Defense Cuts Of $500 Billion Vex Officials As Ax Nears By Laura Litvan

July 2, 2012

Bloomberg News

Overseeing a series of mandated U.S. budget cuts in the 1980s and 1990s, former White House official Barry Anderson was none too popular with agency officials as he insisted that the reductions be applied uniformly.

Anderson recalls a minuscule 0.0013 cut to all domestic programs in 1991 that had him directing Coast Guard officials to nick the budget for maintenance of a single buoy located in the Chesapeake Bay. It was required by law, he said.

“I used the Chubby Checker ‘Limbo Rock’ test: How low can you go?” Anderson, who was assistant director of the White House Office of Management and Budget from 1980 to 1998, said of the directive that cuts be made to every project. He said he administered three sets of reductions this way during his tenure, when a balanced-budget law applied.

With $500 billion in cuts to U.S. defense programs over 10 years set to begin on Jan. 2, industry contractors and analysts say the challenge isn’t only the amount of the cuts, it’s how they’ll be managed. They are waiting to hear if the approach in Anderson’s era will apply — the White House hasn’t said whether it’ll give the Pentagon the authority to make choices within broad categories of spending, or whether it’ll require rigid program-by-program cuts.

That lack of information is creating uncertainty for weapons makers and services contractors, who must proceed as though they won’t have flexibility in applying the cuts.

“Right now we have to assume the worst,” said Cord Sterling, top lobbyist for the Aerospace Industries Association, a Washington-based trade group that includes Lockheed Martin Corp., Boeing Co. and General Dynamics Corp. as members. “This is truly a program by program, contract by contract process they may have to undertake.”

The defense cuts are part of $1.2 trillion in automatic, across-the-board cuts to domestic and national-security programs that will start in 2013 if Congress doesn’t act. The cuts were imposed after talks failed last year on a bipartisan plan to curb the nation’s soaring debt.

Negotiations expected later this year will determine whether the defense cuts can be reduced or averted. Many Republicans want to renegotiate them by the end of December to pare back the effect on defense programs, which amounts to almost a 10 percent cut to the Pentagon’s budget. Democratic leaders, including Senate Majority Leader Harry Reid and House Minority Whip Steny Hoyer, say Republicans must be willing to accept some tax increases in a debt-reduction deal to gain their support for smaller defense cuts.

The effects on defense contractors won’t be immediate. The process, known as sequestration, affects budget authority or how much Congress approves for various programs. Companies are affected by outlays, or government expenditures that take place when the Treasury Department sends out checks. Outlays change more slowly, said Todd Harrison, an analyst at the Center for Strategic and Budgetary Assessment in Washington.

“For the defense industry, it won’t be as sharp a downturn as it might appear at first because there’s a natural lag,” Harrison said. “If you’ve got something on contract, it’s not going to be a sudden shock. It will be a bit more gradual.”

As the maneuvering begins, the White House said it has no immediate plans to issue guidance on how the cuts will be implemented. Kenneth Baer, a spokesman for the Office of Management and Budget, said “we will be prepared” if the sequester goes forward. Now, he said, the agency is waiting to gauge whether Congress will reach a debt-reduction deal that sidesteps the deep cuts.

“While OMB has not yet engaged agencies in planning, our staff is conducting the analysis necessary to move forward if necessary,” Baer said.

Joe Jordan, the White House’s highest-ranking procurement official, said June 27 that the cuts are “bad policy” intended to force a budget compromise, and that his office isn’t preparing for the reductions to take effect.

Jordan, administrator of the Office of Federal Procurement Policy, said in an interview that the office was “not yet at the point where we’re planning for that.”

The lack of guidance from the administration is leading to some tensions with Congress. House Armed Services Chairman Howard P. “Buck” McKeon, a California Republican, on June 27 told the White House budget director to testify July 18 on how the defense cuts will be implemented.

Whether both parties can agree on a pact that reduces or delays the Pentagon cuts isn’t clear, especially as attempts at deals failed in 2011, said Michael Lewis, a defense analyst at Lazard Capital Markets in New York.

“Investors should look at this sequestration as a real threat,” Lewis said. “I have limited confidence that anything will get done.”

If the sequester goes into effect, it would come on top of $487 billion in defense cuts proposed by the Obama administration. The aerospace industry estimates that the budget cuts would lead to the loss of 1 million jobs. Wage and salary reductions would reach $59.4 billion, according to a study for the aerospace trade group by Stephen Fuller, director of the Center for Regional Analysis at George Mason University in Fairfax, Virginia.

The top three states for such job cuts would be California, Virginia and Texas, Fuller’s study found.

A Bloomberg Government study this month found that Virginia, Hawaii and Alaska would have the most risk to their economies from the planned cuts. Virginia, home to the Pentagon and the Norfolk naval base, is at the top of the list as almost 14 percent of its gross domestic product stems from defense spending, the report found.

The magnitude of the cuts also has yet to be determined. The first installment, almost $55 billion in 2013, amounts to about 10 percent of the Obama administration’s base defense budget request for the fiscal year that starts Oct. 1. President Barack Obama has the ability to exempt military pay and benefits, which totals about $135 billion, Harrison said. If he does so, a 13.5 percent reduction would apply to the rest of the defense budget, he said.

The Pentagon has made efforts to blunt the effects on defense programs. The Defense Department said the sequester process would apply to war funds and unobligated funds in defense accounts, broadening the pool of money subjected to the cuts. That means the final reduction would be 9.5 percent across affected programs, Harrison said.

Contractors worry about a lack of leeway if the full $55 billion in cuts goes into effect. Last year’s Budget Control Act, which established the sequestration process, said cuts should be made at the “programs, projects and activities” level.

“It’s not the depth of the cuts that’s the problem, Harrison said. “It’s the abruptness of the cuts and the lack of flexibility.”

Not all companies will be affected in the same way. If the budget ax falls, contractors that provide services to the Pentagon, such as Virginia-based Computer Sciences Corp. in Falls Church or SAIC Inc. of McLean, probably will see a drop in revenue faster than weapons makers such as Lockheed Martin, analysts said.

Services contractors are paid out of “operations and maintenance” accounts that spend at a faster rate, Thompson said, and they could experience 50 percent of the effects of cuts to their Pentagon revenues in the first year they’re administered, he said. For weapons makers, 25 percent is more probable, he said.

The stock price of defense contractors could tumble if progress isn’t made on a deal to avert the sequester, Lewis said. He expects investors will later go on a value-buying binge that will help lift share prices.

“I think we will see significant, multiple contractions, probably in excess of 10 to 20 percent of the current market prices of these shares,” Lewis said of the anticipated wave of selling.

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