Measuring the Impact of Sequestration and the Defense Drawdown on the Industrial Base, 2011-2015 PRELIMINARY FINDINGS MAY 2017
Dear AIA Colleagues: Since enactment of the Budget Control Act (BCA) in 2011, funding for the Department of Defense has been inadequate, arbitrary, unpredictable, and inconsistent. While the full impact of sequestration has been somewhat mitigated by short-term Congressional budget agreements, effects of the cuts have been felt widely in the defense industry. As we have asserted in our aggressive advocacy efforts, neither the government nor the private sector can operate efficiently under these conditions. The BCA requires the President to withhold ( sequester ) funds from discretionary appropriations to stay below arbitrary annual spending limits automatic, across-the-board cuts to government agencies, totaling $1.2 trillion over 10 years, split evenly between defense and domestic discretionary spending. The entire national security establishment has struggled to support its respective missions in response to these reductions. AIA has joined with the Center for Strategic and International Studies (CSIS), a prominent Washington D.C. think tank, in support of their study of the effects of the Budget Control Act of 2011 (BCA) on mid and lowertier suppliers that support key U.S. defense capabilities. Through analysis of publicly-available contract data, this study has sought to move beyond widespread anecdotes about the damage done by sequestration by determining the actual impact lost suppliers, program delays and other turmoil on the defense industrial base. To quote authors Rhys McCormick and Andrew Hunter: The results of this preliminary data analysis show that sequestration and the broader defense drawdown have made a measurable impact on the defense industrial base. Furthermore, the data show that the impact of sequestration and the defense drawdown has not been uniform across the entire defense industrial base. In the final phase of the research, the CSIS study team will expand its analysis to include additional platform portfolios and two additional research variables contract duration, and facilities-related services (FRS), equipment-related services (ERS), and training to explore whether sequestration and the drawdown have resulted in shorter contract durations, and what the impact has been on FRS, ERS, and training contracts during this period of market shock. We look forward to the completion of the final report this summer, and we expect its findings to become core elements of our persistent effort to promote robust, balanced and stable U.S. defense spending. On behalf of AIA and CSIS, I am pleased to present these initial study findings, encompassing three sectors of our industry: Aircraft and Drones, Missiles and Space Systems, and Electronics and Communications. AIA will continue to support this research as it examines other industry sectors, and we are grateful to our friends at CSIS for their work on this grave challenge to our industry. Sincerely, John Luddy Vice President, National Security Policy
MEASURING THE IMPACT OF SEQUESTRATION AND THE DEFENSE DRAWDOWN ON THE INDUSTRIAL BASE BY RHYS MCCORMICK & ANDREW HUNTER The United States has long recognized the importance of supporting and sustaining an advanced defense industrial base to maintain global technological superiority. 1 Maintaining a technologically superior industrial base requires a wide vendor pool from which to produce products, conduct research and development, and provide services for the Department of Defense (DoD). However, since the implementation of the 2011 Budget Control Act s (BCA) mandatory reductions to the federal budget, Congressional, DoD, government oversight, and industry officials all have expressed concerns over the health and future of the defense industrial base. These cuts affect not only the top tier of the industrial base (the prime contractors), but also the more numerous lower-tier suppliers (subcontractors) that are so often the sources of critical technological advances. Heavily dependent on subcontract awards from the prime contractors, some of these subcontractors face the risk of going out of business due to the drawdown. Funding associated with the wars in Afghanistan and Iraq has also declined steeply since 2011, further reinforcing and magnifying the effect of the BCA reductions. The combined effect of these reductions is what is referred to as the current defense drawdown (drawdown) for purposes of this project. The current public discussion surrounding the impact of the drawdown on industry is based largely on anecdotes lacking empirical support. Through analysis of publiclyavailable contract data, this research effort measures the impacts of the drawdown in three sectors - Aircraft and Drones, Missiles and Space Systems, and