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Overview


$1.6 trillion, or over 10% of GDP, political pressure has emerged that will likely force a budget reduction over the next few years. So far, the 2011 Debt Reduction Act mandates minimum


cuts of $350–$474 billion, spread between FY 2012 and 2021. Under the worst-case debt reduction plans, this could rise to $850 billion–$1 trillion, or up to $100 billion per year. Tese proposed cuts hit anticipated and planned growth,


not current FY budget levels. But the big unanswered question concerns how this top-line cut is distributed. Will it fall on the investment accounts (research and development, procurement) that fund the development and production of new weapons? Will it fall on operations and maintenance, or O&M (part of this funds the sustainment of weapons, but much of this funds fuel and other commodities needed to deploy and move forces)? Will it hit Personnel (which has no real impact on weapons)? At this point, it’s still too soon to know, but the defense


industry is bracing for at least half of the cuts to hit weapons procurement, and given the difficult experience of the post- Cold War defense downturn, this caution is understandable. Even with a serious hit to the investment accounts, these look


set to stay above their pre-FY 2007 levels. Also, assuming the Re- publican party wins back the Senate in 2014, these cuts might not happen at all. In fact, for purposes of Teal Group’s forecast, we as- sume that the procurement budget will stay roughly flat through FY 2016, although that’s using nominal, not real, dollars. But top-line budget trends matter less than the changing


dynamics of defense spending. Here, three trends threaten to make the impact of budget cuts much greater than the numbers indicate. Te first problem is inflating costs. Higher costs reduce


DoD’s buying power and threaten profits at contractors. While the US’s sluggish economy is generally not threatened by infla- tion, energy and health care costs and materials prices have remained stubbornly high. Tese three costs are among the top expenses for weapons contractors. Tus, even a freeze of investment accounts at present levels would still result in a likely erosion of DoD buying power and/or defense contractor profits. Te second problem is changing DoD contract terms. Te


accepted weapons acquisition contracts model—cost-plus con- tracts for development and early production, fixed-price con- tracts for full production—is giving way to a different approach that shiſts a greater risk and cost burden to the contractors. Te best illustration of this is Lockheed Martin’s F-35 Low-


Rate Initial Production Four (LRIP-4) contract. Historically, procurement contracts at this early stage of a program have been cost-plus, but F-35 LRIP-4 mandates a high level of over- run risk-sharing. Similarly, Boeing’s KC-46 aerial refueling tanker program was begun with a largely fixed-price contract, including development and production of about half of the aircraſt covered in the program of record. Meanwhile, the profit model is changing. Aircraſt program profits typically go from small at the development phase to


22 Aerospace & Defense Manufacturing 2013


medium at the procurement phase and high at the sustain- ment and upgrade phase. Not only are procurement contracts changing, but smaller programs mean smaller procurement phases. And a declining O&M budget means less sustainment activity—less money for spares, upgrades, and other high- profit sustainment activities. Te biggest problem with the budget is that there are too


many new programs that require funding. Another related problem facing DoD and industry is how to fund important new programs that fly in the face of perceived military needs. An unpleasant legacy of the past decade is the belief that the military is no longer a tool of superpower diplomacy but rather something to be used for fighting insurgencies in strate- gically marginal regions. Tus, over the past 10 years, procurement for body armor,


ambush protection vehicles, helicopters, and UAVs did very well. Traditional big-power capabilities, such as fighters, cargo aircraſt, and ships basically got the crumbs. Yet many of these capabilities, particularly fighters, were badly


taxed by high utilization rates. Unless cash is provided to recapi- talize the fleet, there will be difficult force structure choices ahead.


F-35 and Tacair: Big Questions Tactical aircraſt (tacair) present the biggest single challenge.


Lockheed Martin’s F-35 Joint Strike Fighter, the biggest defense program in world history, is at the center of the debate. Te question vexing tactical aircraſt funding is whether


it can attract a higher share of a declining funding plan. To sustain the current program of record, tacair would need to grow at a 7.1% CAGR. Tis assumes a maximum procure- ment rate by the Air Force of 70 F-35As per year. Teal Group’s forecast calls for a maximum F-35A procurement rate of 48 per year, which still requires a 3.7% CAGR. By comparison, FY 2003–2012 saw a mere 2.3% tacair CAGR. Our forecast assumes that the F-35B and F-35C programs


continue as per plan. But conceivably, budget concerns could derail either of these altogether. In July 2011, Navy Under- secretary Robert Work instructed the Navy and Marine Corps to look at alternatives to the F-35B and F-35C. Tis was the first time a senior DoD official implied that an F-35 variant was vulnerable to budget cuts.


The International Dimension Meanwhile, European governments have been far more ag-


gressive in cutting their already truncated weapons programs. Tis is largely due to the pressing nature of the Eurozone crisis. Te US faces long-term challenges, but many Eurozone countries are pressured to cut their deficits immediately. One problem with the European defense spending trends


is that they fund systems today, but they jeopardize the future with very severe cuts. Te best example of this is the UK Royal Air Force fighter plans. Te UK MoD is now short 20 billion


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