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The Sequester Will Lift, Not Cut, Defense Costs The Sequester Will Lift, Not Cut, Defense Costs

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Magazine / DEFENSE

The Sequester Will Lift, Not Cut, Defense Costs

As manufacturers lose orders and lay off employees, the price of top weapons programs will rise. The anatomy of the F-35 shows why.

(Photo by Fred Clingerman/Lockheed Martin)

photo of Sara Sorcher
July 25, 2013

In retrospect, Bob Stevens was overselling. Last summer, to help motivate lawmakers to undo the sequester, Lockheed Martin’s then-CEO warned that the impending cuts might force him to lay off 10,000 of the defense giant’s 120,000 employees. That never happened. But Lockheed, which reported $39 billion in net sales last year from government contracts, supports a giant ecosystem of subcontractors that provide parts and technology for Pentagon programs. How would the budget cuts affect them?

Mapping that ecosystem would be virtually impossible (just last year, for instance, the Defense Department committed $360 billion on 14 million contracts), so National Journal decided to look at one program as a proxy: the F-35 Joint Strike Fighter, the country’s costliest weapon system. Like almost everything else in the defense budget, its contracts are subject to sequestration’s looming across-the-board cuts. The U.S. is already buying 409 fewer planes than the 2,852 originally planned and has delayed the production of an additional 179.

But even this program is too unwieldy for a systematic investigation. Lockheed, the lead contractor, makes the aircraft’s nose and wing, but Northrop Grumman makes the fuselage, BAE Systems builds the tail section, and Pratt & Whitney constructs the engines. Altogether, 32,500 people across 46 states work on the program. There are 1,400 companies directly supplying the four major contractors. Of those, 600 are considered small businesses.

 

So, to narrow the focus further, I traced a single set of components down the supply chain. Lockheed’s F-35 gets its engine from Pratt & Whitney, which uses metal bearings from New Hampshire Ball Bearings, which buys super-tough metal from a specialty steel mill in Pennsylvania—a Russian nesting doll of national security. Ball Aerospace, which supplies Lockheed with the plane’s antennae, and Faustson Tool, which makes the antennae housing, also gave perspective.

In the end, Lockheed can make fewer fighters and Pratt can make fewer engines than initially planned; they’re big companies with lots of revenue streams, and they’ll be fine. But the sequester will rattle smaller companies already toughening metals, crafting parts, and writing software for planes that won’t be ready for years. Some of these suppliers, analysts predict, will leave the defense industry or go out of business, imperiling the weapons they build. “With sequestration, what looks like modest cuts at the top of the system, down at the supplier level looks like the difference between life and death,” says Loren Thompson, chief operating officer of the Lexington Institute think tank and also a consultant to Lockheed. “It could be the difference between making and losing money for a small enterprise located far from the capital.”

Even for those that survive, the cutbacks will likely change the way they build their budgets, forcing them to reduce risk by raising costs—at taxpayer expense. Unexpected reductions will strain already-thin margins. If a company has prepared for more business, for instance, it may have invested in machines, buildings, staff, and even parking lots. Less volume means charging higher prices to defray those costs. It’s like a shared apartment: If one of three roommates moves out, the others still have to pay the same rent. They may need higher salaries to afford it.

The risk is not just monetary: These hard-to-trace supplier disruptions are an “insidious problem,” says Aerospace Industries Association President and CEO Marion Blakey, a problem that could eventually imperil the defense industrial base and its ability to meet the demand for weapons that national security experts say America needs. “None of us know when all of a sudden the slight tremors we’re feeling under our feet will prove to be a much bigger shift in … the ability of the industry to deliver,” she says.

Consider the companies in this story as a microcosm of the giant supply chain. Other businesses supplying the F-35—or more-vulnerable defense programs—are facing similar challenges. Once the Pentagon officially implements sequester cuts, contracting life will become even worse.