Electronics and Communications - to better understand how contractors have responded to this external market shock. For each platform portfolio, CSIS looked at four variables: Vendor Size: Did the share of contract obligations change among vendors of differing sizes, particularly small businesses? Vendor Count: Did the number of vendors change? Competition: Did competitions for contracts increase or decrease? DoD Component: Did DoD components (Services and agencies) respond differently to sequestration and the defense drawdown? ¹ Portions of this paper have been excerpted from the author s paper presented at the 14th Annual Acquisition Research Symposium hosted by the Naval Postgraduate School. For the original paper, see: Rhys McCormick, Andrew Hunter, and Greg Sanders, Measuring the Impact of Sequestration and the Defense Drawdown on the Industrial Base, (Monterey, CA: 2017 Naval Postgraduate School Acquisition Research Symposium, May 2017), https://www. researchsymposium.com/conf/app/researchsymposium/unsecured/file/144/sym-am-17-050-004_mccormick.pdf. 1
METHODOLOGY Given the naturally occuring volatility in contract obligations year-to-year due to contract award timing, etc., the study team focused its analysis on comparing average annual contract obligaitons from the start of the drawdown in 2012 through 2015. To establish context, the first study period looks at average annual contract obligations from 2010-2011; the second study period, throughout the drawdown, measures average annual contract obligations from 2012-2015. However, the graphs present the data for each fiscal year without averaging or smoothing. To analyze the breakdown of competitors in the market, the CSIS team assigned each vendor in the database to one of three categories. Any organization deisgnated as Small by the Federal Procurement Data System (FPDS) database was categorized as such unless the vendor was a known subsidiary of a larger entity. Vendors with annual revenue of more than $3 billion, including from nonfederal sources, are classified as Large. Due to their system integrator role and consistent market share, the study team placed the five largest defense contractors (Lockheed Martin, Boeing, Raytheon, Northrop Grumman, and General Dynamics) into a seperate category called "Top 5." Finally, any vendor assigned a unique identifier by FPDS but is neither Small nor Large is classified as Medium. DOD COMPONENTS HAVE RESPONDED DIFFERENTLY Across DoD, the response to the market shock imposed by sequestration and the budget drawdown differed among the various major DoD components, both in magnitude and response strategy. At the top line, average overall DoD annual contract obligations from 2012-2015 fell by 21 percent compared to the pre-drawdown period. Of the major DoD components, the Army bore the brunt of these cuts, suffering a 39 percent decline in average annual contract obligations over that same period, while the Air Force (-15 percent) fell at rates below the overall DoD rate of decline. Finally, the Defense Logistics Agency (DLA) (-7 percent), Navy (-12 percent), and Other DoD (-6 percent) fell at rates significantly slower than the overall DoD rate of decline, while the Missile Defense Agency (MDA) grew 12 percent over that same period. Figure 1: Platform Portfolio by Major DoD Components, 2010-2016 2
Among major DoD components, responses to sequestration and the defense drawdown differed. The Air Force, more than any other component, balanced the distribution of the cuts, but still elected to fund certain platform portfolios over others. As annual average Air Force contract obligations declined 15 percent during the drawdown, most Air Force platform portfolios fell at rates similar to the overall rate. The Army made cuts to every platform portfolio, but those cuts were not distributed evenly across the platforms. The Army Aircraft and Drones platform portfolio saw the smallest cut (-8 percent decline in average annual contract obligations), followed by Missiles and Space Systems (-22 percent), and Other R&D (-27 percent). To limit the cuts made in these platform portfolios, more severe cuts were made to Land Vehicles (-67 percent) and other lower profile categories. Finally, similar to the Army, the Navy elected to protect certain platform portfolios over others. However, unlike the Army, the Navy increased funding over previous levels for certain platform portfolios. As overall average annual Navy contract obligations decreased by 12 percent, average annual Navy contract obligations for Aircraft and Drones and Missiles and Space increased by 11 percent and 0.1 percent respectively. AIRCRAFT AND DRONES Average annual contract obligations in the Aircraft and Drones portfolio declined 4 percent compared to predrawdown average contract obligations. The predominant source of that decline was the 41 percent decline in annual average obligations for Aircraft and Drones R&D contracts. Annual average contract obligations for Products remained steady while Services (10 percent) grew over that period. 