The Economy

Federal-Contractor CFOs Brace for Sequestration

With almost $31 billion in contract dollars off the table for this year, at least for now, contractors must juggle sales, labor, pricing, and spend...
David McCannMarch 1, 2013

Across the country, federal contractors are swallowing. Hard. It’s the day they hoped would never come.

The debate as to whether and how much sequestration could damage the economy is in full force. But there’s not much debate that many of the contractors have trouble at their door or that their CFO will be hard-pressed to mitigate the fallout.

Defense contractors will bear a particularly large share of the burden. Of the $85.3 billion in automatic government budget cuts that begin today, the Defense Department will be socked with $40.8 billion. But of the $30.8 billion that would have gone to contractors, $23 billion is related to the DoD.

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Even if only a fraction of all contractors were affected, it would amount to a lot of companies. There were 154,277 of them that worked under primary federal contracts in 2012, according to USAspending.gov, a website launched by the White House as part of its “open government” initiative.

Smaller contractors, for which any substantial cuts would be damaging, may have particular reason to worry. “We’re not laying anybody off right now, but we’re concerned for sure,” says Hank Funsch, longtime CFO of defense contractor Dayton T. Brown and, for the past year, the company’s president. About two-thirds of its $40 million revenue comes from federal contracts.

Dayton T. Brown has some defense contracts for which it was expecting change-of-scope orders to fatten up its earnings on the deals. Of particular concern is a multimillion-dollar pact to develop a major piece of equipment for the Navy.

“We were expecting a change of scope and no problem getting the funding,” Funsch says. “Now all of a sudden [the Navy is] scurrying around trying to contain the scope of the project, because it looks like funding is going to be a big problem. That will hit our revenue significantly.”

Another big chunk of Dayton T. Brown’s earnings comes not from dealing directly with the government but rather as a subcontractor to mammoth contractors such as Lockheed Martin and Northrop Grumman. “We’re finding that they’re just slowing down their decisions,” says Funsch.

The company also has people who work on military bases alongside employees of the Army, Navy, and Air Force. While furloughs are expected to begin immediately for some government workers — who will, for example, be taking an unpaid day off per week for the foreseeable future — Funsch doesn’t know if the same will be required of contract workers. “So far, we’ve gotten no confirmation that we need to conform to that,” he says.

The uncertainty is forcing a change of focus for Funsch and the company’s divisional leaders. “We always have a balanced agenda, but it’s less so now,” he says. “We’re watching very carefully over the front end of our business: our quote activity, our outstanding quotes, what business we are going to land and when, and whether that’s going to continue as we burn through our backlog so that we can keep our workforce stable.”

Funsch does take heart that a third of Dayton T. Brown’s business is commercial, not government-related. That part of the business is growing. Indeed, many contractors are doing whatever they can to reduce their reliance on federal revenue. “They’ve been working on that for a year, and the better-prepared ones for two years,” says Vic Datta, managing director of FTI Consulting, which specializes in advising government contractors. “They’ve been watching this train coming at them for a while.”

To compensate for lost revenue, contractors can employ the usual tactics to cut discretionary spending: freeze hiring, delay capital expenditures, reduce travel and training. But if a deal to restore federal funding doesn’t come soon, many will have no choice but to slash their workforce.

Depending on how many people a company lays off, it might not be able to do so for more than two months. The federal Worker Adjustment and Retraining Notification (WARN) Act requires companies that lay off at least one-third of their total workforce or that of any business unit to notify those to be cut 74 days in advance. “WARN is expensive,” says Larry Lorber, a labor attorney with the law firm Proskauer.

Potentially even more expensive will be possible changes to existing contracts. “The question is, what is the government going to tell contractors?” says Lorber. “That it’s going to spread out its purchases under a contract over a longer period of time? If they do that, will the contractors be able to raise their price per unit? CFOs will have to be accepting of government-contract accounting and pricing.”

Contractors also may face legal actions as a result of cutting staff. Most government contracts require contractors to adhere to federal affirmative-action standards for employing certain protected groups of workers. That won’t change under sequestration, so the risk of being sued by people within protected groups claiming discrimination, always high after layoffs, may be even greater for contractors than for companies not subject to the federal affirmative-action standards. “You have to assume there will be litigation here,” Lorber says. He recommends that contractors provide fair severance packages — which typically require the employee to release the company from all future claims against it — to laid-off workers.

Another labor-related concern is the potential for jeopardizing the exempt status of professional employees, making them eligible for overtime pay. That could happen if a hard-pressed company were to, say, shut down operations for certain periods of time, thereby furloughing all employees, exempt and nonexempt alike.

Under the law, one requirement for exempting employees from overtime is that they be paid the same amount from pay period to pay period. Still, the Labor Department likely would not object if a company decided to, for instance, shut down for a month this summer, or one day a week for the next few months, says Seth Rafkin, a partner in the law firm Cooley LLP.

But “where you get in trouble,” says Rafkin, “is when you take an ad-hoc approach, shortening the work week for a week or two, then going back to full throttle, then shortening the week again.”

Are there any silver linings amid all these clouds? FTI’s Datta thinks so. “Being forced to cut back will probably right-size some of these contractors and allow them to become a little more flexible and variable,” he says. “They may be fat, dumb, and happy when a lot of cash is flowing and there is less reason to be streamlined. But now, how they structure their operating models may change for the better over time.”

Meanwhile, although Dayton T. Brown has revenue at risk, Funsch believes the potential for risk to the economy from sequestration is “overplayed.” After all, the $85 billion in cuts is but 2.3% of the government’s 2013 budget.

“I’m not in favor of across-the-board cuts. It should be done more intelligently and surgically,” Funsch says. “But the tax increases that took effect a couple months ago are worth a lot more dollars than this. It’s being overplayed by Washington, with each side pointing at the other, even though they all signed up for this thing together.”