TOP OF THE FOOD CHAIN

The F-35 is supposed to replace an aging fighter-jet fleet. After cost overruns and delays exploded the initial $233 billion price tag (in today’s dollars) to $391 billion, the Obama administration now believes the fifth-generation, stealthy, supersonic aircraft is on track. The government plans to buy 2,443 of them in the coming decades, about 14 percent fewer than initially expected. But the enormous price tag and the gargantuan program—there are variants for the Air Force, the Marine Corps (which can take off and land vertically), and the Navy—make the F-35 an obvious target for budget cutters. It is the biggest identifiable concentration of money in the entire defense-acquisitions system. That makes it an especially ripe target, given that, even before the sequester, the Pentagon was set to cut $487 billion from its budget over a decade.

The Pentagon’s fiscal 2014 spending outline, which is not yet final, protects the F-35. Lockheed hopes to wrap up contracts this month for the 35 planes due for delivery to the Pentagon and international customers by 2015. But according to Lockheed’s F-35 communications director, Mike Rein, across-the-board cuts could hack anywhere from five to nine aircraft from the 29 planes destined for the U.S. military. And sequestration, which will gouge a half-trillion dollars from defense accounts, is on the books for a decade—meaning that fewer planes are possible in future years, too.

That will change Lockheed’s economy of scale. Some 9,000 employees work on the F-35 in Fort Worth, Texas, and a typical jet contains about 1 million parts. “You need quantity to drive the price down,” Lockheed’s senior vice president of Washington operations, Greg Dahlberg, says. The fewer planes produced, the higher the cost per plane. Other Western countries with budget headaches could also reduce the 716 planes they are currently set to buy. “It’s a spiral you don’t want.”

Meanwhile, budget uncertainty affects the way Lockheed bids for parts, corporate officials say. Giving companies a guarantee for, say, 500 parts in set quantities over five years would yield one stable price, but suppliers could mitigate their risk by charging Lockheed more for a softer order. Stretching out the program or buying fewer aircraft would be a “penny-wise and a pound-foolish” strategy, Dahlberg says. “They might save some, short term, but it’s going to cost the taxpayers more over time.”

Here’s why. The 39 planes the U.S. purchased in 2011 cost $120 million each. But in 2018, 180 planes will cost $75 million each. So when Lockheed more than quadruples the production rate, the customer saves $45 million per airplane. It’s difficult to predict whether a long-term cost hike would exceed the short-term savings, but it’s fair to say that if the government still plans to buy roughly the same total number of planes, it would save by doing so in large batches, rather than dribbling out the order over time. Some money, of course, is already spent: To keep assembly on schedule, some items, such as parts for the landing gear, must be ordered years before the plane is assembled.

Lockheed has been downsizing since 2008, laying off nearly 30,000 employees so far and shutting down facilities. But Dahlberg says small suppliers “don’t have the financial cushions, resources, to weather some of this stuff as well as we do.” Thanks to the previously planned cuts, before sequestration had ever been hatched, major firms began selling off shipyards, laying off workers, and expanding their commercial businesses so they weren’t so reliant on defense. “I like to call the contractors the canaries in the coal mine,” says Gordon Adams, former defense budget official in the Clinton White House. “They see a drawdown before anybody else sees it.”

A generation ago, the United States was building four kinds of fighter jets at the same time. Now, the F-35 will be the only one in production within five years, so manufactures don’t have the padding they once did. “If I’m making a canopy for the F-35 fighter, and for some reason there’s a gap in production, there’s nobody else anywhere that wants to buy my canopy,” Thompson says.

And a problem with one key supplier can tangle the whole program. Last summer, the company that builds the transmission for Apache helicopters went bankrupt, causing hiccups that delayed production: Without a transmission, the chopper can’t fly. (More broadly, Thai floods in 2011 showed how a concentrated disaster can roil an entire industry. That year, water soused the enormous factories where 40 percent of the world’s hard drives were made. Global hard-drive prices soared by roughly one-third, boosting the cost of PCs, too.) That’s why, if a supplier is at risk, Lockheed—read: the government—may need to shell out “astronomical amounts of money just to have access to the technology,” Thompson says. In other words, a bailout.

