Sequestration's impact on the defense electronics market

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February 12, 2015

COTS CONFIDENTIAL. Every month the McHale Report will host an online roundtable with experts from the defense electronics industry – from major prime contractors to defense component suppliers. Each roundtable will explore topics important to the military embedded electronics market. This month we discuss the effect of sequestration has had on the defense electronics community.

This month’s panelists are: Bobby Sturgell, Senior Vice President of Washington Operations for Rockwell Collins and former Acting Administrator of the Federal Aviation Administration (FAA); Eric Sivertson, Executive Vice President of ATD Business Unit, Kontron; and Michael Carter, CEO and Owner of IXI Technology.

MCHALE REPORT: Whether it ends tomorrow or lasts another year or more, how would you describe sequestration’s affect on the defense community?

STURGELL: The impact to date has meant the loss of tens of thousands of good, high-paying jobs in the defense industry, as well as the delay or cancellation of many national security programs. Stephen Fuller, a well-respected economist at George Mason University, now expects sequestration to cost the U.S. over 1.5M jobs, with about 820,000 coming from the defense community.

Sequester reductions also further delay the funding of new weapons systems and equipment. With smaller investment budgets supporting a dwindling number of major programs built by a smaller industrial base, it is more likely that postponing production of a particular weapons system will cause the loss of technical expertise and manufacturing facilities throughout the defense industry. I think that’s why you’ve seen a focus by the DoD over the last couple of years to better understand the impacts to the industrial base and their suppliers and what key areas need protection. Defense companies will not continue to keep factories open and keep employees on the payroll in the absence of revenue to cover these costs.

SIVERTSON: Focus. If anything, sequestration has caused much of the community to focus on what it will continue to pursue and what must change. Additionally, I think the biggest impact has been to the lower tier suppliers (the 2nd, 3rd, and lower tier contractors) and a tightening of the procurement belts at the major primes. I think COTS has become more the norm and procurement is looking for leveraged advantages from the supply base. Stated another way, cost control has flowed down during sequestration with those who inflated the most by adding the least value were critically impacted. Not all bad.

CARTER: It has slowed down product development industry wide. The U.S. military is in a constrained budget environment and can’t invest in technology development. They feel frustrated at the prime contractor level as they cannot get guaranteed funding to give to an embedded COTS supplier like us to develop technology. It is preventing state-of-the art technology from getting into hands of warfighters and has delayed other tech development. Whether you are IXI Technology or Lockheed Martin, unless you have a funded contract you have to develop technology on your own funds today.

MCHALE REPORT: How has it affected the defense electronics industry and COTS suppliers?

CARTER: For companies like IXI Technology, sequestration has hindered product development. In years past, we could have received funding for co-development or NRE, but with sequestration it has dried up. All product development at IXI Technology today is performed 100 percent via company funds with zero commitment from contract awards. The result is I’ve had to develop fewer products for our roadmap. Because of sequestration, new system development is concentrated in tech insertion and refreshes, and there is not adequate funding for companies like IXI Technology. Hence, why we are funded 100 percent internally.

STURGELL: The effects of budget cuts are already being felt across the defense electronics industry and our suppliers (who mostly supply commercial goods and services). It is especially true in the defense electronic industry, where our supplier chain consists mainly of small and mid-size companies. While the public thinks of the defense industry as consisting of a half-dozen large companies, the reality is that the industrial base is a diverse and complex entity, and it is comprised mostly of companies that are primarily commercial in nature that provide unique and hard-to-make products that enable the production of critical systems used by the military (this is especially true in the defense electronics industry). In fact, it is estimated that two-thirds to three-fourths of every dollar awarded by the DoD at the prime level is spent for subcontracted goods and services provided by smaller companies with typically much less capacity to absorb the dramatic shifts in funding and priorities that are being caused by sequestration.

SIVERTSON: I think many in the industry felt that it lost the appeal that was there in the early post-9/11 timeframe when expenditures and growth were zooming. So some have reduced their focus and emphasis on this market. For others, there is growth and more demand to fill in the void left by 2nd and 3rd tier contractors’ inability to remain competitive with the shrinking development budgets, or those that had historically done well on providing less value at higher price points. COTS neutralizes these 2nd and 3rd tier contractors to some degree and opens the door for the prime contractors to move in a more direct fashion towards the COTS suppliers. Frequently you are now seeing the primes look to reduce their overall supply base to reduce procurement costs and to squeeze significantly on those left as key suppliers. There is effectively more volume going to fewer players. So the winners get more business, but they must compensate by reducing price to help the primes in overall cost reductions. In some ways this is a good thing for the overall community. But, it does shake out a few players and certainly can be less attractive from a profitability point of view.

MCHALE REPORT: How can defense companies accurately forecast business in such an uncertain climate?

SIVERTSON: This is hard for them. Many are stuck waiting on programs to continue and make their next round of funding, but with large amounts of uncertainty. This makes for a difficult time in planning and a difficult time in retaining critical resources. No one likes to wait around to see if a program will continue. Most engineers and program teams prefer certainty. So, you also get a negative effect on real productivity. This makes for malaise or chaos, and actually can negate the goal of sequestration by dragging out programs that could close sooner if there was more certainty in the next milestone’s funding. I think the best approach that many are employing is one that focuses on key trends that will be funded no matter what the climate. Areas such as cybersecurity and continued growth in unmanned vehicles are safe bets. I think you see the primes continuing to focus their efforts in these areas knowing that there will be continued need and investment here for the foreseeable future.

