Automatic cuts could drive smaller defense-industry firms out of business

The prospect of $600 billion in automatic defense cuts could drive an increasing number of smaller defense firms out of the industry — or out of business altogether.

The defense industry is already on a downward slope, between the recession, drawdown in the wars in Iraq and Afghanistan and an initial Pentagon budget cut of $450 billion.

Industry advocates warn that a Pentagon budget cut of $1 trillion in the next decade would steepen the pace at which contractors see defense revenues fall, putting at especial risk smaller firms that are tied up in specialty businesses and have a high percentage of revenue coming from government contracts.

A rise in defense firms merging, moving into commercial industries and going out of business are all likely scenarios, industry groups and budget analysts say.

“It’s a cumulative thing,” said Todd Harrison, a senior fellow at the Center for Strategic and Budgetary Assessments. “The reduction in war funding is coming on top of reductions on the base defense budget.”

The defense industry expanded in the past decade as two wars were being fought simultaneously. Part of the decline is natural as those wars near an end and the U.S. economy continues to recover slowly.

Some reduction and consolidation among small contractors is already occurring, said Fred Downey, vice president of national security at the Aerospace Industries Association, an industry trade group. But sequestration would shoot that number higher because of the automatic cuts, he said.

“Some of the smallest companies, they just don’t have the resources to wait it out, and in some cases they’ve closed their doors,” Downey said. “Between the recession and the reduction, the cost of money is higher, and the ability of the smaller companies to raise capital has diminished.”

Sequestration would have an impact on the major companies as well, and belt-tightening among big contractors would trickle down to hit the small subcontractors. That’s because the major players would look to perform many of the tasks currently subcontracted to other firms in-house as a way to save costs.

“Right now they contract out a fair amount of what they do to smaller, second-tier or third-tier companies,” Harrison said. “If you start cutting back significantly on their business, they’re going to try to insource more of that work rather than outsource it. So the cuts could be magnified on the second- and third-tier contractors for that reason.”

It remains unclear how much of an impact sequestration will have on contractors, because the cuts don’t take effect until January 2013 and defense hawks in Congress have vowed to reverse them. No studies have been undertaken to suggest how many companies might go under because of sequestration.

The Pentagon is already preparing to cut $450 billion from its budget over the next decade, and Defense Secretary Leon Panetta has said adding the automatic cuts on top would be a “doomsday” scenario. However, the Pentagon is not yet planning how it would implement sequestration cuts, according to Pentagon officials.

One of the biggest questions on the minds of budget-crunchers is how big a share of the cuts would come from weapons programs versus personnel costs.

Until sequestration is resolved, the defense industry could be facing a year’s worth of uncertainty about where — and how big — the cuts will be.

Dawne Hickton, vice chairman, president and CEO of RTI International Metals, said she’s already planning to move more of her business out of defense and into the commercial market. Her company, a titanium producer, is estimating its defense business will drop from 30 to 40 percent annually to as low as 15 percent, she said.

“We’re looking at spending our capital and resources diversifying — why spend it on looking into military research and military innovation?” Hickton said. “The downside for U.S. defense policy is that companies like us that make up the defense industrial base are really moving on.”

Industry groups like the AIA have tried to make the argument against sequestration about losing jobs. The aerospace association released an economic modeling forecast in conjunction with George Mason University that found 1 million jobs could be at risk if the automatic cuts occur, including 352,000 in the defense industry.

But critics of Defense Department spending say those figures are overblown, relying on a worst-case scenario that assumes military personnel accounts are not touched.

Charles Knight, co-director of the Project on Defense Alternatives, which advocates for a smaller military, said the impact on procurement and contractors wouldn’t be the doomsday scenario that’s being predicted.

“The sequester provisions are a legislative game, basically, and they’re never going to roll out the way the law suggests,” Knight said. “I don’t think we’re going to get to 2013 and see that size of cuts by any means.”

Knight said the sequester was designed with such large cuts to defense that Congress would ultimately change it. He said cutting a large chunk of defense spending at once in 2013 was bad policy.

“I don’t advocate doing any of this quickly, but making sure that later in the decade we have a smaller defense budget that’s less active,” he said. “There’s not going to be a sudden additional $55 billion taken out of the defense budget in January 2013.”

Even if the sequestration cuts don’t make a direct hit on the Pentagon, contractors still must start planning now.

“I can’t wait until January of 2013 to make decisions,” Hickton said. “We can’t sit around and wait for an election year to decide where the plant should take orders. We’re going to take commercial orders and not going to reserve space for defense.”