In previous LRN Risk Forecast Reports, I noted that government contracting requires a sharp calculation of risks versus rewards. Typically, that calculation has come out in favor of companies expending the necessary time and effort to maneuver a minefield of often complex and frustrating regulations in order to reap the financial benefits and stability associated with government contracting. For 2014, some companies might be recalculating their analysis and reconsidering whether the benefits still outweigh the risks of government contracting.
First, here’s a quick review of where we’ve been. The Budget Control Act (BCA) of 2011 required the federal government to reduce spending by more than $1 trillion by 2021. This amounts to cutting about $109 billion from the budget each year. To accomplish this, the BCA created the Joint Select Committee on Deficit Reduction (the “Super Committee”).1
“Sequestration” was the name given to the mandatory, across-the-board spending cuts (totaling about $1.2 trillion) that would occur automatically should the committee fail to compromise. As we know, there was no grand compromise, and Congress allowed the sequester to occur last year. Budget cuts were split equally between defense discretionary spending, non-defense mandatory (entitlement) and discretionary (non-entitlement) spending, without an increase in tax revenue. This represents about $55 billion in cuts from both the defense and non-defense budgets every year.2
Defense spending cuts were spread across all branches. While some programs were spared, other sections of the military have seen 7 to 10 percent of their budgets eliminated.
Non-defense spending cuts are typically program-specific and categorized as either mandatory or discretionary. Most mandatory programs such as Social Security, Medicaid, food stamps, and retirement benefits are currently exempt from reductions. Medicare is the exception, though cuts are capped at 2 percent per year ($11 billion in 2013) and limited to providers and insurers, not beneficiaries. The Government Accountability Office issued a decision on May 21, 2012 that Department of Veterans Affairs spending is exempt from sequestration (with the exception of limited administrative expenses).
Non-defense spending cuts were accomplished through broad reductions in funding for discretionary programs. Under sequestration, $1.2 trillion in budget cuts began on January 2, 2013, and are scheduled to continue through FY 2021.4
The BCA of 2011 also provided a way to avoid sequestration if Congress successfully acted to achieve equivalent deficit reduction savings. If Congress attained less deficit reduction savings than required, sequestration cuts could be reduced by the amount in savings actually realized. For example, if Congress created $80 billion in alternative deficit reductions, and the plan became law, the $1.2 trillion sequestration would be reduced by $80 billion.5
On January 1, 2012, the House passed a series of tax changes and revenue enhancements that avoided the “fiscal cliff” of across-the-board tax increases (the Senate passed the same bill late into the night of New Year’s Eve). This bill also delayed sequestration required by the BCA of 2011 by two months, literally “kicking the can” down the road for the new Congress to deal with in the first quarter of 2013.
As we all know too well, Congress failed to act. Instead of the 2012 “sequestration” process inspiring cooler heads to prevail, Congress failed to pass a continuing resolution to keep the government running after October 1, 2013, resulting in the first federal government shutdown since 1995.
Although the world as we know it did not end with the sequestration in 2012, for government contractors, the 2013 government shutdown was like a tornado ravaging a town after an earthquake. Many contractors had to lay off staff assigned to affected government agencies and programs, further straining their already anemic bottom lines. One large government contractor reported that the shutdown cost the government about $30 million, while others reported profit declines by more than 25 percent. Contractors that provide services to the government reported declining sales, and many warned that 2014 could be even worse.6 The few contractors who are improving their profits are doing so not by boosting their sales, but by managing their costs. That means declining employment, freezing or reducing salaries and benefits and an overall shrinking in contractor capability. As one contractor recently told the Wall Street Journal, “[d]oing business with the government is not for sissies.”7
Unfortunately, the worst may be yet to come. Several federal agencies found extra funds that helped them survive the automatic budget cuts in FY 2013, allowing them to minimize draconian terminations of contracts. For example, the Pentagon used more than $5 billion in unspent money from previous years to ease its $39 billion budget cut. The Department of Justice (DOJ) found more than $500 million in similar money. Agencies that have thus far withstood the harshest effects of the 2013 cuts are preparing for a second round in 2014 that will likely be worse than the first. Senate Appropriations Committee Chair Barbara Mikulski (D-MD) said that agency budget chiefs “squeezed everything to get through the first year, thinking we would come to our senses.” Unfortunately, that didn’t happen. Most of those accounting maneuvers were one-time steps. The automatic spending cuts in 2014 promise to be far more painful to both federal agencies and the contractors that support them.8
Congress recently passed a budget deal to avoid the political fallout from another government shutdown. Nevertheless, fundamental issues involving spending priorities have been put on the back burner, as neither house of Congress can agree on a long-term spending plan. As a result, it remains increasingly difficult for contractors to plan for a 2014 (and beyond) with declining budgets, continued threats of shutdowns and uncertainty in their programs.