Also, I’m seeing certain modernization continue, and that is an area that many can still place a somewhat educated bet upon. Naval upgrades and modernization is one of those areas, the shift to concerns in the Asia Pacific region help you understand this obvious need. Also many primes are looking past the U.S. shores and moving into EMEA and appropriate areas within the Asia Pacific region. Finally, some of the primes are now dipping into their own funds to keep development moving along, independent of the funding. This is a bold and risky move, but some have been forced to take this approach. This is very similar to the process followed by commercial vendors whereby they frequently are putting their own funds at risk to finalize products into production. Sequestration has forced some into this situation, betting on the production order versus waiting for funding to finish development. In a way, this is a good effect from sequestration because it lowered the government’s investment profile, but certainly a business model very few primes are well equipped to handle or desire. In the end, much of this will still get passed on in higher G&A to the government whether it goes to production or not.

CARTER: You have to listen to what the military leadership is saying then canvas the market and see where the unmet needs are, such as reduced SWaP. Then when they do come knocking you already have that product developed and ready for them to procure. Forecasting the demand for emerging technologies is difficult. However, sequestration or not, I know that the military has to lose weight, consume less power, and be more agile. So if I can forecast how to meet that need for my customers, I can be successful.

This is not a lifestyle business. It involves important work where lives are at stake. So if you can’t forecast what’s needed and ignore the military leadership, you will be discounted by them. At IXI Technology we are one of many so we have to make a commitment to the leadership that we will support them, sequestration or not.

STURGELL: Defense companies can make some predictions, but cannot accurately forecast their business in this uncertain climate. Certainly one of the strategies is to be conservative and forecast for the worst-case scenario. Further, as with any declining market, public companies take actions such as diversifying their portfolio, reducing their overhead, or even abandoning the declining market. Consequently, the DoD is most likely losing some of the capacity and capabilities needed to guarantee U.S. military technological superiority for the next generation. In this environment, it is critical to have a more productive and collaborative dialogue between industry and the DoD to help understand and mitigate these risks.

MCHALE REPORT: The DoD’s FY2016 DoD budget request has significant increases in funding. Does this signal that an end to sequestration is right around the corner? Why or why not?

STURGELL: This year’s budget request and last year’s proposed Strategic Growth Initiative are both clear signals that the Nation’s defense and national security needs are not being met under sequestration funding levels. All that is needed to confirm this is to listen to the senior uniformed officers’ testimony to Congress over the last couple of years about the detrimental impact of sequestration to our national defense.

If you remember, the Budget Control Act of 2011 (BCA) established two major cuts to projected defense spending from FY2012-21. First, the BCA directed a reduction of $487B in projected defense spending over 10 years starting in FY12, and second, it established a trigger mechanism that, if enacted (and it was), would reduce defense spending by more than $50B each year for a cumulative total of $500B by FY21.  Similar cuts were made in domestic discretionary spending.

Even though the Bipartisan Budget Act enacted in December 2013 (know as the Ryan-Murray deal) staved off the sequestered-enacted top line fiscal numbers for 2 years (FY2014-15), Congress still had to come up with a way to get these savings. This year, it is hard for me to see a path at this point to either a change in the law or another Ryan-Murray type of deal. Although a fair number of folks in D.C. are optimistic that spending levels will be increased, the debt and deficit issues are still looming large over the budget and have many members on the Hill very concerned. So, absent any changes in mandatory spending (unlikely as we enter a Presidential cycle), any increased defense spending will have to be offset by domestic discretionary spending or an increase in revenues. There is significant political opposition to both.

SIVERTSON: What I find interesting is that sequestration never really took full hold. It has been the threat of it that looms highest in everyone’s mind. But that threat has lead to program delays, indecisions, and a contractor malaise that is not really healthy for anyone. I think the real question here is when can these businesses that depend on the DoD budget get back to a better place with regards to planning and executing in an environment of more certainty. Given the desire by both sides for this, I think there is a will developing within Congress and the DoD. If this aligns strong enough and the Executive Branch leads, I think we’ll see something better happen and the threat of sequestration put to bed for a while. The DoD is clearly attempting to lead the charge here. I think the overall economy and budget still have many troubles left to work out, but I don’t think the “era of sequestration’ has been exceptionally helpful to anyone.

The spent is still high, many programs are still moving forward (albeit slow and, in the long run, more expensively), and yet now we have lost some of our effectivity. That’s not good for anyone. Putting sequestration behind us would be a healing event for the whole country. Also, sequestration was just a cover for a lack of effective cooperation between two opposing parties. Given that one is now a little more in power, I think, for good or for bad, at least there will be agreement and forward motion on trying to get a better balanced or agreed upon budget. Sequestration was just a weak excuse to avoid solving the real issue of agreement on this. Given that most of us desire more certainty, I think the trend is building for sequestration to go away. We have many threats we still face in the world and it has been proven through history that having a strong defense actually avoids conflicts. I think the will of the American people is still to move forward with a strong defense and coupling that to a need for certainty and a preference for more unity within our political system – sequestration can very quickly become the common enemy that we all seek to see defeated quickly. In this age of continued and prolonged conflict, this is a war that can be ended quickly. If it does move in this direction, sequestration’s burial will more of a celebration than funeral.

CARTER: I certainly hope so. I don’t like to get into political commentary, but a Republican-controlled Congress typically means higher levels of defense funding. Last year we were told by many in the industry that sequestration was coming back in 2015 with a vengeance, but I have yet to see that. In fact it seems as if sequestration has slowed somewhat. Regardless, I believe we will be successful because we can fund our own product development to stay committed to the military customer.