Senior executives of major defense companies rarely seek publicity. They also seldom openly criticize their customer, the Department of Defense, or the organization that provides that customer with funds, the U.S. Congress. So it is noteworthy when Robert Stevens, the outgoing CEO of Lockheed Martin feels it necessary to publicly warn of the consequences of sequestration, not just for his company or the defense industry but for the U.S. military and the nation’s security.
Mr. Stevens has been warning about the particularly severe problems that sequestration will create because of the legal and regulatory requirements imposed on defense contactors. In a recent speech to media representatives, he pointed out that sudden and serious cuts in major defense programs will require prime contractors such as Lockheed Martin to change the terms of their agreements with the thousands of vendors in its supply chains. These vendors, in turn, would have to spread their costs over fewer items, causing the price of each to rise. Lockheed Martin would be required by acquisition regulations to pass these costs on to the government. In addition, according to Stevens, these vendors would have the right to make a claim against Lockheed Martin for the adverse impact to their business of this unplanned reduction in demand for their products and Lockheed Martin would be required to pass those claims on to the Pentagon.
Stevens has also warned of the impact on the defense workforce of sequestration. Because sequestration requires across the board cuts to programs, the potential layoffs are certain to be widespread. By some estimates, more than a million jobs are at risk. The impact on industry will be a loss of talented workers and production skills. Although the law only takes effect on January 3, 2013, the 1989 Worker Adjustment and Retraining Notification Act requires companies to provide warning of planned layoffs at least 60 days before they take effect. This means that layoff notices must be received a few days before the November elections. Many defense companies are trying to dance around this requirement in fear of being accused of playing politics.
The U.S. defense industry is one of the most heavily regulated sectors of the U.S. economy. Companies in this sector must abide not only by the rules and regulations that apply to all other businesses but the special contracting and reporting requirements imposed by Congress and the Pentagon. Walmart does not have to provide detailed cost data to its customers or certify the prices charged by its vendors but defense companies do. General Motor’s customers do not get to tell the company how to design cars, make changes to that design while the cars are going down the production line or, having signed a contract decide to change the terms of the agreement or even cancel the order entirely just for that customer’s convenience. But the Department of Defense can.
For all this aggravation you might think that defense companies earn extraordinary profits. Sadly, such is not the case. The top 20 defense companies in terms of dollars on contract have an average 2011 profit margin of 2.85% and an operating margin of 6.22%. This compares to the Dow 30 average of an 11.64% profit margin and operating margin of 16.04%. Return on assets was 3.84% for the top 20 defense contractors and 10.95% for Dow 30 companies. Return on equity for defense contractors for 2011 was 21.01% and 22.41% for Dow companies. The total revenues of the top 100 defense companies from Pentagon contracts were less than total revenues for Walmart or Exxon alone.
Bob Stevens is an honorable man, a remarkably capable CEO and a good steward of the national interest. His warnings need to be taken seriously. Even though they may not say so publicly, he really is speaking for almost all the other CEOs of defense companies.