For Matthew Mulherin, who manages Navy aircraft carrier construction for Huntington Ingalls Industries Inc. (HII:US), automatic defense spending cuts set to take effect in January are an “end-of-earth scenario.”
That’s why Huntington Ingalls and such companies as Lockheed Martin Corp. (LMT:US) and Boeing Co. (BA:US) are fanning out to stave off defense reductions that would amount to $55 billion a year through 2021. The cuts, through a process called sequestration, will be triggered if lawmakers don’t agree by year’s end on ways to reduce government debt by $1.2 trillion over a decade.
For defense contractors such as Huntington Ingalls that depend on government funding, the prospect of automatic spending cuts has prompted a “lobbying effort not like anything I’ve seen” to give lawmakers a “constant education,” said Matthew Paxton, president and chief executive officer of the Shipbuilders Council of America.
The automatic cuts would compound an already difficult market for contractors who face a projected 22 percent drop in defense procurement outlays by 2015, said Deutsche Bank AG defense analyst Myles Walton. Sequestration would occur on top of the $487 billion in cuts that President Barack Obama has proposed over the next 10 years.
To emphasize the ripple effect of defense cuts on U.S. jobs, the builder of a version of the Navy’s Littoral Combat Ship in Mobile, Alabama, said it led representatives of 50 suppliers from 25 states to Capitol Hill last month to meet with more than 100 lawmakers. The company, Austal Ltd. (ASB), reminded lawmakers of the defense and economic value of the shallow-water ships that hunt submarines and sweep for mines.
The trade group for the aerospace industry has organized luncheons with lawmakers and worker rallies outside defense plants. Florida Republican Ander Crenshaw, a member of the House defense appropriations subcommittee, addressed a May 21 rally of 400 workers the group organized outside a Kaman Corp. (KAMN:US) aerospace plant in Jacksonville.
Employees at Bethesda, Maryland-based Lockheed, the world’s largest defense company, increased political donations 9 percent for the 2012 election from their 2010 election giving, according to the Federal Election Commission. So far this election season, Lockheed’s political action committee has contributed $2.26 million, including to members of defense committees in Congress.
General Dynamics Corp. (GD:US), which teams with Huntington Ingalls to build Virginia-class nuclear submarines, boosted its political donations almost 10 percent in this election cycle, to $1.2 million, according to its campaign-finance filings. Led by Boeing’s $4.2 million, defense companies spent $33 million on lobbying in the first quarter of 2012.
The defense lobby spent almost $132 million in 2011 as a new Republican House majority pushed spending cuts and Democrats demanded that reductions include defense as well as social programs. This year the industry is on track to spend about that amount, according to the Center for Responsive Politics, a non- partisan Washington group that monitors political spending.
Huntington Ingalls’s team of lobbyists includes former U.S. Senators Trent Lott, a Mississippi Republican, and John Breaux, a Louisiana Democrat. The business partners developed expertise in Congress looking out for the two Gulf Coast shipyards in their states that Huntington Ingalls now owns after it was spun off last year by Northrop Grumman Corp. (NOC:US) Neither Lott nor Breaux returned telephone calls seeking comment.
Defense contractors are “most fearful” of “indiscriminate arbitrary reductions across the board,” that could spur as many as 350,000 job losses if the automatic cuts take effect, said Cord Sterling, vice president of the Aerospace Industries Association of America.
In the absence of guidance from President Barack Obama’s administration about how the cuts would be carried out, bigger companies “have to assume those go into place” so “they will be taking actions late summer or fall” to restructure or downsize, he said.
The prospect of cuts already is having a “chilling effect” on the industry and Lockheed and other companies may stop hiring and training, Lockheed chief executive officer Robert Stevens said in March on Capitol Hill. Last week he said that laws requiring advance notice of firings may prompt grim warnings in September and October.
“We may have to notify every one of our employees and all of our suppliers and subcontractors that they may or may not have a subcontract,” Stevens said May 31 at a conference for investors.
The supply chain (HII:US) of parts and components of complex weapon systems and ships is at risk if smaller companies can’t plan, Paxton of the shipbuilders’ council said.
“Smaller companies are not hiring now and come this summer will start laying people off,” Paxton said. Some suppliers and “smaller shipyards will be closing their doors” unless Congress acts, he said.
Preparing for the cuts is like “planning for the end of the world,” said Mulherin, president of Huntington Ingalls’s Newport News, Virginia, shipbuilding division. “I am almost afraid to provide a notion” of what may happen under sequestration “because I don’t want it to become real,” he said.
Virtually all of Huntington Ingalls’s $6.6 billion 2011 revenue came from the Defense Department or the Coast Guard.
Huntington Ingalls’s USS Gerald Ford aircraft carrier, the first in a new class of three such ships, has been under construction since 2009 and is set for delivery in 2015. Huntington’s contract to construct the Ford probably will exceed its target cost of $5.2 billion by $884 million, the Navy reported to Congress on March 29. The ship’s total projected cost, including equipment from other companies, is about $12.3 billion. That’s roughly an 18 percent increase over the past four years, according to the Congressional Research Service.
The complexity of Navy shipbuilding, which requires Mulherin’s management team to plan and choreograph each step of construction, illustrates the difficulty posed by budget cuts.
