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Sequester Questions Hover Over Defense Defense spending, already on the decline from its war years’ peak, may not feel the full brunt of sequestration cuts as feared. As Congress and the Obama administration prepare for another budget battle, suppliers of metals to the defense industry are hoping for some compromise. By Dan Markham, Senior Editor For several years, sequestration was the budget boogeyman keeping defense contractors awake at night. Now that the mandatory across-the-board federal spending cuts have emerged from the shadows, they don’t seem quite as scary as imagined. Sequester went into effect March 1, starting the clock on the $500 billion, 10-year reduction in spending by the Department of Defense. So far the effects have been relatively minimal, sources say. Upcoming budget negotiations in Washington may even exorcise the demon. The biggest hit to defense spending has already taken place, says Richard Aboulafia, vice president for the Fairfax, Va.-based Teal Group, a defense and aerospace market analysis firm. The Budget Control Act of 2011 authorized the reduction of $487 million in defense spending from 2012-21. “There’s already been considerable budget downturn. Procurement peaked a couple of years ago and has come down 25 percent. Now we’re arguing sequestration on top of that, which would be painful, but the serious damage is behind us.” Still, the Department of Defense, and the many vendors who supply it, would prefer to see sequester go away entirely. But with Congress still at loggerheads, there’s no guarantee. The DoD authorized a Strategic Choices and Management Review to help the department plan for any of the possible outcomes of the 2014 budget debate. They are based on three possible scenarios: the adoption of President Obama’s budget, which incorporates a back-loaded $150 billion in defense spending over the next 10 years; sequestration-level caps, which would cut an additional $52 billion from defense spending in 2014 as part of the $500 billion in decade-long cuts; and an in-between scenario that would most likely reduce spending by about $250 billion over that same 10-year period. Aboulafia believes the latter option is the most likely. “I think we’ll get some kind of a compromise. I don’t think we’ll get hit with the full sequestration. If we have $250 billion in cuts, rather than the full $500 million, it will still be painful. But some can be moved to personnel and overhead and some borne out by the natural rundown of operations in Iraq and Afghanistan.” So far, some metals suppliers have felt the effects of federal spending cuts more than others. Michelle Allinson, vice president of sales and marketing for Aerospace Alloys, a Bloomfield, Conn.-based specialty metals distributor, says her company has seen a drop-off in business from defense customers in the range of 9 percent. Worse, the company expects demand to dip again in 2014. “We’re feeling some of the pain, though fortunately the commercial market is carrying us right now,” she says. Andy Dimock, sales manager for Texas Specialty Metals Inc., McKinney, Texas, says his company saw an initial drop in business due to the budget issues, but it has bounced back in recent months. Texas Specialty supplies the defense industry for three primary purposes: research and development, Defense Logistics Agency stocks and maintenance programs. “The inventory side of the business has tapered off a bit, more so than R&D and maintenance,” he says. Adam Tolbert, sales manager of American Metals Inc., Fort Mill, S.C., says his company’s sales have not been negatively affected by the sequester. At least not yet. “It’s possible things may change tomorrow, though,” he adds. Perhaps where the forced cuts to date have had the greatest impact is on the personnel side. “A lot of folks who work for large defense OEMs are going through significant drawdowns and layoffs,” says John Batiste, president of Rochester, N.Y.-based Klein Steel and a retired Army major general. He expects some of the downsizing to carry over into 2014 regardless of what happens in Congress. “Defense OEMs need to see the future pretty well before they start bringing people back on,” he says. “There’s a lack of trust, I believe, with Congress.” Allinson agrees employment cuts are the most noticeable effect of the sequester. “They’ve started putting people on furlough. Working with the Department of Defense has gotten more challenging.” Since spending cuts were inevitable, it has been the preference of officials such as Defense Secretary Chuck Hagel to target costs associated with inefficiencies and personnel, thereby preserving funds for weapons and other combat-ready expenditures. The DoD claims personnel costs have increased 40 percent above inflation since 2001. Some government personnel cuts have already taken place, which has consequences for government vendors. “Furloughed employees have less time to do the same amount of work,” Allinson says. “Things are taking longer to process in their system. And getting source inspectors out to review material is getting harder.” With or without sequester, federal spending cuts will hit some military programs harder than others. Aboulafia says the Joint Strike Fighter program, among the biggest government expenditures at more than $12 billion annually, is relatively safe. Aerospace metals suppliers are benefiting from the JSF program, as well as strong demand from commercial aircraft manufacturers in the U.S. and abroad. One exception to the strength in aircraft is in rotorcraft, Aboulafia adds. Army programs are most likely to get hit in the coming years, he says, due in part to the wind down of fighting in the Middle East and anticipation of future activity in areas where a large standing army is not required. The changing nature of the military’s needs will result in a major shift in programs, Tolbert agrees, which will affect metal distributors, as well. “We are currently involved in major programs that support military wartime efforts, and we’ve seen an explosive growth since 2001 in those fields. However, as U.S. involvement in global conflicts starts to slow down, we’ll see a shift away from new production to repair and maintenance and then into research and development.” Dimock points to one upside for metals distributors—the DoD is taking costs out of the pipeline by reducing inventory at its depots. While such an approach puts additional pressure on service centers, particularly with the bureaucratic nature of some government dealings, it does allow them to serve the greater just-in-time needs of some defense customers. Despite all the spending cuts, there remain pockets of demand in the military market for enterprising distributors to fill, Batiste says. “But it takes hard work and persistence. If companies want to be in that space, they have to commit the resources to do it.” While most of the news from Washington on the defense spending front has been abysmal, the domestic steel industry did get one bit of good news in April. The DoD reinterpreted a ruling on domestically produced material that previously allowed armored plate used by the military to be melted in a foreign country and shipped back to the U.S. as ingots. That exception has been removed. “The DoD has agreed military steel has to be 100 percent made in the U.S.A.,” says Batiste. “I think that’s terrific.” [“I think we’ll get some kind of a compromise. I don’t think we’ll get hit with the full sequestration.” Richard Aboulafia, Teal Group] Selling to Defense Challenging on Several Fronts Despite the sequester debate and fears of future spending cuts, service centers that do business with the government remain dedicated to the defense market. There’s no reason to expect any major changes in the way business is conducted between metals suppliers and government contractors, they say, though selling to Uncle Sam is not necessarily for everyone. “For a business just getting started, one can find the government contracts to be very overwhelming. A great deal of infrastructure is needed to support government work,” says Andy Tolbert, sales manager for American Metals Inc., Fort Mill, S.C. “This isn’t necessarily saying the supplier has to have a large business with herds of employees, but rather policies and procedures in place that will support the requirements needed to accurately fulfill government contracts.” Once those policies and procedures are in place, however, distributors serving the defense markets find it easy to cross over to serve the commercial market, he adds. Andy Dimock, sales manager for Texas Specialty Metals, McKinney, Texas, says there are two key attributes a company must possess to do government work—patience and quality. “To do business with the government takes a long time. There’s a lot of paperwork and personal information the government requires, and numerous inspections they conduct on site,” Dimock says. Michelle Allinson, vice president of sales and marketing for Aerospace Alloys, Bloomfield, Conn., believes some suppliers may begin to shy away from selling to government contractors whose layoffs have left them shorthanded. “They’re taking a lot longer to inspect the material, they’re taking a lot longer to process the material and they’re taking longer to pay. So liquidity for the small business is going to be an issue,” she says. “I would argue that the supply chain is suffering more from the credit crunch than it is from the falloff in Pentagon procurement, though certainly one hasn’t helped the other,” adds analyst Richard Aboulafia of the Teal Group.