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Waiting for US Defense Cuts to Hit



By Richard Aboulafia
Vice President, Analysis
Teal Group Corp.
Fairfax, VA

Finishing a Great Decade

The last 10 years were very good for defense. The US defense budget enjoyed a very strong decade of increases, and defense contractors enjoyed a strong period of growth and profits. Between FY 2003 and 2012, weapons procurement grew at a 6.1% compound annual growth rate (CAGR).

The broad political consensus is that a serious budget deficit, a growing national debt, and the reduction of combat operations in Iraq (to be followed by a reduction of operations in Afghanistan) mean that the current high defense plateau is unsustainable. While the delta of the anticipated defense spending downturn is quite uncertain, changing budget dynamics will have a strong impact on aircraft programs.


More Than Just Numbers

The US defense budget is not historically cyclical. That is, there is no historical correlation between defense spending and any economic trend, such as economic growth or national debt. Yet with a record national debt and an FY 2011 budget deficit of around $1.6 trillion, or over 10% of GDP, political pressure has emerged that will likely force a budget reduction over the next few years.

So far, the 2011 Debt Reduction Act mandates minimum cuts of $350–$474 billion, spread between FY 2012 and 2021. Under the worst-case debt reduction plans, this could rise to $850 billion–$1 trillion, or up to $100 billion per year.

These proposed cuts hit anticipated and planned growth, not current FY budget levels. But the big unanswered question concerns how this top-line cut is distributed. Will it fall on the investment accounts (research and development, procurement) that fund the development and production of new weapons? Will it fall on operations and maintenance, or O&M (part of this funds the sustainment of weapons, but much of this funds fuel and other commodities needed to deploy and move forces)? Will it hit Personnel (which has no real impact on weapons)?

At this point, it’s too soon to know, but the defense industry is bracing for at least half of the cuts to hit weapons procurement, and given the difficult experience of the post-Cold War defense downturn, this caution is understandable.

Even with a serious hit to the investment accounts, these look set to stay above their pre-FY 2007 levels. Also, assuming the Republican party wins back the Senate in 2012 (and quite possibly the White House) these cuts might not happen at all. In fact, for purposes of Teal Group’s forecast, we assume that the procurement budget will stay roughly flat through FY 2016, although that’s using nominal, not real, dollars.

But top-line budget trends matter less than the changing dynamics of defense spending. Here, three trends threaten to make the impact of budget cuts much greater than the numbers indicate.

The first problem is inflating costs. Higher costs reduce DoD’s buying power and threaten profits at contractors. While the US’s sluggish economy is generally not threatened by inflation, energy and health care costs and materials prices have remained stubbornly high. These three costs are among the top expenses for weapons contractors. Thus, even a freeze of investment accounts at present levels would still result in a likely erosion of DoD buying power and/or defense contractor profits.

The second problem is changing DoD contract terms. The accepted weapons acquisition contracts model—cost-plus contracts for development and early production, fixed-price contracts for full production—is giving way to a different approach that shifts a greater risk and cost burden to the contractors.

The best illustration of this is Lockheed Martin’s F-35 Low-Rate Initial Production Four (LRIP-4) contract. Historically, procurement contracts at this early stage of a program have been cost-plus, but F-35 LRIP-4 mandates a high level of overrun risk-sharing. Similarly, Boeing’s KC-46 aerial refueling tanker program was begun with a largely fixed-price contract, including development and production of about half of the aircraft covered in the program of record.

Meanwhile, the profit model is changing. Aircraft program profits typically go from small at the development phase to medium at the procurement phase and high at the sustainment and upgrade phase. Not only are procurement contracts changing, but smaller programs mean smaller procurement phases. And a declining O&M budget means less sustainment activity—less money for spares, upgrades, and other high-profit sustainment activities.

The biggest problem with the budget is that there are too many new programs that require funding. Another related problem facing DoD and industry is how to fund important new programs that fly in the face of perceived military needs. An unpleasant legacy of the past decade is the belief that the military is no longer a tool of superpower diplomacy but rather something to be used for fighting insurgencies in strategically marginal regions.

Thus, over the past 10 years, procurement for body armor, ambush protection vehicles, helicopters, and UAVs did very well. Traditional big-power capabilities, such as fighters, cargo aircraft, and ships basically got the crumbs.

Yet many of these capabilities, particularly fighters, were badly taxed by high utilization rates. Unless cash is provided to recapitalize the fleet, there will be difficult force structure choices ahead.


F-35 and Tacair: Big Questions

Tactical aircraft (tacair) present the biggest single challenge. Lockheed Martin’s F-35 Joint Strike Fighter, the biggest defense program in world history, is at the center of the debate.

The question vexing tactical aircraft funding is whether it can attract a higher share of a declining funding plan. To sustain the current program of record, tacair would need to grow at a 7.1% CAGR. This assumes a maximum procurement rate by the Air Force of 70 F-35As per year. Teal Group’s forecast calls for a maximum F-35A procurement rate of 48 per year, which still requires a 3.7% CAGR. By comparison, FY 2003–2012 saw a mere 2.3% tacair CAGR.

