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Federal News Radio - July 31, 2013, By Jared Serbu

Just four months after the start of sequestration and with uncertainty persisting about whether the spending caps will stay in place, observers in the Pentagon and in industry say it's too early to quantify exactly how the cuts have impacted the Defense industrial base. But at least one thing's certain: If you're the CEO of a Defense contractor, how worried you are correlates closely with the size of your company.

According to DoD's latest tally, the across-the-board cuts that took effect March 1 sliced DoD's procurement accounts by 9.6 percent midway through the fiscal year, and some accounts were hit even harder as the department sought congressional permission to reprogram money in order to buttress lost funding for military readiness and other priorities.

A cut of that scale seemingly would make a noticeable dent in the bottom lines of the nation's largest Defense contractors.

But as it turns out, that's not the case.

Last week, the Pentagon's big five contractors, Lockheed Martin, Northrop Grumman, General Dynamics, Boeing and Raytheon wowed Wall Street with their latest quarterly earnings reports: four raised their previous earnings projections for 2013, all five beat analyst expectations and S&P's Aerospace and Defense Index of publicly traded defense stocks was at its highest mark since 2008.

But things aren't quite as rosy in the lower tiers of the Defense industry.

"As the cuts are beginning to bite, it's the smaller companies that are really seeing the impact first," said Marion Blakey, the president and CEO of the Aerospace Industries Association, a trade group that represents the large primes and several hundred other firms. "And you know, that's tough because about 70 percent of the programs and equipment that ultimately get furnished come from small companies. And they're being hit pretty hard."

As part of Federal News Radio's special report, Private Side of Sequestration, we looked at the impact of sequestration on the Defense industrial base.

It's not as though sequestration or the more generalized notion of a Defense spending drawdown have been pain-free for the larger companies or their workforces. The big firms have spent the last several years trimming staff and taking other streamlining measures in preparation for federal spending cuts.

Lockheed, DoD's biggest contractor, said last week that it alone has shed 30,000 workers over the past three years - more than 20 percent of its staff.

Blakey said several of her organization's larger members also are moving to diversify more of their lines of business outside of the Defense sector. She said those sorts of things are much harder for smaller, specialized firms to do.

"Small companies don't have that kind of flexibility, they don't have that kind of bench, and candidly they don't have access to the kind of capital that you need to make new investments that might turn the business in a new direction," she said. "They therefore really do take the brunt of the early cuts."

Critical niche capabilities at risk

The Pentagon said it has small business at the top of its list of worries about sequestration's effect on the industrial base. Elana Broitman, the principal deputy assistant secretary for manufacturing and industrial base affairs, said the department especially is concerned about critical niche capabilities that would have to be offshored or perhaps lost entirely if a given business could no longer stay afloat.

She said DoD is watching the situation carefully in ways it couldn't do before because of its "sector-by-sector tier-by-tier" (S2T2) mapping effort of the Defense industry.

"It's remarkable what we're able to see," she said. "We get some very detailed information, which we obviously protect with great confidentiality, but we can now see right down to the facility level: Is that facility dependent on single contract? Is that facility part of a big company or a small company?"

Broitman said DoD has tools at the ready to intervene in order to keep critical firms afloat for very brief periods if it determines that one is on the brink of failure, including the Defense Production Act and the Manufacturing Technology Program, known as ManTech. But she said the department hasn't seen the need to deploy any of those tools as a direct response to sequestration so far, since it doesn't expect the most severe effects of the cuts to impact the industrial base until fiscal 2014.

Chronic indecision

The economics of scale aside, there's something quite different about the way this particular Defense spending drawdown is playing out, said ML Mackey, the CEO and co-founder of a small Boston-based IT firm, Beacon Interactive Systems.

It's not just that defense budgets suddenly got smaller, and it's not just that no one knows yet how small. Between sequestration and a DoD budget that was passed six months too late, chronic indecision in the federal budgeting process means that Defense agencies and components themselves have gone for months at a time in 2013 without knowing which of their individual mission priorities they'd be able to fund. And 2014 remains a big question mark.

"Every business owner struggles with uncertainty, that's a given. It's never a done deal that you're going to make a sale, but there should at least be some consistency in the competitive landscape so that you understand how to engage and when it's reasonable to expect an opportunity to close," Mackey said. "But we're in a situation now where it's not just the vendor having a difficult time with uncertainty. The customer is filled with uncertainty, saying, 'I know we need this, but I have no idea when I'm going to get the funds, and I have no idea if I can get it under contract by the end of the fiscal year when the money goes away.' That kind of uncertainty is just wreaking havoc across the industrial base."