2 AIRCRAFT AND DRONES: VENDOR SIZE Under sequestration and the defense drawdown, the Top 5 vendors saw increases in both annual average contract obligations and market share in the Aircraft and Drones market. Between 2012 and 2015, average annual contract obligations going to the Top 5 increased by 3 percent compared to the prior period. Unlike the Top 5, Large vendors took substantial cuts in both market share and average annual contract obligations. During the drawdown, average annual contract obligations for Large vendors fell from $21.4 billion at the start of the drawdown to $17.8 billion by the end of the drawdown, a 17 percent decline. The share of contract obligations going to Small and Medium vendors remained relatively steady throughout the drawdown, 5 and 8 percent respectively. Over the same period, total average annual contract obligations for Medium vendors increased by 2 percent, while average annual contract obligations for Small vendors fell 12 percent. Figure 2 shows Aircraft and Drones by vendor size from 2010 to 2016. ² The overall DoD contract spending peaks in 2009 with the drawdown beginning in earnest in 2012. However, Aircraft and Drones platform contract obligations are an exception that peaks that year. Removing 2012 from the post drawdown period, average annual contract obligations for Aircraft and Drones declines by 10 percent as compared to the 2010-2011 period from 2013-2015. 3
Figure 2:Aircraft and Drones Contract Obligations by Size of Vendor, 2010-2016 Top Five Large Medium Small AIRCRAFT AND DRONES: COMPETITION Under sequestration and the defense drawdown, the historical trend of increasing contract obligations awarded without competition in the Aircraft and Drones sector accelerated. Between 2000 and 2010, only 26 percent of Aircraft and Drones contract obligations were awarded after effective competition, while 67 percent of contract obligations were awarded after no competition. 3 Between 2012 and 2015, the share of annual average contract obligations awarded after effective competition fell to 18 percent, while the share of annual average contract obligations awarded without competition increased to 79 percent. Figure 3 shows Aircraft and Drones by competition classification from 2010 to 2016. Figure 3: Level of Competition for Aircraft and Drones Contract Obligations, 2010-2016 Degree of Competition ³ CSIS uses the term 'effective competition' to refer to competition with 2 or more offerors. 4
AIRCRAFT AND DRONES: VENDOR COUNT As shown in Figure 4, the number of vendors in the Aircraft and Drones sector increased over the course of the defense drawdown after initially declining. This result is somewhat surprising given that since 2005, except for 2008, the number of vendors in the Aircraft and Drones sector had been declining compared to the previous year, reaching approximately 6,100 vendors in 2010. This decline continued until 2014, when there were under 5,700 vendors in 2014, a 7 percent decline from 2010. However, beginning in 2015, the number of vendors in the Aircraft and Drones sector increased by 6 percent, to approximately 6,050. Looking at vendor count, the decline mostly occurred among the Medium and Small vendors. In the case of Small Vendors, the drawdown only continued the downward trend in Small Vendor count since 2008. During the beginning of the drawdown, the number of Medium vendors fell slightly below pre-drawdown levels. Both Medium and Small vendor counts began to rebound in 2014. Figure 4: Aircraft and Drones Vendor Count by Vendor Size, 2007-2016 Vendor Count Fiscal Year 4 Vendor Size ⁴ 'Large+' combines the CSIS vendor size categories Top 5 and Large into a single category for vendor DECEMBER 2015 5 AIA YEAR-END REVIEW
MISSILES AND SPACE SYSTEMS In the Missiles and Space Systems sector, average annual contract obligations during the defense drawdown declined 11 percent as compared to pre-drawdown average contract obligations. The predominant source of that decline was the 39 percent decline in annual average contract obligations for Missiles and Space Systems R&D contract obligations. Annual average contract obligations for Products increased slightly (3 percent) while Services grew significantly (37 percent) over that period. MISSILES AND SPACE SYSTEMS: VENDOR SIZE Under sequestration and the defense drawdown, average annual contract obligations for Missiles and Space Systems vendors of all sizes decreased, albeit unevenly. The Top 5 saw the smallest decline (-8 percent) followed by small vendors (-14 percent). Large vendors (-24 percent) and Medium vendors (-22 percent) saw declines significantly higher than the overall rate of decline. As Figure 5 shows, vendors of all size saw declines in average annual contract obligations, the Top 5 increased their share of Missiles and Space Systems sector at the expense of every other vendor size category. Throughout the drawdown, the Top 5 share of the Missiles and Space Systems sector increased from 78 percent to 81. Meanwhile, all other categories lost market share. Figure 5: Missiles and Space Systems by Vendor Size, 2010 to 2016 Top Five Large Medium Small 6