Our forecast assumes that the F-35B and F-35C programs continue as per plan. But conceivably, budget concerns could derail either of these altogether. In July 2011, Navy Undersecretary Robert Work instructed the Navy and Marine Corps to look at alternatives to the F-35B and F-35C. This was the first time a senior DoD official implied that an F-35 variant was vulnerable to budget cuts.


The International Dimension

Meanwhile, European governments have been far more aggressive in cutting their already truncated weapons programs. This is largely due to the pressing nature of the Eurozone crisis. The US faces long-term challenges, but many Eurozone countries are pressured to cut their deficits immediately.

One problem with the European defense spending trends is that they fund systems today, but they jeopardize the future with very severe cuts. The best example of this is the UK Royal Air Force fighter plans. The UK MoD is now short 20 billion pounds to pay for equipment over the decade. The RAF will still take delivery of Eurofighter Tranche 2s and 3As because those aircraft are under contract. But the legacy fleet of Tornados will likely be retired much faster than expected, and the Eurofighter Tranche 3B will be cancelled. With this plan, the Eurofighter program will wind down in 2015/2016.

In a few years we will see a day of reckoning for European military aircraft contractors. Unless something changes in their home markets, or unless they win the key India medium, multi-role combat aircraft (MMRCA) competition, the last Eurofighter will be delivered in about five years.

This budget-cutting strategy also jeopardizes Europe’s standing on the export market. If the home market retires planes, it doesn’t develop upgrade and support packages for them. This basically puts export customers on notice: They might be buying a plane that turns into an orphan faster than expected. And killing the line means the time available to search for export customers is running away fast.

With the US market flat or declining, and with European companies hobbled by weak home markets, US defense primes are starting to focus on international customers. With a combination of faster economic growth rates, high resource prices that help grow government budgets, and ongoing geopolitical tension, key markets in the Mideast and Asia look set to place record orders for US and European equipment.


Other Programs, Other Problems

Strategic lift programs confront a budget outlook that’s similar to tacair’s. Like tacair, military lift did not benefit from the FY 2003–2012, with procurement funding falling at a 1.7% CAGR. This is largely due to the end of USAF C-17 procurement.

However, even finding the cash for the current C-5M re-engining, C-130J procurement, and KC-46 tanker programs of record will be a major challenge. To afford all three under their current funding schedule, military lift procurement cash will need to grow at an 11.8% CAGR.

Given these budget pressures, and looking at the precedent of past budget downturns, there are three useful guidelines to remember for programs.

The first, inevitably, is that serious performance problems make a program a target for eager budget-cutters. After the Cold War, the two "easiest" budget kills were the two most troubled programs, Lockheed’s P-7 maritime aircraft, and the General Dynamics/McDonnell Douglas A-12 carrier stealth attack jet.

The F-35’s performance problems make a bad budget situation worse. The one virtue of the KC-46’s fixed-price contract is that this program will be tougher to kill due to development problems, since most serious cost overruns will be borne by Boeing, not DoD.

A second guideline might just be "don’t seek resurrection." The high-profile program kills of recent years—Lockheed Martin’s F-22 fighter, Boeing’s C-17 lifter, General Electric’s F136 Alternate Fighter Engine—are not likely to be reversed.

Finally, new program starts have fared very poorly in past defense budget downturns, so a third guideline is that new starts are the most vulnerable. New fixed-wing starts scheduled for the next few years include the USAF T-X advanced trainer replacement requirement (to replace the current T-38 fleet) and the Next Generation Bomber. The latter has already been effectively deferred, and is now subsumed by the Long Range Strike concept exploration effort. The KC-46 will likely survive due to the long-delayed and overdue nature of the requirement, but again, looking at the challenge of funding military lift in this budget environment, it’s still far from safe.

Rotorcraft programs scheduled to begin in the next few years are more numerous. They include the Army Armed Aerial Scout (AAS), the USAF CommonVertical Lift Support Platform (CVLSP), and USAF HH-60 replacement program (CSAR-2). Unlike fixed-wing platforms, rotorcraft did benefit enormously from the recent budget downturn. Many rotorcraft programs are only now reaching full procurement, and at least these current recapitalization efforts will likely be sustained.

In the case of both fixed and rotary-winged new start programs, the odds are heavily against them happening on time, implying a continued reliance on aging legacy fleets. Yet operating legacy aircraft is also an expensive proposition as these systems age. This means that new capabilities and technologies are effectively driven out by the costs associated with legacy capabilities, and the need to maintain current military effectiveness. In downturns, "transformational" systems become bill-payers for older ones.

In short, given the difficult budget environment, there are risks ahead for all military aircraft programs, big or small. Maintaining military capabilities during the post-Iraq and Afghanistan defense drawdown won’t be easy. But the US’s fixed-wing aircraft force, which failed to benefit from the FY 2003-2012 spending upturn, is uniquely vulnerable. And while current rotorcraft programs are likely safe, funding for new program starts are highly uncertain.


This article was first published in the 2012 edition of the Aerospace and Defense Manufacturing Yearbook.

Published Date : 8/1/2012

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