Any slowdown in carrier production caused by spending cuts would affect subcontractors, said Michael Clute, president of the 180-employee Ward Leonard Electric Co. The company builds controllers for electric motors on the Ford that power winches, fans, pumps or other electric-powered devices.
“Once you turn the faucet off, everything unwinds,” he said. “We wouldn’t have the business to hold these skilled employees.”
Besides the logistical difficulties that shipbuilding delays would mean for Huntington Ingalls’s subcontractors and suppliers, sequestration could cut into the company’s future revenue during a time of flat or declining sales.
Huntington reported on May 9 that it had first-quarter sales of $1.57 billion, down 6.9 percent from a year earlier. Net income fell 27 percent to $33 million, or 67 cents per share, from $45 million, or 92 cents.
The company’s revenue, projected to be $6.4 billion in 2014, would be cut 10 percent by sequestration to $5.8 billion, Deutsche Bank’s Walton said. The company posted revenue of $6.5 billion last year.
The spending “direction is definitely down” and “as the defense budget goes down, it accounts for the vast majority of revenues in these companies,” he said.
The austerity in defense spending comes a year after Huntington Ingalls’s spinoff from Northrop Grumman, which sought to focus its business on aerospace and information systems.
In 2002, Huntington bought Newport News Shipbuilding for $2.6 billion after winning a takeover battle against General Dynamics Corp. Northrop had acquired the Ingalls shipyard in Mississippi and the Avondale yard in Louisiana when it bought Litton Industries in 2001 for $5.1 billion.
The shipbuilding industry’s slim profit margins prompted Northrop to decide to spin off the company, now the largest builder of U.S. Navy surface ships, Walton said.
Historically, “the return on assets isn’t good” in shipbuilding and “that was a focus for Northrop to improve” Walton said. Over the past decade “the shipbuilding business at Northrop has had two fits of euphoria and collapse.”
Still, Huntington Ingalls shares (HII:US) are up 16 percent this year, compared with a gain of 1 percent in the S&P 500 Aerospace and Defense Index. (S5AERO)
Investors view the shipbuilder as less susceptible to “spending volatility” than defense companies with shorter-term contracts, Walton said.
Huntington Ingalls executives say multi-year contracts insulate the company for as long as five years.
“Whether you are in a sequestered environment or not, the nation needs the Navy,” and “the Navy needs aircraft carriers,” CEO Mike Petters said in an interview in his office overlooking the 550-acre shipyard on the James River.
While Petters expresses confidence, Howard “Buck” McKeon, the California Republican who is chairman of the House Armed Services Committee, says sequestration would require the Pentagon to “go down every line item and cut 8 or 10 percent.” The higher percentage would apply if Obama exempts military pay from the reductions.
Virginia Representative Rob Wittman said Huntington Ingalls representatives have told him that an across-the-board cut of 8 percent to 10 percent would be problematic for the shipbuilding industry.
A Republican whose district near Newport News is home to many other defense contractors, Wittman says he hears from companies “on a daily basis.”
The House-passed defense authorization measure would stretch out funding of the next carrier, the USS John F. Kennedy, to six years from five. Obama’s proposed 2013 budget includes money for planning and advanced procurement of materials for the Kennedy. It also seeks to lengthen the construction period by two years.
Any delay in the start of the Kennedy’s construction imposed by sequestration would be damaging, Mulherin said.
“When I finish Ford I don’t want to let those people go,” he said. “You have thousands and thousands of fully capable shipbuilders ready to go build the Kennedy” so “if I don’t have work for them it’s just wrong.”
At Newport News, more than 3,000 welders, pipe fitters, electricians and other specialists in shipbuilding trades work shifts around the clock five days a week to construct the USS Gerald Ford. Another 3,000 shipbuilders are completing the overhaul of the USS Theodore Roosevelt, in port for nuclear refueling halfway through its 50-year service life. It was outfitted with a new mast, complete with the Navy’s state-of- the-art electronic communications and radar gear.
Newport News also is preparing for the February arrival of the USS Abraham Lincoln, the next carrier due for nuclear refueling. The company is under contract to plan the Lincoln’s overhaul and hasn’t signed the execution agreement.
Mulherin said he’s confident the Pentagon will go ahead with the Lincoln’s overhaul even if sequestration happens because “the Navy just won’t let one of these things sit pier side with two reactors on board without an intended function.” The Lincoln “can’t keep operating, it’s out of gas, so something has to be done.”
Democratic Representative Bennie Thompson of Mississippi said he hears frequently from Huntington Ingalls, which employs 11,000 people at its Pascagoula yard. Company representatives want to talk about what would happen if funds “anticipated for certain programs are no longer available,” he said.
Republicans and Democrats in Congress are split over how to handle the automatic cuts. Obama and Democrats insist on keeping the sequestration trigger to require Congress to agree on spending cuts and tax increases to reduce the long-term debt.
To spare defense, the Republican-run House passed legislation to cut $310 billion from domestic spending, including food stamps and benefits for federal workers. The measure probably won’t advance in the Democratic-controlled Senate.
Like most lawmakers, McKeon said he doesn’t expect the tax and spending issues to be addressed until after the November election, setting the stage for the defense lobbying effort to reach full force in the so-called lame-duck session late this year.
Virginia Democrat Bobby Scott, whose district includes Newport News, said he wouldn’t cut other spending to avoid defense cutbacks so Republicans can preserve the income tax cuts. “Let the tax cuts expire,” he said.
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