Defense companies buckle up for budget whiplash in 2019

Defense firms, fresh off a two-year budget deal that created some predictability in Pentagon spending, are strapping in for a roller coaster ride in 2019.

Chief among the concerns is the widely divergent possibilities for the overall size of the proposed defense budget for fiscal 2020, due to Congress in one month, along with new personalities at key positions in the House, the Pentagon and the White House.

The original defense spending plan dropped from $733 billion to $700 billion when President Donald Trump announced a cut in October. But Republican lawmakers reportedly won Trump over last month, getting him to agree to $750 billion.

But that’s only if lawmakers can cut a deal to raise spending and avoid sequestration mandated by the Budget Control Act. Democrats will have control of the House and Rep. Adam Smith, the next chairman of the House Armed Services Committee, will be bringing his own set of priorities to the policy-writing panel.

“Everybody had a big smile on their face,” said Michael Herson, president of the lobbying firm American Defense International. “But nobody believes it’ll be 750. Who knows what the final number will be? That’s the rub. That’s the scare.”

And it doesn’t end there. Mick Mulvaney, a budget hawk, has been elevated to acting White House chief of staff, where he can exercise more authority over negotiations. The ouster of Defense Secretary Jim Mattis in late December created a series of additional question marks.

Oh, and any budget deal for next year could be negotiated amid the special counsel probe into Russian interference in the 2016 election. It won’t be a good time for compromise.

“What’s killing us is this constant whiplash of uncertainty about what the numbers are going to be,” said a defense industry official, who asked not to be named. “Wall Street has just clobbered us because of that.”

What’s clear that while the defense industry is used to funding uncertainty, nothing matches the pile of challenges waiting next year. Here’s a look at the biggest ones, according to defense experts, lobbyists and industry officials,

What’s the topline?

When news broke last month that Trump backed spending $750 billion on national defense — $34 billion more than fiscal 2019 and $17 billion more than Pentagon planners thought the fiscal 2020 level would be — contractors were pleased and defense stocks went up.

But without a deal to raise spending caps, the Pentagon’s base budget will be $576 billion, which means major weapons cuts. The figure doesn’t include the overseas spending account, which isn’t subject to the caps, or Energy Department funding that governs the nuclear stockpile.

“If the final number is lower, where’s the bill payer?” Herson said. “Is it modernization? And if it is, what modernization will suffer as a result?”

Byron Callan, a defense expert with Capital Alpha Partners, said the violent shifts in the topline are turning long-term corporate planning on its head.

“These businesses, they’re not thinking about this year. They’re thinking about where they’ll be in five years’ time,” he said. “If the outcome is U.S. defense spending is now gonna look flat, it’s a very opportune time to show defense customers that you may have something better or different than the program of record.”

He said growth assumptions will need to be re-examined, which affects hiring, capital expenditure and workforce management. Firms will also need to rethink how they spend their research and development dollars.

“The guys who want to be around for a while who don’t want to have their lunch eaten by someone else, they’ll have to hold and probably step up [R&D] spending a bit,” he said.

Defense lobbyist Jeffery Green said trade associations are leading the charge in convincing Congress to strike a deal to raise spending.

“They’re hammering home at the macro level that budget instability is a true threat to the industrial base,” he said. “It’s hard to make long-lead investment when you’re planning quarter-to-quarter.”

Eric Fanning, president and CEO of Aerospace Industries Association, says the biggest driver on the topline number will be the Democratic takeover of the House.

He thinks three things are crucial to the next budget: size of the spending levels, predictability and consistency.

“The big questions to watch when Adam Smith becomes chair is where he advocates for dollars spent,” Fanning said. “We want to make sure that the modernization programs and R&D dollars stay consistent because that’s a very hard thing to unwind and wind back up again.”

Mr. Smith returns to Washington

Smith, the Washington Democrat poised to take charge of House Armed Services, looms large over the spending question.

On the one hand, he’s a known-quantity and enjoys a collegial relationship with outgoing chairman Rep. Mac Thornberry (R-Texas).

On the other, Smith has signaled his interest in slashing defense spending, especially reducing the nuclear triad. That’s the nation’s network of ballistic-missile submarines, long-range bombers and underground missile silos.

The submarine and bomber legs are likely safe from cuts, said Mark Cancian, senior adviser with the Center for Strategic and International Studies. The silos, however, are vulnerable, both physically and politically.

