The defense drawdown is now well underway, and the defense industry is starting to pack up, if one is to believe what is being said this week at the Paris Air Show.
Defense budgets peaked in FY 2010, including war funding, and have been down about 10 percent in constant dollars. Factor in the budget sequester for this year, which looks like it will hang on through the rest of the fiscal year (and maybe make a repeat appearance next January), and the defense budget will have fallen 24 percent in constant dollars from their height.
The future does not look different. If the sequester remains, one can expect another roughly $500 billion to disappear from projected defense budgets over the next nine years.
Oddly, defense contractors seem to be doing OK, so far. Sales had declined a bit even before sequestration set in, but profit margins are holding strong for the big guys -- Lockheed Martin, General Dynamics, Raytheon, Boeing, Northrop Grumman, L3.
This apparent fiscal health is actually an economic Potemkin village. Profit margins may hold, but U.S. sales are clearly headed down. The illusion stems from the reality that the major defense contractors are still working on programs funded in previous years, when budgets were higher.
But as the U.S. defense budget heads down, DOD's dollars to buy stuff will drop more quickly than the overall budget, as they have in every drawdown since the Korean War. Between FY 1985 and FY 1998, for example, the defense budget declined 31 percent in constant dollars, while funding for research and purchases of hardware fell 53 percent.
This reality is already apparent today -- budgets for weapons research and acquisition, before the sequester, were already down nearly 20 percent in constant dollars since FY 2010, and, with the sequester, could decline nearly 30 percent.
I like to see the major defense contractors as the canaries in the budgetary coal mine -- they get the earliest signal of a change in fiscal direction, and they start to react well ahead of the policymakers and elected officials, many of whom think that the party is going to last forever.
The industry response to the coming decline began several years ago. Major contractors sold or consolidated business units, entered new markets (largely through acquisitions), and trimmed the workforce. Northrop Grumman, for example, sold its Newport News shipyard in 2011, leading to the creation of an independent business -- Huntington Shipyards.
Boeing is reducing its management workforce by 30 percent and has closed defense production operations in Kansas and California. L-3 sold its consulting and government services businesses. Lockheed Martin already began consolidation and cutbacks in its missile and training operations in 2012. Overall, aerospace industry employment, which grew through the past decade, began a predictable decline in 2012, in advance of any implementation of the sequester.
As in the past, when the U.S. market tails off, the big contractors prepare to leave the country, hoping that international markets will make up for the loss in sales volume in the United States. The latest straw in the wind is an increasingly aggressive industry push to make up overseas for the sales that are declining at home.
And the U.S. defense industry has products it urgently wants to sell overseas. Lockheed hopes its F-35 will have a big export market. It is, after all, being built in partnership with Britain, Turkey, Italy, and Denmark, among other countries, which are expected to buy it -- that was the whole point of cooperative agreements on F-35 development and production. For Lockheed and the U.S. aerospace industry, F-35 international sales are critical; this is the only fifth-generation fighter on the international market. If it sells, it would guarantee a leading position for U.S. firms in the international fighter market for years to come.