Several firms and industry analysts told Federal News Radio that contracting activity began to pick up substantially in the last several weeks as the contours of the budget cuts and available funding became clearer, just in time for most of the contracting workforce to be furloughed because of the same cuts.

That's added another wrinkle to the problem, said Joe Brock, the chief operating officer of Pragmatics, a mid-tier IT and engineering firm based in Reston, Va.

Brock assessed sequestration as a "bump in the road" that his company would weather through, thanks largely to a refocusing effort it began prior to the budget cuts designed to zero in on competitions in which it could clearly distinguish itself against competitors.

But he and other corporate leaders say the contracting paralysis that persisted for the first half of fiscal 2013 led to a lot of lost opportunities.

"I think there's a lot of scrambling now to recover and do replanning based on the fact that sequestration has actually happened, and as a result we've seen some programs just lose their funding right before their acquisition was coming out, and we've seen customer bases where the options weren't executed as a result of lost funding right at that moment," he said.

Brock said it was difficult to quantify the amount of potential business his firm had foregone as a direct result of sequestration.

"But I can tell you this: We probably have three times as many bids in that are awaiting award as we traditionally have had. And the total value of that is in the hundreds of millions of dollars," he said.

Money on contract delayed

Mackey, who is also the vice chairman of the National Defense Industrial Association's small business division, said small business are facing another common challenge in DoD this year: the funding uncertainties coupled with a furloughed federal contracting workforce often mean that even when a bid's been awarded, there's frequently a delay in getting money actually placed on contract.

"That means you have to stay in a holding pattern before you can actually start executing on work," she said. "That's a challenge for everyone across the industrial base, but it's a disproportionate and really terrible challenge for small business, because we have much smaller pockets. We have much less ability to weather decreased cash flow, but also the planning for your team. You have to hold your team together if you're going to effectively execute. We can't just cut staff and then pick them back up again when the contract comes. The way a small business is extremely effective and innovative is by keeping their team in good operational condition. I've watched a lot of my colleagues either cutting employees or just closing their doors because they can't wait it out, hoping they'll be under contract by the end of the year."

Mackey said she doesn't blame the government contracting workforce for those challenges. She called them understandable responses to the uncertainties agencies are facing around sequestration. And the big prime contractors are facing the same bureaucratic delays, but they have enough cash on hand to weather the problems, so much so that they're busily paying shareholder dividends and repurchasing stock in 2013.

But Mackey said larger firms also are benefiting from another shift this year in government contracting. Since DoD put so much activity on hold while Congress and the administration ironed out the details of sequestration, agencies now are scrambling to get work done. And that means a lot of business that would have ordinarily been split up into various competitions where small businesses could compete now are being hurriedly bundled into megacontracts that go to large vendors.

"If you have $100 million you have to get under contract, it's just much easier to get all of this on one big contract than to do seven of them and include opportunities for the small businesses to be the prime, but we're losing a lot of the (small business contracting) gains that have been made in recent years around keeping that innovation at the forefront, keeping those cost savings and competition there," she said. "We're really, really tilting the scales in terms of small business participation."

Mark Klett, the CEO of Klett Consulting, a small systems engineering firm in Virginia Beach, Va., said the troubled waters for small defense businesses didn't start on March 1 with sequestration. They started with the unpredictable on-again- off-again flow of funding borne out of congressional gridlock.

"It's stop and go, it's herky-jerky just to get the funding to keep personnel working," he told the Senate Budget Committee last week. "In the past year, for example, I've had to put 30 percent of my personnel who are critical to Defense programs on the bench, and not because anyone wanted them there. We've had to go in on projects for 90 days, then come off. And who pays for those folks to sit on the bench? It comes out of our company overhead. I gladly pay that because they have bills to pay, and that's what you have to do as a small business. You have to maintain your core capabilities. We don't have any pink paper in our company."

To view this article at the source publication, go to http://www.federalnewsradio.com/394/3406377/Small-firms-feel-first-bite-of-budget-cuts-as-large-contractors-stock-soars.

The information above is for general awareness only and does not necessarily reflect the views of the Office of Economic Adjustment or the Department of Defense as a whole.