Industry sources say they think the Pentagon might prop up an ailing yet essential company, but a senior Defense official who works on supply-chain issues says the agency would prefer to find other ways to help. The Pentagon will determine “how critical is that company to continued success of our mission,” he says. “If it is critical, can we move current budgeting around in a way that allows them to continue to produce without any additional cost to the taxpayer?” Starting in 2011, the Pentagon worked with the service branches to ensure that they buy enough ammonium perchlorate—used in rockets and missile launches—to help American Pacific Corp., a company struggling after NASA closed its space-shuttle program. There are funds available in case of a “crisis,” the official said, such as when the Pentagon invested some $2 million for research and development to help Oasis Advanced Engineering, which works on components of the Abrams tank. Ostensibly, the infusion paid Oasis for R&D, but it also kept the company afloat.

TRICKLE-DOWN EFFECT

After President Obama signed the 2011 Budget Control Act, which threatened automatic cuts if Republicans and Democrats couldn’t agree on a budget plan within 17 months, Pratt & Whitney’s Chris Flynn promised employees at the East Hartford, Conn., headquarters that the sequester was “not going to happen.” Finally, Flynn had to admit he was wrong.

Then came the consequences: Pratt’s “voluntary separation program” enticed nearly 600 of 16,000 employees to retire, and the company expects more workforce cuts later. Across the defense industrial base, others share Pratt’s woes: In an Aerospace Industries Association survey released last week, 83 percent of the trade group’s members say budget cuts in the last two years have reduced their sales and profits; more than 60 percent say their production levels have decreased because contracts were delayed or postponed; and nearly 50 percent report hiring freezes and employee layoffs. So far.

For its part, Pratt, which employs 1,600 people on the F-35, had already made its program more efficient beginning in 2009, slashing the engine’s price by 40 percent, even though Pentagon reductions or other delays mean the company is producing less than half the volume it originally expected. Now sequestration is pressuring the big corporations such as Lockheed and Pratt (and, therefore, their suppliers) to cut costs even more. “The worst thing you can do in a difficult budget environment is make yourself a target by being seen as unaffordable and bad value for the money,” says Richard Aboulafia, vice president of analysis for the Teal Group Corp., a defense market-research firm. The goal is not to appear “like a pile of cash, that it solves all our other problems if [budget cutters] go after it.”

These pressures have been tough for Pratt’s 140 suppliers, which employ 2,100 people on the F-35 engine program. They must make up-front investments to buy equipment and test products but won’t get paid until their customer buys their goods. And Pratt can no longer guarantee that demand, leading to “tough conversations” with suppliers, says Jill Albertelli, vice president of Pratt’s Global Supply Chain. One company had moved to a larger building to help support the engine and other materiél it sells to Pratt, but, expecting sequester-induced cuts, it has delayed hiring skilled welders and engineers to fill that space for up to a year. Another company announced the closure of its new facility because of the spending cuts. “We’re going to see more of that,” Albertelli predicts. Roughly one-third of Pratt’s small-business suppliers make mostly military products. “Obviously, their livelihood is at risk.”

One subcontractor, New Hampshire Ball Bearings, was counting on the rise of F-35 production just to break even after it lost business from the older fighter jets it served. But NHBB, which has 1,200 employees in New Hampshire and 300 in California, is in a “cautious frame of mind right now,” says Jim Geary, vice president of sales. His company makes about 100 unique bearings—the metal spheres that allow other parts to rotate—for the F-35’s airframe and engine. NHBB uses machines to bend a bar of steel until it looks like a ring, puts it in a furnace, grinds down all the surfaces, then hones pathways where the balls and rollers travel within the bearing. The company put off for at least six months the decision to buy grinding machines it needs. If business declines, Geary hinted at possible layoffs. “We have to consider whether the workforce is aligned with our needs.”

