Defense Companies Bracing for Slowdown

With glitzy exhibits displaying model fighter jets, mock cockpits and flashy videos of missiles obliterating targets, major defense contractors came prepared to hawk their multimillion-dollar weapon systems.

But attendance on the exhibition floor at the annual Air Force Assn. conference last week was sparse. Air Force officials, the defense industry’s biggest customers, were packed into adjacent conference rooms instead, listening to ominous warnings of an impending slowdown in spending.

“The cuts are coming,” one defense analyst warned.

“It’s a troubling trend,” a top Air Force budget planner said.

In one of the association’s most somber gatherings in years, top generals joined with airmen, officers, defense contractors and military analysts to consider what could be the service’s last big increase in spending for the foreseeable future.

The mood was further subdued in the wake of the Air Force secretary’s decision to slash the number of airmen by 40,000, or about 12%, as a way to free up about $4 billion to help pay for new fighter jets.

“We believe it is our duty to make sure that if there is only one remaining airman, he will have the best equipment to fight the nation’s fight,” Air Force Secretary Michael W. Wynne told reporters after delivering the conference’s keynote address. At the same time, he lamented, “you can’t continue to cut the Air Force to pay your bills.”

In the aftermath of the 2001 terrorist attacks, the country has undertaken the biggest military buildup since the Reagan administration.

In fact, the Pentagon’s $447-billion budget for the next fiscal year, which Congress passed last week, is the largest ever, unadjusted for inflation.

But barring another major attack, Pentagon officials, contractors and analysts say, the military is about to enter a period of slowing spending on weapons amid protracted cost pressures.

Much like corporate America, the military has seen a dramatic increase in healthcare and other benefit costs. In the last decade such expenses have jumped 51%, well outpacing the rate of inflation.

Add the nearly $10-billion monthly bill to fight the wars in Iraq and Afghanistan, and the Pentagon has a “looming crisis in acquisitions,” said Major Gen. Frank R. Faykes, the Air Force’s deputy assistant secretary for budget.

“The resources being allocated to defense are beginning to level off ... at a time when we know we need to recapitalize,” Faykes said in an interview. He pointed to the graying of the Air Force’s fleet, with an average aircraft age of 24 years, up from about 10 years in 1971.

He added, however: “We’re not getting additional resources.”

To contractors, the message seems clear: Don’t expect the double-digit growth in defense revenue that the industry has enjoyed during the last five years.

“It does not sound good,” Darryl Davis, head of Boeing Co.’s advanced precision engagement and mobility systems unit, said of likely moves to curtail spending on research and development of new weapons. The St. Louis-based unit designs military aircraft and maintains a large workforce in Southern California assembling the C-17 transports for the Air Force.

Analyst Loren Thompson believes that the defense procurement budget will hit its peak this year and then begin a steep decline, perhaps as much as 25% in the next decade.

“The cuts will continue for some time,” said Thompson, of the Lexington Institute in Arlington, Va. “We are likely to see substantial cuts to investment accounts to compensate for the continuous rise in military healthcare and retirement benefits.”

A record backlog of orders -- $82 billion this year -- is likely to keep defense contractors busy for a while. But analysts say companies will be challenged to keep up the pace of profit and revenue growth they have enjoyed in recent years.

“People have been talking about the slowdown for a couple of years, but I think they’re feeling like we’re now at the edge,” said Byron Callan, aerospace analyst at Prudential Securities in New York.

Contractors, anticipating the changing budget landscape, have begun eyeing nontraditional defense businesses such as government information technology and border security.

Lockheed Martin Corp., the nation’s largest defense contractor, recently acquired two companies that provide data processing and facilities construction and management for the State Department.

The Bethesda, Md.-based company, better known as the maker of the F-22 fighter and the C-130 Hercules transport, these days generates about half its annual revenue from digitizing documents for the National Archives, automating mail handling for the Postal Service and other so-called systems and information technology businesses.

Northrop Grumman Corp. of Century City this year created a new business unit, technical services, that has gone after multibillion-dollar contracts to manage large government facilities such as the Los Alamos National Laboratory in New Mexico.

Boeing recently won a contract from the Department of Homeland Security, potentially worth $2.5 billion, to build a virtual fence of towers, sensors and cameras to detect incursions along the U.S.-Mexico frontier. The project could eventually extend to protecting U.S. coastlines as well, providing even more business for the Chicago-based company.

“You’re seeing people trying to adapt to a new environment,” said Robert H. Trice, Lockheed’s senior vice president for business development.

Boeing, the No. 2 defense contractor, said it was looking at other ways to leverage its military business.

For example, it is considering building a commercial variant of the C-17 that could be sold to air cargo companies.

Boeing estimates a market for 40 to 50 of the aircraft, which operators could use to transport heavy items such as oil rig equipment to remote areas that lack adequate runways.

The military version of the C-17 costs about $165 million.

A commercial market could help extend the C-17 production line in Long Beach several more years beyond its current expected 2009 closing.

But executives said Boeing would not venture far from its core competency in developing weapon systems. It is mindful of the defense industry’s record of failures in trying to diversify into commercial markets. Northrop once made buses; Boeing itself recently decided to get out of the business of providing Internet service to airlines.

The Homeland Security contract involves applying skills and technology that Boeing had already developed for defense customers, executives said.

“We’re going to stay close to the skill and expertise that we have in defense,” said George K. Muellner, head of Boeing’s Long Beach-based advanced systems business, which recently created an “adjacent markets” unit that will pursue homeland security, Coast Guard and civil government work. “We’re not going to be selling things at Wal-Mart.”

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peter.pae@latimes.com