Industry Market Trends

Shelter from the Sequester: How Manufacturers Are Surviving

Jun 12, 2013

Yesterday, IMT examined the sequester and how it is likely to affect U.S. manufacturing. The picture isn't complete for two reasons. For starters, the worst of the sequester's cuts have yet to hit. Second, many of the companies simply aren't speaking to the press on the topic.

As such, manufacturers' distress has been understated. Despite the sequester, the U.S. economy shows signs of life. The stock market is reaching record highs, the housing market is ticking upwards, and gross domestic product rose 2.5 percent rate in the first quarter of this year. The Congressional Budget Office predicts the deficit will shrink this fiscal year to $642 billion, or just 4 percent of gross domestic product. Thanks to the sequester, coupled with higher tax revenue and improved economic growth, the deficit has been shrinking by about $42 billion a month for the past six months.

Some are beginning to believe the sequester has been worth it. Most economists say it's too early to tell, since some federal agencies and the contractors that sell to them are merely furloughing now. But some may resort to workforce layoffs beginning next month.

Since there was ample warning that the sequester was on its way, many companies took steps to insulate their businesses as much as possible. Some manufacturers rushed to get contracts signed last year before the sequester went into effect and are in the process of fulfilling those contracts now, which means the cutbacks haven't hit their balance sheets yet. Others have diversified their portfolios beyond federal contracts while shutting down non-essential functions.

Many defense companies girded themselves against sequestration in advance by making acquisitions in areas such as unmanned aerial vehicles (UAV), computer security, health care IT, and C4ISR (command, control, communications, computers, intelligence, surveillance, and reconnaissance).

Specifically, Raytheon acquired cyber-security company Teligy, and General Dynamics acquired health care IT company Vangent, which has been winning call center contracts to enroll Americans in health care exchanges in advance of the Patient Protection and Affordable Care Act. Pratt & Whitney has been able to shift some focus from its government contracts to its private sector businesses.

"Pratt & Whitney's diverse portfolio enables us to balance between commercial and military programs in the short term," company spokesman Ray Hernandez told IMT.

The National Association of Manufacturers (NAM) told IMT that companies have been quietly but furiously doing what they could to prevent negative outcomes from the sequester.

"Companies started acting to protect themselves and make hard decisions last year," NAM spokesman Matthew LaVoie said, noting that a number of companies prepared by cutting some jobs and slashing executive pay.

Multinational manufacturing company Honeywell, which has large defense contracts with the federal government, told IMT that its diverse portfolio is helping the company to minimize the effects, and maintains that the sequester is serving an important purpose.

"Cuts to the defense budget are part of the overall reductions in government spending necessary to address the nation's debt issue," said Steve Brecken, a spokesman for Honeywell's aerospace division. "We have been anticipating and planning for sequestration for over a year, and to date, the impacts have been largely as we expected.  We do not anticipate any changes in our financial outlook nor any layoffs or furloughs due to sequestration, mainly due to our thoughtful planning and our large commercial aerospace businesses."

Smaller manufacturers that fill in gaps in the supply chain for the larger companies may feel the effects more acutely, as they don't have the kind of cash needed to acquire or launch new business lines. About 70 cents of each military purchasing dollar goes to supplier firms.

Pratt & Whitney's Hernandez noted that many of that company's suppliers are small businesses. As a result of sequestration, many will likely be forced to delay decisions on hiring and capital investments. NAM's spokesman LaVoie predicts that pressure on large contractors will cause ripple effects up and down other sectors of the industrial economy outside of the defense supply chain.

The the sequester is intended to trim the fat from a U.S. military budget that now exceeds $700 billion a year -- more than the next 12 nations combined. Out of necessity, the military will be forced to cull programs that aren't working and find alternatives to those that are too costly.

If the ultimate goal is to shrink the U.S. deficit, the sequester would appear to be working. However, the full impact to the U.S. economy from lost manufacturing coupled with reduced levels of research and development might not be seen for years, or even decades, to come.