Since the late 1990s, NHBB has invested tens of millions of dollars in equipment for heat treatment and measuring, as well as in machines that turn, grind, drill, and hone its parts. Although the Pentagon has already reduced its F-35 orders, NHBB and other companies still hope to see more profit by 2018, when Lockheed begins churning out 180 craft per year, if not before. If this doesn’t happen, “our payoff won’t be realized,” Geary says.

When the weapons market contracted after the Cold War, “people were really walking away from defense,” Aboulafia says. “Now, it’s very difficult to say you’re going to walk away from the biggest government procurement budget in the world in times like these.” Businesses may crumble before they can branch out. Aboulafia describes the corporate attitude toward government spending as, “I just can’t quit you.” The suppliers also struggle to serve diverse military programs, because advanced weapons require long qualification processes in which companies must prove they can deliver the goods up to spec. If they can’t walk away and they can’t find more clients, companies may have little recourse but to raise prices to keep up with overhead costs. “We’re seeing people take fewer risks and, therefore, their costs are higher, and those costs are passed upward,” Aboulafia says. (Such information is largely anecdotal, because of a dearth of public data on defense subcontractors and their business; the government does not collect it.)

This caution affects suppliers at every level. Not only does NHBB need months to develop its products, but its own supplier, Latrobe Specialty Metals, needs 20 weeks to fortify its steel to withstand temperatures from below zero to 1,000 degrees—per the Pentagon’s F-35 requirements. The 900-person Latrobe, Pa., company combines scrap metal with minerals such as ore and other chemical elements; heats the mix to 3,000 degrees; pours it into a mold; and strengthens it further by chopping it into bars. The “qualification” process to ensure that the product meets the military’s rigorous standards is costly and time-consuming, so Latrobe must sell enough to make the business worthwhile.

Mark Weberding, Latrobe’s director of bar products, already sees orders from his customers, such as NHBB, ebbing. He likens it to Christmastime, when a grocery store makes its “best guess” of how much eggnog it needs. If the store buys too much, it spoils on the shelves. Weberding understands that his customers don’t want to be “stuck with the materials,” but the predicament leaves Latrobe and other lower-tier suppliers with “lost orders and lost revenue” that are hard to replace.

DISCONNECTED

Far from the nation’s capital, some businesses on the bottom of the defense food chain don’t track the ins and outs of sequestration drama. “I know this is going to sound ridiculous, but I don’t even pay attention,” admits Heidi Hostetter, director of operations for Faustson Tool, based in Arvada, Colo., which employs about 30 people. The company takes a 400-pound hunk of raw aluminum from an approved source, and its massive, German-made, five-axis mills cut away and shape the material until it weighs 10 pounds. Making the square upper-antennae housings and oval lower-antennae housings for the F-35 is about one-third of Faustson’s business.

Hostetter asked if the clunky term referred to $85 million in cuts expected in fiscal 2013; I clarified that the number is actually $85 billion, split between defense and domestic discretionary spending. “Billion?!” she exclaimed. “A half-million dollar hit can shut my doors!” If the Pentagon does pare back one-quarter of its F-35 purchase this coming year, Faustson would lose “approximately $200,000”—enough to preclude buying any more equipment to support the program.

The company has already trimmed down. Six years ago, it bought a 17,000-square-foot building to prove it could house the milling machines to meet the F-35’s needs for two decades. The facility sat vacant as Faustson struggled to meet the demand for price reductions from its customer, Ball Aerospace and Technologies, after the large orders that Ball—and ultimately, Lockheed—had promised never materialized. Finally, last year, Faustson put the building up for sale. Now, Hostetter says, there’s no guarantee that the company would be able to meet the manufacturing demand should production return.

