Defense downturn should be manageable.

• Author: Erwin, Sandra I.
• Position: Defense Watch

The defense industry lobby made a strategic miscalculation by using job-loss scare tactics in the fight against Pentagon budget cuts. The sequester in 2013 did not result in massive unemployment, and the profits of top Pentagon contractors experienced historic highs.

The bipartisan budget agreement that essentially freezes defense spending for 2014 and 2015 gives the industry some relief It also will compel Pentagon contractors to make key decisions about their long-term future.

The realization that there will be no big-time industry collapse--and that the downturn will happen in dribs and drabs--should spur the defense industry to plan smarter strategies so it can survive lean times and lay the groundwork for future growth, analysts suggest.

The budget deal that Congress approved last month provides much needed clarity following nearly three years of frustrating gridlock and virtual paralysis in the defense sector.

The defense market is on an inevitable downward slide, but not headed over the cliff.

After Pentagon spending peaked in 2010, industry waited for the other shoe to drop. The reality has been a softer landing. In 2012, the top 20 U.S. defense contractors experienced a 3.3 percent reduction in revenues. Through the first nine months of 2013, the top 20 saw revenues dip by 2.5 percent, according to estimates by the consulting firm Deloitte LLP. For 2014, sales are projected to slip by 2.5 to 3 percent. "It's a slow drip," says Tom Captain, vice chairman of Deloitte's aerospace and defense sector. Without the fear of a precipitous plunge, the industry now has an opportunity to make a "strategic change," he says.

Top defense firms have performed well financially, above Wall Street's expectations, by playing by the rules of corporate efficiency--shrinking staffs, closing facilities and buying back their stocks. Companies, however, need a sustainable strategy for long-term growth, Captain says. That means they will have to make investments, either through mergers and acquisitions, or by funding next-generation technologies that hold promise of a big future payday.

A much-anticipated wave of corporate mergers, acquisitions and selloffs in the government contracting sector should begin in 2014, Deloitte analysts predict, although there will not likely be any blockbuster deals involving the top five Pentagon contractors.

The restructuring might not make big headlines but could, over time, reshape the industry in significant ways. Some...