Bloomberg News

Drone Maker Among Smaller Firms Squeezed by U.S. Budget Cuts

March 13, 2013

GRAPHIC: Small Firms Feel Pinch of U.S. Spending Cuts

The Pentagon’s embrace of unmanned aircraft propelled AeroVironment Inc. (AVAV:US) to the No. 1 producer of small drones for the U.S. military.

Now, Washington’s automatic spending cuts have helped make it one of the first companies in the federal supply chain to report an unprecedented slowdown in government orders. Investors are signaling concern that it won’t be the last.

AeroVironment is among 18 small to mid-sized contractors in a Bloomberg index that has fallen 7.3 percent this year. That’s compared with a 6.6 percent gain in an index of the top 10 Pentagon vendors, led by Lockheed Martin Corp. (LMT:US) Investors have taken a “flight to size” to escape smaller defense firms more vulnerable to the budget squeeze, said Mark Jordan, a St. Louis- based analyst at Noble Financial Capital Markets.

“The wrong one or two contracts being radically truncated, for a small company could be very meaningful,” Jordan said in a phone interview. “For some of the larger ones it would kind of get lost in the shuffle.”

The across-the-board spending cuts triggered on March 1 would total $85 billion in the remaining seven months of the fiscal year, and $1.2 trillion over nine years, assuming Congress and the president don’t agree before then on an alternative.

The reductions would be divided equally between national security and domestic programs. They would hit military contractors the hardest, falling on top of $487 billion in Pentagon cuts already planned over 10 years.

Vulnerable Vendors

AeroVironment, based in Monrovia, California, is especially vulnerable because it gets 83 percent of its revenue (AVAV:US) from the federal government.

As demand surged from the Army, Marine Corps, Special Operations Command and Air Force, the company’s revenue (AVAV:US) more than doubled to $325 million in the year ended April 30 from fiscal 2006.

The firm surprised investors on March 5 by reporting a 35 percent drop in third-quarter revenue amid a slowdown in military orders. Shares of the company plunged 9.8 percent the next day.

“We’ve experienced acquisition delays in the past that have impacted planned revenues within a period, but never of this magnitude,” Chief Executive Officer Tim Conver said during a conference call with analysts.

Contract Slowdown

Conver said executives had factored in “the government budget process and sequestration uncertainty” as it planned for the fiscal year. They knew there would be delays in government contracting, he said.

Even so, the recent slowdowns are “way beyond our initial conservative factoring,” Conver said.

The Defense Department, for example, had approved 2012 funding for AeroVironment’s hand-launched Raven drones. It awarded a contract valued at as much as $65.9 million in May.

While the military has had that funding for more than 438 days, the contract has yet to be completed, Conver said. By comparison, the longest wait time for its Raven drones in the past four years was 161 days, he said.

Steve Gitlin, vice president of investor relations for AeroVironment, declined Bloomberg’s request to interview Conver about the effects of sequestration on the company.

Smaller companies are generally more susceptible to downturns and delays in federal spending because their work is mostly on a shorter cycle and tends to be focused on specific products that are shipped soon after they’re booked, said Michael Ciarmoli, an analyst with Cleveland-based KeyBanc Capital Markets Inc.

“The Lockheed Martins, the Northrop Grummans (NOC:US), the Raytheons -- their businesses are comprised of mostly long-term, fixed-price contracts,” Ciarmoli said. “They’ve got the ability to smooth out revenue volatility.”

‘Cripple Entrepreneurs’

For smaller companies, the across-the-board spending cuts will be another layer of hardship. They are on top of the other defense cuts and on top of years of unstable federal spending in which Congress has used stop-gap spending measures to keep the government operating.

The new reductions promise to slice into supplies and services, where smaller businesses “provide high value,” Maureen Schumann, a Defense Department spokeswoman, said in an e-mail.

“Sequestration will continue to erode the small business industrial base, cripple entrepreneurs, and reduce areas where the department needs to make investments to foster an environment of innovation,” Schumann said.

Budget Volatility

At Jo-Kell Inc., a small distributor based in Chesapeake, Virginia, inventory has swelled as the military has delayed orders for products such as circuit breakers and transformers.

“We’re concerned that contracts we have bid on might be pulled out from under us,” Chief Executive Officer Suzy Kelly said in a phone interview. “It’s not outside the realm of possibility that they would do that.”

The budget volatility is especially tough on small business owners now reluctant to expand their companies, said Kelly, whose firm is based near the world’s largest naval station in Norfolk, Virginia, and employs about 60 people.

Glenn Williamson, chief executive officer of engineering contractor KinetX Inc., said the year leading up to sequestration was “like water drip torture.”

Prime, or direct, contractors began putting “the squeeze” on smaller suppliers like Tempe, Arizona-based KinetX to reduce prices, said Williamson, whose company supplies engineers for work on military satellite and drone programs.

“The primes were getting a little bit of a jump on the game, if you will, with the supply chain,” he said in a phone interview.

Pay Cuts

In response, top management at KinetX took a 50 percent pay cut five months ago, he said. That came after a companywide, 10 percent salary reduction about a year ago, he said.

KinetX gets 85 percent of its revenue from prime vendors that include Chicago-based Boeing Co. (BA:US) and Falls Church, Virginia-based General Dynamics Corp. (GD:US)

As federal agencies delay work, prime contractors are putting off promises to subcontract, said Raj Williams, chief executive officer of Annapolis, Maryland-based Green Sensitive Design LLC.

“It’s a chain reaction,” Williams said.

Separately, her environmental consulting firm won a seat on a multiple award contract in November with the General Services Administration to provide energy consulting and maintenance service. She hasn’t received any work yet.

“We’re all in a holding pattern,” Williams said.

-- Editors: Stephanie Stoughton, Mark Rohner

To contact the reporter on this story: Kathleen Miller in Washington at Kmiller01@bloomberg.net

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


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Companies Mentioned

  • AVAV
    (Aerovironment Inc)
    • $35.77 USD
    • 0.31
    • 0.87%
  • LMT
    (Lockheed Martin Corp)
    • $159.44 USD
    • 2.05
    • 1.29%
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