Ball Aerospace, a Boulder, Colo.-based company supplying low-observable antennas to Lockheed, employs about 2,800 people. Seventy percent of its business supports the defense and intelligence communities. Two years ago, Ball also invested in a new aerospace manufacturing center to support the F-35, its fifth-largest defense contract, and other growing programs. “If sequestration hits all the programs like it’s bound to, there’s a probability that facility is going to go underutilized,” Ball’s program manager, Ken Rockwell, says. “The whole sequestration environment makes it very difficult to go out and make large capital investments when you don’t know if sales are going to come in.”

Faustson’s antenna housing is so precise that a thread half as wide as a strand of hair couldn’t fit between it and the antenna it holds. If one part is slightly off, the F-35 won’t fly—or, in some cases, even fit together. If Faustson can’t meet Ball’s new price demands, Ball may get the part from Australia, Hostetter says, even though Faustson spent 10 years with skilled machinists and sophisticated tools to create its housing. If Ball takes its business offshore, she says, “something would be impacted, either quality or delivery or both.”

Infographic

WAITING FOR THE WORST

So far, the fiscal cliff has been more of a slope. Defense contractors’ first-quarter earnings did not suffer much; Lockheed’s, released this week, rose 10 percent over the last quarter. But “the worst is still to come,” warns David Berteau, senior vice president at the Center for Strategic and International Studies. “It’s going to take a good while before we can see the effects” of sequestration on suppliers. The delayed impact, he worries, could mislead lawmakers and policymakers. “The old budget cutters’ rule was, ‘If the pain’s not all that great, then I must not have cut deep enough.’ ”

For the first time in Frank Kendall’s four decades in the defense world, the sector is not being treated as a political protectorate. The Pentagon’s acquisitions chief says that, as policymakers remain gridlocked over the deficit, his department is at “the end of the whip, along with the rest of the federal government.”

There’s an initial cost to reducing troop levels or razing the installations that house them, and the department says it doesn’t want to sacrifice programs that directly affect war-fighters. So the cuts will have to come from research, development, and procurement accounts—perhaps as much as 20 percent, as Defense Secretary Chuck Hagel recently wrote to lawmakers; that’s disproportionately high, considering that the defense budget only requires a 10 percent cut under sequestration. While the department is unlikely to cancel a major acquisition program such as the F-35, analysts believe the Pentagon will probably continue to reduce the pace at which it buys the aircraft and shrink the size of its order—as it has done. That will be painful even for a politically controversial program the Pentagon wants to protect, but the consequences will be worse for other, less visible, defense programs, which may be gutted. “Hundreds of program line items, large and small, would have to be cut significantly,” Hagel wrote. “We would be forced to buy fewer ships, planes, ground vehicles, satellites, and other weapons.”

Such disruptions across the industrial base could harm America’s “ability to sustain our design teams and our technological superiority over time,” Kendall worries. And fewer dollars can lead to a brain drain: Industrial officials say they doubt engineering graduates will choose the defense industry in such unstable times. Technical manufacturing know-how can be lost if even a few people head for the door at small companies. “It’s very difficult to recover that in a short period of time, to produce some of this technically demanding kind of product,” Geary says.

The Pentagon is currently surveying second-, third-, and fourth-tier suppliers to look for thin areas in the supply base and identify companies that could be in trouble with the sequester trickle-down. But the Defense Department can’t do much to keep them afloat. “We’re willing to intervene on occasion,” Kendall says. But while the Pentagon may consider offering financial aid to a critical supplier, resource constraints mean that such intervention will be rare. “Unfortunately, when you’re taking as much money out of the budget as we are, we’re not going to be able to protect everybody.”

Sequestration will not kill the defense industry. The military will always need weapons and equipment, which is perhaps why the pleas from Lockheed and other defense giants failed to sway Washington policymakers to compromise and avoid sequestration in the first place. But the budget downturn will be painful, and certain parts of the food chain may go hungry. Once these cuts become real, small- and medium-sized business in members’ districts will start to suffer, and that is sure to bite politically. By then, it may be too late to save them.

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