MISSILES AND SPACE SYSTEMS: COMPETITION During most of the drawdown, the Missiles and Space Systems platform portfolio saw a decrease in the share of contract obligations awarded after effective competition as shown in Figure 6 below. In the years prior to the start of the drawdown, 63 percent of contract obligations were awarded without competition. Throughout the drawdown, the percentage of contract obligations awarded after no competition rose from 63 percent to 71 percent. As the share of contract obligations awarded after no competition increased, the share of contract obligations awarded after effective competition and the share of contract obligations awarded with just one bidder fell from 30 percent to 24 percent, and 7 percent to 5 percent, respectively. Figure 6: Level of Competition for Missile and Space Systems Contract Obligations, 2010-2016 MISSILES AND SPACE SYSTEMS: VENDOR COUNT Shown in Figure 7 below, the number of vendors in the Missiles and Space Systems sector had been gradually decreasing since 2009, but declined sharply (13 percent) after the drawdown. Throughout the drawdown, the average number of vendors declined by approximately 16 percent. Small and Medium vendors bore the brunt of this decline, falling by 13 percent and 16 percent respectively compared to the 8 percent decline in the number of Large+ vendors. Figure 7: Missiles and Space Systems Vendor Count by Vendor Size, 2007-2016 Vendor Count Fiscal Year Vendor Size 7
ELECTRONICS AND COMMUNICATIONS In the Electronics and Communications potfolio, average annual contract obligations during the defense drawdown declined 26 percent as compared to predrawdown average annual contract obligations. Compared to the other platform portfolios analyzed in this paper, the cuts in Electronics and Communications were more evenly distributed between Products (-23 percent), Services (-27 percent), and R&D (-32 percent). ELECTRONICS AND COMMUNICATIONS: VENDOR SIZE Over the course of the drawdown, the cuts in the Electronics and Communications platform portfolio disproportionaly affected the Top 5 and Large vendors in 2010, as shown in Figure 8. In 2010, the Top 5 and Large vendors were awarded $17.0 and $21.0 billion; in annual average Electronics and Communications contract obligations respectfuly. At the end of the drawdown, the Top 5 and Large vendors were awarded $11.7 and $ 13.9 billion in annual average contract obligations respectively. Which represented a 32 percent and 34 percent decline respectively. By contrast, Small vendors experienced cuts smaller than the overall rate of decline. At the start of the drawdown, DoD awarded Small vendors $10.8 billion in average annual contract obligations across the Electronics and Communications sector. At the end of the drawdown, Small vendors received $9.9 billion in average annual contract obligations, an 8 percent decline. Of note in Figure 9, the rise in the share of Electronics and Communications contract obligations awarded without competition is driven both by declines in average annual contract obligations awarded after effective competition (-21 percent), and by an increase in average annual contract obligations awarded without competition (+3 percent). At the start of the drawdown, DoD awarded an average of $51.9 billion in annual Electronics and Communications contract obligations without competition. At the end of the drawdown, average annual contract obligations awarded without competition had grown to $53.6 billion. 8
Figure 8: Electronics and Communications Contract Obligations by Size of Vendor, 2010-2016 Top Five Large Medium Small ELECTRONICS AND COMMUNICATIONS: VENDOR COUNT Throughout the course of the drawdown, the decline in the number of vendors in the Electronics and Communications sector accelerated before slowing down in 2014 as shown in Figure 10. Compared to approximately 18,000 vendors in 2009, there were approximately 14,000 vendors in 2014. The declining trends in vendor counts impacted vendors of all sizes, but Small and Medium vendors saw steeper percentage reductions. Comparing average number of vendors in the years at the start of the drawdown and then throughout the drawdown, the number of Medium vendors fell 15 percent, Small vendors fell 17 percent, and Large+ vendors, fell 6 percent. Figure 9: Level of Competition for Electronics and Communications Contract Obligations, 2010-2016 9
