Defense Industry Faces Downturn

There are few industries whose fortunes are so closely tied to government as defense contractors, companies that now provide the military with everything from fighter jets to janitors. And for the past eight years, business has been very good.

But with that government customer now ailing, the boom times are likely to end.

Long-term problems loom for the defense industry — growing Pentagon costs for items other than weapons, calls for defense contracting reform by both men vying for the White House, and uncertainty over how massive government expenditures to prop up the economy will affect defense spending, by far the largest discretionary portion of the federal budget. With the Treasury pouring billions of dollars into rescue plans, there is suspicion that Washington's appetite for expensive defense programs will diminish.

"No one really yet knows when or to what extent defense spending could be affected, but it's unrealistic to think there won't be some measure of impact," Boeing Co. Chief Executive W. James McNerney wrote in an Oct. 2 e-mail to company employees in which he warned the plans could "crowd out" defense funding.

Major military contractors are scheduled to report their quarterly earnings next week, and with defense spending still robust, there are few forecasts of an immediate downturn for the industry that has enjoyed record profits in recent years. But analysts say leaner times are ahead.

"They see the writing on the wall that the budgetary environment is going to get tighter," said Michele Flournoy, president of the Center for a New American Security and a former deputy assistant of defense in the Clinton administration.

As President Bush's term ends in January, defense firms also face the prospect of greater scrutiny under either Republican John McCain or Democrat Barack Obama. The two presidential contenders are scheduled to debate for a final time Wednesday before the Nov. 4 election.

Both have called for some measure of defense contracting reform following a series of delayed or bungled awards, including another failed attempt this year by the Pentagon to pick either Boeing or Northrop Grumman Corp. to build a $35 billion Air Force refueling plane. McCain has boasted in the first two debates of his role in scuttling an earlier Boeing contract for the planes, saying he has "taken on" contractors.

A new president also will be constrained by larger economic issues. Health care and other personnel costs for the military will consume a larger proportion of defense spending, especially if the armed forces grow as both candidates envision. The appetite for defense programs and their huge price tags could diminish as Congress and the administration face tighter overall budgets.

"Both candidates will use the Pentagon as a bill payer for domestic priorities," said Mackenzie Eaglen, a national security analyst for the conservative Heritage Foundation.

Under Bush, defense spending grew significantly. Including funding for the Iraq and Afghanistan wars, 2009 fiscal year defense spending is slated to be $612 billion, up about 40 percent during his eight years in office.

As military spending rose, so did defense contractor profits. Companies like Lockheed Martin Corp. and General Dynamics Corp. have consistently posted double-digit quarterly earnings growth and record sales. Bethesda, Md.-based Lockheed, the nation's largest defense contractor, had $42 billion in sales last year, most of it coming from government spending.

Having a stable government customer meant the defense industry was a relative safe haven for investors. While their shares have fallen with the broader market, many defense companies have large cash reserves and contracts stretching over decades to help weather the crisis.

"We believe our products and services will continue to be recognized as vitally important to the mission of our government customers and to our constituencies in Congress," said Lockheed spokeswoman Cheryl Amerine.

But Wall Street analysts warn the government's $700 billion bailout plan, which now includes $250 billion to directly buy shares in the nation's leading banks, can only pressure future defense spending.

It seems "nearly impossible" that future military budgets "will remain unscathed by the current fiscal reality," Ronald Epstein, a defense analyst with Merrill Lynch, wrote in a recent investor note.

In a time of economic turmoil, some big defense programs that are behind schedule, over budget or in development, could prove a tempting place for Congress or a new administration to make cuts.

The Army's plan to outfit brigades with high-tech tools under its Future Combat Systems modernization program led by Boeing and SAIC Inc. may cost up to $200 billion, and some analysts say it could be scaled back to reduce costs. Air Force hopes for more of Lockheed's F-22 stealth fighter jets could be hurt by their price tag of $191 million per plane.

But industry officials argue that ongoing national security issues, like the growing threat from insurgents in Afghanistan, would make it a mistake to slash support for defense.

"This is not a simple problem," said Fred Downey, vice president of national security for the Aerospace Industries Association, a trade group representing contractors. "We can't afford to stop any of these programs."

Still, military officials have a cautious outlook. At last week's annual Army conference where contractors showcased their latest weapons, service leaders said uncertainty over the Pentagon budget and national economic health made it hard to predict how their priorities will fare.

"I don't know what the crystal ball is going to say for defense spending," Lt. Gen. Ross Thompson III, the military deputy to the Army's acquisitions secretary, told reporters. "We've got some serious issues the country has got to deal with."