That could hit the Ground-Based Strategic Deterrent, the program to replace Minuteman III intercontinental ballistic missiles. The Air Force awarded contracts to Boeing and Northrop Grumman in 2017 and a winner will be chosen to produce the missile in 2020.

“That program could be canceled, or more likely delayed,” Cancian said. He noted that GBSD was a part of the Obama administration’s nuclear modernization plans, making Democrats less likely to kill it.

Another vulnerable program is the Long Range Stand-Off weapon, a replacement for the Air Launched Cruise Missile. Lockheed Martin and Raytheon received developmental contracts in 2017, and a winner is expected in 2022.

“It’s always been in a quasi-status, and many arms controllers have identified it as an unnecessary program,” Cancian said of the LRSO.

Smith has also taken aim at early plans for a low-yield nuclear weapon, which the Trump administration called for in the Nuclear Posture Review. Critics say such a weapon would make war more likely because there would be a lower threshold to launch it.

Beyond programs, Cancian believes the nation’s nuclear weapons laboratories — Los Alamos, Lawrence Livermore and Sandia — could face cutbacks if nuclear funding is reduced. “If they delay any of those programs, it’ll be felt at the weapons labs.”

Loren Thompson, a defense industry consultant, said companies and lobbyists who try to save certain programs or try to fight funding delays need to know that Smith isn’t like other lawmakers.

“Normally, constituents’ interest carried the day when making the case [for fully funding programs],” Thompson said, noting that lawmakers are focused on bringing jobs to their district. “Smith is not that kind of guy. More than most members, he’s a person who operates on principle, and therefore companies, when they do interact with him, have [shown up] armed with principled arguments, as opposed to the usual offering.”

Mulvaney, Mattis and Mueller

Other wild cards affecting the defense budget negotiations are some of the bigger changes swirling around the nation’s capital.

One is the elevation of Mulvaney as acting White House chief of staff. Once a leading fiscal hawk in Congress, Mulvaney has brought his cost-cutting mission to the White House and has tried to rein in spending in other parts of the government as head of the Office of Management and Budget.

In a note to investors, Callan mentioned that Mulvaney was almost certainly the driving force behind Trump’s decision to slash spending across all departments by 5 percent. For defense, that meant dropping planned fiscal 2020 spending from $733 billion to $700 billion.

Mulvaney appeared to lose that battle when Trump told Republican lawmakers that he would bring that number up to $750 billion. But that was when Mulvaney was merely the head of OMB, not the man running the West Wing as John Kelly’s temporary replacement.

“As acting chief of staff, Mulvaney will have daily access to Trump,” Callan wrote. “An issue for defense is how his views on federal spending, debt, and deficits impact or change Trump’s thinking. It will also matter for the FY21 budget that will be prepared during 2019.”

Then came the news that Mattis was leaving. While the retired Marine general’s credibility on Capitol Hill provided comfort to industry when it came to defense funding — he was one of the people who personally convinced Trump to raise the spending request to $750 billion — more depends on who will replace him.

Callan cautioned against overreacting to the Mattis news.

“We disagree with the belief that the resignation of SecDef Mattis is a clear-cut negative for the defense outlook,” Callan said in another investor note. “A focus just on FY20 DoD budget dynamics is too myopic, in our view.

“The bigger question remains who will replace Mattis,” he added. “Since Mattis disagreed with a number of Trump’s policies, it’s fair to presume that Trump will choose a replacement who will agree more stridently with his policies and views.”

In naming Deputy Defense Secretary Patrick Shanahan as acting secretary, Trump elevated someone steeped in the defense industry, not military policy. He’s a long-time Boeing executive, yet Callan questions whether Shanahan “will fight as passionately as Mattis for funding.”

Beyond new Pentagon leadership, Herson took a longer view toward the Robert Mueller probe as it examines Russian influence in the 2016 election and whether the Trump campaign worked with Moscow. While the situation isn’t related to defense spending, it could create such a toxic atmosphere on Capitol Hill that lawmakers on either side won’t be in the mood to negotiate a budget deal.

The GOP-controlled Senate could mark its bill to $750 billion, while the Democratic-controlled House would likely come in at a lower number. The two sides can’t conference until there’s a budget deal, which could be late in the year while the government is operating under a continuing resolution, Herson said.

“Everyone is trying to figure out what the end game is, and it’s complicated by the fact that the Mueller probe could be out,” he said. “Will the Democratic House be in the process of impeaching the president? How do you sit down and negotiate under that environment? There will be no goodwill left.”

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