Bloomberg News

Sequester Looms as Threat to Small Firms in Defense Supply Chain

October 19, 2012

Tail of Supply Chain Suffers in Sequester as Lockheed Prospers

Workers build a seat assembly for an E-2 Hawkeye plane at the CPI Aerostructures Inc. manufacturing facility. Photographer: Victor J. Blue/Bloomberg

Gray metal panels about the size of paperback books lie on a mechanic’s table at CPI Aerostructures Inc. (CVU:US)’s plant in Edgewood, New York, an hour’s drive east of Manhattan.

The pieces will soon be attached to an A-10 attack jet’s outer wing, part of a Boeing Co. upgrade project. CPI’s 200 employees also build gunner windows for United Technologies Corp.’s Black Hawk helicopters and provide wing panels for a Northrop Grumman Corp. (NOC:US) radar plane.

CPI is one of the hidden links in the Pentagon’s supply chain, connecting machine shops to the nation’s largest defense companies. Military work helped it triple revenue to $74.1 million in the past decade. Now, the manufacturer is among thousands of small firms that may find themselves at risk as $500 billion in automatic cuts threaten to ripple through the industry early next year.

“You look at ducklings crossing the street and they’re following mom and dad and they’re all in line,” CPI Chief Executive Officer Edward Fred said in an interview at the company’s headquarters. “Who gets hit last is the little duck, but they’re still vulnerable, and we will be, too, no doubt about it.”

The cuts, known as sequestration, are part of $1.2 trillion in proposed reductions to national security and domestic programs. They would occur if the Obama administration and U.S. lawmakers fail to negotiate an alternate deal to cut the nation’s deficit.

Bipartisan Standoff

The automatic reductions would come on top of $487 billion in defense reductions already planned over a decade.

If the sequester hits and remains in effect, Fred said he will have to consider cutting as much as 20 percent of CPI’s staff. While he hopes leaders in Washington will find a solution, he said he is frustrated by the bipartisan standoff.

“This congress, for whatever reason, has chosen to dig its heels in and nobody wants to do anything -- Democrat or Republican,” he told CPI workers gathered for an Oct. 2 meeting at the company’s offices.

As the reductions trickle down from top defense contractors, they may cause more pain to the firms at the middle and bottom of the food chain.

Small companies are “living hand to mouth in a business sense,” Peter W. Singer, a senior fellow who studies defense and foreign policy at the Washington-based Brookings Institution. “They’re not going to be able to weather the storm that some of the larger companies would.”

‘Massive Impact’

Some of the small firms don’t have the capital or credit to sustain themselves during a “massive impact the size of sequestration,” Chip Sheller, a spokesman for the Aerospace Industries Association, an Arlington, Virginia-based group that represents top contractors such as Lockheed Martin (LMT:US) Corp., said in a phone interview.

Another risk for CPI and other small businesses is their lack of diversification, said Mark Jordan, a St. Louis-based analyst at Noble Financial Capital Markets.

“In a small company there’s no place to hide if you lose a 20 percent customer,” Jordan said in a phone interview.

CPI gets 26 percent of revenue as a subcontractor on Northrop Grumman’s E-2D radar plane program and 16 percent of revenue supplying parts for Boeing’s A-10 upgrades.

Small-Cap Suppliers

Investors have taken a dimmer view of the smaller military suppliers. An index of 24 Pentagon subcontractors has fallen 13 percent since May 1. The top five U.S. defense contractors -- Lockheed, Boeing (BA:US), General Dynamics Corp. (GD:US), Raytheon Co. (RTN:US) and Northrop -- gained 1 percent during the same period.

Both groups lagged behind the Standard & Poor’s 500 Index (SPX), which has advanced 3.7 percent since May 1, and S&P’s Smallcap 600 Index, which has gained 2 percent since then.

The subcontractor index, which is weighted by market capitalization, includes firms that get at least 10 percent of revenue from sales to the top five weapons contractors and have market values less than $1 billion.

CPI, part of the index, has dropped 33 percent since May 1. Other companies include Chelmsford, Massachusetts-based Mercury Computer Systems Inc. (MRCY:US), which has declined 29 percent since then, and Orlando, Florida-based API Technologies Corp. (ATNY:US), which has fallen 32 percent.

Pentagon Cuts

The military’s supply chain also includes thousands of closely held subcontractors whose fortunes are tied to those of the top defense companies.