Figure 10: Electronics and Communications Vendor Count by Vendor Size, 2007-2016 Vendor Count Fiscal Year Vendor Size 10
CONCLUSIONS Vendor Size: Did the share of contract obligations change among vendors of differing sizes, particularly small businesses? The data match previous CSIS analysis showing that changes in share the share of contract obligations among vendors of differing sizes depended on the sector of the defense industrial base. In the Aircraft and Drones sector, the Top 5 vendors maintained and expanded their market shares how that the changes in during the recent defense drawdown at the expense of Large vendors. In the Missiles and Space Systems sector, the Top 5 vendors expanded their market share at the expense of vendors of all sizes. Finally, in the Electronics and Communications sector, Small and Medium sized vendors increased their market share at the expense of Top 5 and Large vendors as a result of average annual contract obligations declining at rates below the overall sector rate of decline. Competition: Did the share of contract obligations awarded after effective competition change? The data show that sequestration and the drawdown have had different impacts on the rate of effective competition within the various sectors of the defense industrial base. The decline in the rate of effective competition and subsequent rise in the share of contract obligations awarded without competition in the Missiles and Space Systems sector matches the trends seen in the Aircraft and Drones sectors. However, the rate of effective competition within the Electronics and Communications sector remained relatively constant despite the DoD overall topline declining 26 percent. Furthermore, the rise in the share of average annual contract obligations awarded without competition came largely at the expense of singleoffer bids, one of the broader DoD goals throughout this period. Vendor Count: Did the number of vendors change? The vendor count data, when combined with the competition and vendor size data, show three distinct trends. The Aircraft and Drones sector saw fragmentation in the market throughout the defense drawdown. Though the number of Aircraft and Drones Small vendors begins to increase in 2014, those Small vendors are competing for a smaller share of the sector. In the Missiles and Space Systems sector, the data suggests the market is experiencing consolidation. Throughout the drawdown, the rate of effective competition, the number of Small and Medium vendors competing in this sector, and the market share of Small and Medium vendors all declined at the expense of gains for the Top 5. The final platform portfolio, Electronics and Communications, experienced a decline in the number of Small vendors, but those remaining competed for an increasing share of the market. When combined with a steady rate of effective competition throughout the drawdown, the data suggests that the Electronics and Communication sector remains relatively healthy despite some consolidation. Summary and Next Steps The results of this preliminary data analysis show that sequestration and the broader defense drawdown have made a measurable impact on the defense industrial base. Furthermore, the data show that the impact of sequestration and the defense drawdown has not been uniform across the entire defense industrial base, with each sector analyzed in this paper responding differently. In the final phase of the research, the CSIS study team will expand its analysis to include additional platform portfolios and two additional research variables contract duration, and facilities-related services (FRS), equipmentrelated services (ERS), and training to explore whether sequestration and the drawdown have resulted in shorter contract durations, and what the impact has been on FRS, ERS, and training contracts during this period of market shock. About the Authors Rhys McCormick is a research associate with the Defense- Industrial Initiatives Group at the Center for Strategic and International Studies. Andrew Hunter is the director of the Defense-Industrial Initiatives Group and a Senior Fellow in the International Security Program at the Center for Strategic and International Studies. This material is based upon work supported by the Naval Postgraduate School Acquisition Research Program under Grant No. N00244-16-1-0002. The views expressed in written materials or publications, and/or made by speakers, moderators, and presenters, do not necessarily reflect the official policies of the Naval Postgraduate School nor does mention of trade names, commercial practices, or organizations imply endorsement by the U.S. Government. 11
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