The Daily Item, Sunbury, PA

December 29, 2012

Defense Contractors' Shopping Lists on Hold Ahead of Budget Cuts

By Nick Taborek and Brendan McGarry
Bloomberg News

WASHINGTON — Kratos Defense & Security Solutions Inc. in July bought a company that makes drones used for military target practice. Then the contractor put further acquisitions on hold.

With Washington's budget impasse threatening $500 billion in automatic defense cuts over a decade, Kratos's chief executive officer said the firm didn't know where to place its bets. In the past year, the maker of security and surveillance systems has also halted equipment upgrades and trimmed research spending.

"Guys like us are going to hold a good portion of their cards until there's some budget clarity," Eric DeMarco, the company's CEO, said in a telephone interview.

Military suppliers already have been preparing for a leaner decade by stockpiling cash, cutting jobs and slowing spending.

The automatic cuts would come on top of $487 billion in defense reductions planned over 10 years. The latest round is scheduled to begin next week if Congress and the White House don't reach an alternate agreement to shrink the nation's deficit or delay the whole process of automatic cuts and tax increases known as the fiscal cliff.

"The fiscal cliff in my mind has already been here," said Robert Burton, a partner at the law firm Venable LLP in Washington. "It arrived some time ago."

Companies in recent months have seen federal contracts canceled, delayed and scaled back because of agencies' uncertainty about future budget levels, Burton, who represents federal contractors, said in a phone interview.

In response to the risk of tax increases and budget cuts, satellite equipment maker Comtech Telecommunications Corp. this month lowered its profit forecast for fiscal 2013.

"We believe that the U.S. government's failure to resolve the 'fiscal cliff' has resulted in increased uncertainty throughout our customer base," Fred Kornberg, chief executive officer of the Melville, New York-based company, said in a Dec. 6 statement.

Small contractors such as Nash Locke, with less than $1 million in annual revenue, are also making preparations.

Two months ago, Jeanne Peck, president of the McLean, Va.-based technology firm, stopped hiring consultants to help find and evaluate contract opportunities and started doing the work herself, she said.

Peck is saving money in case the automatic cuts take effect and hurt her business, which relies on contracts from the Defense and Education departments, she said.

"I end up being exhausted," Peck said in a phone interview. "I end up working more and other people who would otherwise do that work for me do suffer a bit."

The $1 trillion in automatic cuts, known as sequestration, would be split between domestic and national security programs. Obama and congressional leaders planned to meet at the White House Friday to discuss how to avoid those reductions and expiring tax increases that together would total more than $600 billion in 2013.

Some of the biggest defense contractors are cutting jobs and preparing for lower sales.

SAIC Inc., a McLean, Va.-based technology and services vendor, is eliminating 700 positions in order to "emerge as a powerful competitor on the other side of this downturn," John Jumper, the company's chairman and chief executive officer, said during a Dec. 5 conference call with analysts.

Revenue at Lockheed Martin Corp., the world's largest defense contractor, is projected to fall 2.1 percent to $45.2 billion in fiscal 2013 from this year. Analysts predict Northrop Grumman Corp.'s revenue will decline 2.7 percent to $24.4 billion during the same period, and Raytheon Co.'s sales will fall 1.4 percent to $24.1 billion, according to the average estimates compiled by Bloomberg.

The possibility of sequestration hasn't deterred investors in defense stocks. Shares of the Pentagon's top 10 contractors have gained 1.9 percent since the Nov. 6 presidential election through yesterday, compared with a 0.7 percent drop in the Standard & Poor's 500 Index.

Shares of Kratos have fallen 11 percent during the same period even as analysts have predicted the company's sales will increase. The contractor's revenue is projected to rise 5 percent to $1.02 billion in fiscal 2013 from $971 million this year, according to estimates compiled by Bloomberg.

While Kratos is still investing in areas such as drones and cybersecurity, it has reduced research and development by about 25 percent, DeMarco said.

The company has delayed buying new plant equipment, including robots that stitch circuits onto computer chips. After completing its July acquisition of Composite Engineering Inc., the target-drone maker based in Sacramento, Calif., Kratos plans to stop buying other defense companies until the second half of 2013, DeMarco said.

Kratos in fiscal 2011 derived 74 percent of its revenue from U.S. government contracts, down from 86 percent in 2009. The company is hedging against the downturn in defense spending by increasing sales of security systems for civilian use, DeMarco said.

While DeMarco said he's optimistic about the firm's future, he says companies face heightened competition over a smaller pool of federal contract revenue.

"When the pie is shrinking, the only way companies can grow is by stealing others' work," he said.