Some of the smaller suppliers are already struggling with reduced Pentagon spending. Military contracts fell 4 percent to $372 billion in the fiscal year ended Sept. 30, 2011, from the fiscal 2009 peak of $387 billion, according to procurement data compiled by Bloomberg.

Slower military orders have forced Alken Industries Inc., a machine shop that supplies CPI, to cut 12 of its 72 employees, said Anthony Landisi, the company’s vice president of business development.

Alken Industries, based in Ronkonkoma, New York, is seeking opportunities outside of defense, which now accounts for 95 percent of its sales, he said in a phone interview.

“We have a great concern because our livelihood depends on the military,” Landisi said. “You never want all your eggs in one basket, and right now we got all our eggs in the military basket.”

Belt-Tightening

The company is “already running as lean as we possibly can,” Landisi said. “Our belt is pretty much tight. But, if the work is not there, we’re going to have to trim here and there and let some people go.”

Acutec Precision Machining Inc., a family-owned subcontractor that makes part of the hydraulic system for the Lockheed Martin F-35 jet, is bracing for the automatic cuts.

“I won’t be buying the new equipment I want to,” said Rob Smith, the company’s chief executive officer. “I’m going to have to be very cautious.”

The 300-employee company, located 30 miles from Erie, Pennsylvania, gets a third of its revenue from defense work.

Smith said he is closely monitoring the automatic cuts to see whether they will affect his company’s programs, including the F-35, the Pentagon’s most expensive program and a potential target for budget cutters.

“When the big guys get a cold, we get pneumonia,” Smith said in a phone interview.

A Million Jobs

CPI’s Fred said he doesn’t expect any of the subcontractor’s major programs to be substantially scaled back. They include Boeing’s upgrades to the A-10 Thunderbolt II jet and work on Northrop Grumman’s E-2D naval radar plane. Those two programs and the Black Hawk account for about 45 percent of the firm’s revenue.

The Pentagon in July signed an $8.5 billion Black Hawk deal with United Technologies’ Sikorsky division that covers purchases through 2017.

All programs are at risk, though. The Defense Department has said the sequester would result in every budget item shrinking by 9.4 percent, excluding military pay and benefits.

A study paid for by the Aerospace Industries Association said 1.1 million jobs would be lost due to automatic defense cuts. The figure has been disputed by analysts such as the Brooking Institution’s Singer, who say there isn’t enough information to come up with a reliable estimate.

Huntington’s Suppliers

Even so, the automatic cuts would reduce head counts at companies that rely on defense, Singer said. “It can’t help but cause them to lose jobs,” he said in a phone interview.

Chief executive officers of some of the biggest defense contractors have warned U.S. lawmakers and the public about the sequester’s threats to small businesses.

“We are very concerned that the most vulnerable segment of our supplier base is the over 12,000 small and minority businesses,” Robert Stevens, head of Lockheed, said in a statement last month.

Michael Petters, chief executive officer of aircraft carrier maker Huntington Ingalls Industries Inc. (HII:US), in August said the cuts would harm an already vulnerable supplier base.

“The supply chain has been dwindling and weakening, I’d say over the last several years,” Petters said in a conference call with Wall Street analysts. “We expect the supply chain to be challenged over this next time frame.”

Parking Cars

For Justin Sicignano, 26, losing his job at CPI -- his first in the aerospace industry -- might mean a return to parking cars.

During a break from assembling an escape hatch for a Lockheed Martin P-3 Orion surveillance plane this month, he said he prefers the concentration that his work as a mechanic requires.

“It’s almost like a form of art in a way because you have to do things precise,” he said. “Everything has to be perfect.”

Bill Ehrig, a mechanic at CPI who helps build the landing gear doors for the A-10, said the looming sequester scares him.

“I’m tired of being laid off and looking for work,” he said. “I’m 58 years old now, and I just would like to find enough work until retirement time.”

To contact the reporter on this story: Nick Taborek in Washington at ntaborek@bloomberg.net

To contact the editor responsible for this story: Stephanie Stoughton at sstoughton@bloomberg.net


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Companies Mentioned

  • CVU
    (CPI Aerostructures Inc)
    • $11.58 USD
    • -0.27
    • -2.33%
  • NOC
    (Northrop Grumman Corp)
    • $123.92 USD
    • 0.65
    • 0.52%
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