Pentagon policy to withhold cash sends industry scrambling

By Aaron Gregg / The Washington Post

WASHINGON — The defense industry is reacting sharply to a new policy that could push the Pentagon to pay contractors less money up front when it buys major weapons systems and instead link payments more closely to key production milestones.

If implemented, the new policy, which the Defense Department proposed late last month, could lower the amount of government funding contractors receive when they incur large costs in the early phases of a contract. Under a policy in place since 2001, such payments typically cover 80 percent of those costs. The new policy would slash that rate to 50 percent.

Instead, the Defense Department wants to tie payments to a set of performance measures, rewarding contractors for completing deliveries on time or maintaining quality. The rule would also add new restrictions for companies convicted of fraud.

The Pentagon plans to implement the new rule by the end of the year.

The Defense Department argued in its proposal that the current system has failed to account for historically-low interest rates that have made it easier for contractors to finance projects on their own. Progress payment rates were set in 2001 and haven’t changed, even though interest rates have been close to zero since 2008.

The Pentagon “has been providing financing in excess of that warranted based on the historically low interest rates in effect since 2008,” the Defense Department wrote in its justification for the new rule. The new policy “will result in savings [of] hundreds of millions of dollars to the taxpayers by eliminating an unintended consequence of the past practice associated with providing contract financing in excess of what was necessary.”

Stock prices swooned industry-wide this week after Bernstein analyst Douglas Harned drew attention to the issue in a research note. Northrop Grumman shares dropped 3.5 percent Thursday; Lockheed Martin fell 1.8 percent; General Dynamics fell 0.56 percent; and Raytheon fell 2.1 percent.

“We believe if the new proposal is implemented, it could have a significant negative impact on defense contractor cash flows,” Harned wrote.

For defense investors, the policy is an unwelcome blip in a long rally, with Boeing leading the stock market’s rally since 2016. Initial worries that the Trump administration would take a tougher stance toward government contractors – spurred on by early presidential tweets criticizing Boeing and Lockheed Martin for cost overruns — have so far done little to hurt the industry.

Instead, defense contractors have been awash in cash, thanks to new defense spending under a Republican-controlled Congress and a tax overhaul that slashed their corporate tax rates.

Defense stocks are viewed as among the most recession-proof assets on Wall Street, owing to the industry’s reliance on government spending. But the possibility of a government shutdown later this month, and the prospect that defense budgets could shrink if Democrats retake Congress in November, have injected new uncertainty into the sector.

“For people that are counting on that predictability, (the new financing rule) is coming as a bit of a shock,” said Byron Callan, a stock analyst with Capital-Alpha partners. “I think the market just kind of woke up to it in the last 48 hours.”

Industry associations that lobby on behalf of defense contractors vowed to fight the new policy, arguing that it will discourage innovation, distort competition and punish contractors who take on difficult or risky projects in service of U.S. national security. At a public meeting Sept. 14 held by the Defense Department, the three largest trade associations representing government contractors all asked for the rule to be rescinded. (A Defense Department spokesman did not return a request for comment on industry’s reaction to the proposed rule.)

Alan Chvotkin, executive vice president of the Professional Services Council, argued that the rule would create new risk for contractors and would fail to achieve the Pentagon’s goal of rewarding better performance.

Wes Hallman, senior vice president at the National Defense Industrial Association, said in a statement that the new rule would discourage the most advanced companies from working with the government, ultimately damaging the technological prowess of the U.S. military. “Reducing research and development and innovation-focused financing will hurt industry’s ability to assist the Defense Department in its modernization efforts,” Hallman said. “It could further impede our ability to keep pace with our near-peer competitors around the globe.”

Aerospace Industries Association vice president John Luddy said the rule would undermine the national security strategy announced this year by Defense Secretary Jim Mattis, which de-emphasized counterterrorism in favor of competing with Russia and China in a great power competition.

“By reducing financing early in a contract, this rule would limit the working capital of industry to do the exact things that help us innovate and ‘move at the speed of relevance,’” Luddy said in an email, alluding to an earlier statement from Mattis. “If this rule goes into effect, the impacts will be significant and detrimental for the companies in our industry.”