be paid for in part by cutting from other discretionary funds.

nitially, the exuberant optimism was matched by reality. In April, the administration asked for a $30 billion outside the traditional cycle. Congress provided $23 billion to boost readiness, with some going to procurement.

However, as the administration has learned, Washington, D.C., is not easy to navigate, even with its party controlling both houses of Congress. The promise of explosive spending right out of the gate has turned into more of a “Wait ‘til next year” story.

“The budget that’s been submitted is not radically different than the Obama budget,” says Richard Aboulafia, vice president of analysis for the Teal Group, Fairfax, Va. “On the other hand, the Obama budget wasn’t half bad. Once you get past the vast expectations of huge growth, the fundamentals are pretty good.”

The biggest roadblock in the way of huge gains in defense spending are the rules regarding legislation and the continuation of the Budget Control Act, the Congressional statute that created sequestration.

“The Budget Control Act is not addressed. It’s still out there through 2021, and there’s no significant legislation to address it,” says Bill Edgar, managing director of Govini, a public sector analysis firm based in Washington.

Pat Able also believes the Budget Control Act remains problematic to a full-scale run-up in defense spending. “It’s been a good year, but I say that cautiously. The overriding issue with the government is still funding, with sequestration and continuing resolutions,” says Able, who runs the government business unit for TW Metals, Exton, Pa.

Able says the realities of Washington have tempered expectations from earlier in the year. “Enthusiasm has died down. They anticipated things breaking relative to the defense budget quicker, but some of the other political issues have gotten in the way.”

Aboulafia agrees. “We’re not sure how we’re going to pay for it. You still have the problem with the Congressional logjam and a reliance on continuing resolutions that might just continue,” he says.

And the administration has said it’s not interested in offsetting defense increases with generosity in other areas of spending. “The administration has been very clear. When it comes to budget negotiations, any increase is going to favor defense. Historically, in the two previous bipartisan budget agreements, Congress agreed that when they increased for defense, they also increased for non-defense. This administration is saying, ‘Nope, we’re going to be fiscally responsible,’” says Edgar.

Even with that, as Aboulafia notes, spending was already trending in a positive direction. Since bottoming out a little above $550 billion in fiscal year 2015, the budget has grown to $606 billion in fiscal year 2017.

The FY18 budget request calls for a $51 billion increase in the base budget, though that’s offset somewhat by a lower request for Overseas Contingency Operations. Altogether, the 2018 budget request calls for an increase of $33 billion from the 2017 outlay.

Beyond the base number, the administration has enacted certain priorities that will affect where money is spent. According to Edgar, the key themes of the DoD under Secretary James Mattis is to improve warfighter readiness, meet national security challenges and focus on the future.

Warfighter readiness includes two primary goals, both of which are beneficial to the metals sector. They include more aircraft in the air, more ships in the sea and more troops in the field. Additionally, the DoD wants more munitions on hand to rebuild the current force.

The national security challenges include sustaining capability development for new warfighter concepts, and the future goals include creating a new defense strategy, developing and implementing reforms to improve efficiencies and reduce costs, and “get bigger and more lethal.”

“Because of the BCA, many argue, we haven’t been able to sufficiently recapitalize and reset, much less invest in the future military,” Edgar says. “The concern is we have a lot more near-peer, almost-peer competitors out there with the proliferation in technology, Russia and China in particular.”

Combating that is the Third Offset, designed to develop the military for the future. The First Offset occurred during the Eisenhower Administration, the genesis of Mutually Assured Destruction. The second was the build-up in technologies in the Reagan administration that helped bury the Soviet Union.

“The Third Offset plays on that technological theme, and says we really need to focus on making leaps forward. A lot of it is around unmanned systems and combating unmanned systems, and around electromagnetic capabilities, navigation systems, and tracking and targeting of systems,” Edgar says.

But in the meantime, the buzzword is readiness. “There was a wearing down of our equipment, wearing down of our soldier and our airmen and women and Marines. That has to be addressed immediately,” says Edgar, noting that this issue was the focus of the initial $30 billion request.

Among the readiness objectives include increased manning levels in the Army and Marine Corps; additional funding for operating forces, logistics, maintenance, training and spares; additional shipyard capacity and aviation depot maintenance for the Navy; increased flight training for the Army; and targeted new end strength increases for the Air Force and Navy.