Let the Buyer and Seller Beware
With the only certainty being future reductions in contracting dollars, today’s marketplace poses several new risk areas which government contractors, and those considering either buying a government contractor or entering the business for the first time, need to consider.
Buying a Government Contracting Business
In periods of market growth, it is common for companies or investors who have not traditionally played in the government market space to become active in this area. However, the main attraction of government contracting has been its stability in terms of revenue and profits. In this period of downturn, investors need to be exceedingly cautious about the underlying funding streams supporting company revenues. While this is often more stable in the case of prime contractors, it is less so for subcontractors. With a shift in government contracting strategy to “technically acceptable, lowest cost,” primes have little option but to cut costs, squeeze subs and even bring in-house certain functions that were previously subcontracted. Therefore, it is more important than ever for subcontractors to establish themselves as critical to a project, and for potential buyers to assess just how necessary they are given these external budget pressures.
Assessing Risks and Adjusting Prices
Government contractors with cost-reimbursable contracts often have six or more years where final costs and expenses have not yet been agreed to by the government (usually pending audit by the Defense Contract Audit Agency (DCAA)). The risk of contract adjustments unfavorable to the contractor increases as time goes on without a resolution. DCAA auditors, under pressure from Congress, are more aggressively questioning costs that could impact the final bottom line for companies. This could, or should, impact the analysis of the company’s value and the value of their future contracts as they enter into negotiations for mergers or acquisitions with outside companies.
Government contractors should continue to consider several possible impacts of budget reductions on the government procurement process:
There are several proactive steps government contractors can take to mitigate the risk of inevitable budget and contracting cuts in 2014, improve their competitive posture and survive the unpredictable environment that has become the “new normal” of government contracting:
The full LRN Risk Forecast Report can be accessed at: http://pages.lrn.com/risk-forecast-report-2014
1 Conference Report on H.R. 2112, Consolidated and Further Continuing Appropriations Act, 2012,
Congressional Record, November 14, 2011
2 Ousley, Jeff. Sequestration Could Have Serious Consequences for Military Members, Veteran’s United, August 7, 2012 (www.veteransunited.org)
3 Ousley, Jeff.
5 Martin, Willard. “Preparing for Government Sequestration and Budget Cuts,” Government Contracts Update, Winter 2012.
6 Larking, Tim. “Sequestration II: Expect Budget Rollercoaster In 2014”, Information Week, September 17, 2013
7 Needleman, Sarah, “Shutdown Means More Pain”, Wall Street Journal, October 17, 2013
8 Taylor, Andrew. “Automatic Spending Cuts Would Bite More in 2014.” Huffington Post, November 11, 2013.
9 Burroughs, Mark. “New World: The Future of Government Contracting”. Dixon, Hughes, Goodman LLP.November 2013
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Eric Feldman is recognized for his deep knowledge and expertise in government contracts and relationships. Eric retired from the Central Intelligence Agency (CIA) in 2011 with over 32 years of experience in Inspector General oversight and federal auditing in both the Executive and Legislative branches of government. Eric served in executive positions with the Offices of Inspector General at the Department of Defense, Defense Intelligence Agency, and CIA, and was the longest serving Inspector General of the National Reconnaissance Office (NRO) from 2003 to 2009.