However, even with the billions in the budget, there is a limit to how much freedom there is to pursue various objectives, says retired Lt. General Joe Martz, who served most recently in the Army Capabilities Integration Center. Martz notes that much of the military’s base pay outlays are effectively spoken for. For example, under the Army’s current $151 billion FY17 budget, large percentages of that total are earmarked for military pay, civilian pay, installations and other pass-through accounts. That leaves 15-20 percent of the budget left for future readiness objectives, he says.

“The Army tries not to go below 17 percent for future readiness, though sometimes when we’re in procurement holidays, we were underneath that 17 percent,” he says.

There are also some plans to cut expenses where possible, such as through the Base Realignment and Closure Act. There is an estimated 20 percent overcapacity in infrastructure and legacy systems that could be eliminated, Edgar says, though he notes that additional investment in other locations must also be made to accommodate new requirements.

Service centers working with the defense industry, or other contractors to the industry, provide material for any number of functions. Who they serve, and when, can dictate how healthy activity is.

Standard Metals, a Hartford, Conn.-based distributor of nonferrous metals to the military, saw a difficult start to 2017, as one active submarine program was winding down and the next hadn’t ramped up. Company owner Steve Buzash anticipated the slowdown, though the cycle lasted a little longer than usual.

Now, however, with Block 5 beginning to take off, his company is poised for a long period of strong sales to the market. “We’re looking at business being really robust in the first quarter of 2018, and we’re already picking up right now.”

He says the two largest sub builders have been calling distributors such as his to make sure they are capable of handling the increased demands. “We’ve had both companies checking with us to make sure we have the proper warehousing facility, the proper equipment and the proper manning so we can react very quickly to their needs,” he says.

The strength in activity from the Navy has been evident to Able, whose company serves all branches of the military. “When you think about the world and how defense is changing, and it’s oceans connecting us to remote areas. The Navy is really the important thing right now.”

Able says his company has seen activity in both the shipbuilding and maintenance ends, while also infrastructure related to construction and fabrication work at Naval sites. “We’ve seen some nice opportunities there.”

The uptick in overall activity has been enjoyed by T&T Materials Inc., a full-line service center that specializes in serving defense and other government agencies. “We have seen some modest increases in purchasing activity. I wouldn’t call it robust,” says James Mossgraber, vice president and general manager of the Rochester, N.Y.-based company. “I think it will continue to improve, but it will be pretty measured improvement.”

That’s the sense Eric Blore gets. “We’re a little ways down the food chain, so when a submarine gets built, it takes a while to get to us. There’s probably been a little uptick in activity, and everyone is expecting more in 2018,” says Blore, who works in the technical sales department for Marmetal Industries, a Hartboro, Pa.-based supplier of naval brass and copper nickel.

Beyond changes in demand activity, suppliers to the defense industry can occasionally be faced with changes in the already-stringent requirements. Selling to the government presents unique challenges compared with commercial customers.

Mossgraber says the government purchasing people he works with won’t provide forecasts the way a commercial customer might. “We don’t have any kind of indicators directly from the customer,” he says.

That absence of foresight is a challenge for an inventory-based business. “We treat every quote and every purchase as a spot buy. If one of the Naval bases sends us a request for 10 pieces of something, we would not buy 50 and put the other 40 in inventory until they buy again. They might not buy it again, or they might buy it tomorrow.”

Able says the government has been pushing the idea of Audit Readiness throughout the supply chain, allowing for the potential for comprehensive audits. Additionally, new Defense Federal Acquisitions Regulations are focusing on cyber security.

“There are certain risks involved, risks of compliance, risks of cyber security, risks of meeting all the DFAR regulations. You almost have to be a lawyer to figure out all the requirements and statutes,” he says. “You have to know the language the government speaks to be able to understand it.”

That’s why many of the service centers serving the government, whether large entities such as TW Metals or smaller single-facility operations, don’t just dabble in it. If they decide to engage in selling to the government, it typically is a significant part of the business.

“The number one difference boils down to quality systems, traceability and documentation. It’s something we’ve been doing for a long time, and it’s not much of a challenge for a company such as ours,” says Blore.

There are advantages to selling to the defense department as well. The qualifications required, the documentation to be delivered and the other requirements provide a decent barrier for entry, as some distributors may not want to undertake the steeper learning curve.

Also, Mossgraber notes, there’s no risk involved when it comes time to square up your accounts. “The government does pay, and it pays to the terms specified,” he says. “And there’s a very small likelihood they go out of business.”

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