* Core performance flat for second year running
* Program cuts from 2009 beginning to be felt
* Some firms may feel impact of tighter '12 defense budget
By David Alexander
WASHINGTON, July 26 With military spending stagnant and the Obama administration looking at billions of dollars in cuts, the U.S. defense industry faces belt-tightening and consolidation over the next few years as companies begin to feel the pain, analysts say.
Core performance among the top 105 defense contractors was flat for the second year in a row in 2010, Deloitte consulting firm reported last week, and new business booked by the companies was not enough to replace the revenue collected from completed contracts, suggesting another stagnant year in 2011.
"That's an indicator of the status of the industry, which is treading water at this point," said Tom Captain, Deloitte's vice chairman for aerospace and defense.
Loren Thompson, a defense analyst at the Lexington Institute think tank, said the industry was fairly healthy following a decade of growth in U.S. defense budgets. But program cuts two years ago -- like the termination of the Air Force's F-22 fighter and the Navy's future cruiser -- were beginning to affect the bottom lines of some firms, he said.
"Most of the cuts that are being made to work forces are pre-emptive rather than a reaction to major budget reductions," Thompson said. "However, the industry senses that tough times have begun and expects ... conditions to progressively deteriorate for some time to come."
Defense contractors may begin to feel the bite in 2012. President Barack Obama is asking for $689 billion in defense spending for the 2012 fiscal year, about $35 billion less than 2011 -- the first significant reduction in years. Congress may cut the military budget back even more as lawmakers wrestle with record budget deficits.
"We are now at the point where 2012 is becoming the year of defense funding contraction," said analyst Jim McAleese, of McAleese & Associates.
FIRMS ANTICIPATE DECLINE
While Obama has asked for an increase of more than $20 billion for the Pentagon's base budget, that amount is more than offset by the $41 billion decline in war funding due to the U.S. withdrawal from Iraq.
Some defense firms have already begun to anticipate the decline. Lockheed Martin (LMT.N) announced a voluntary layoff program for about 6,500 employees last week, a move that followed a series of cutbacks over the past year.
McAleese said Lockheed's action appeared aimed at reducing general and administration costs and trimming overhead, steps designed to make the firm more cost-competitive as well as contributing directly to the bottom line.
"The Lockheed thing is good corporate governance," McAleese said, adding there was no sign yet of an industrywide trend toward reductions. "Lockheed is getting out ahead of everybody else."
Lockheed, the Pentagon's No. 1 defense supplier by sales, topped Wall Street quarterly profit estimates in results reported on Tuesday as sales rose in its fighter jet and military plane division. [ID:nN1E76O14N]
McAleese said that due to the nature of defense contracts for big weapons platforms like Lockheed's F-35 Joint Strike Fighter -- the military's most expensive military hardware purchase -- the company was unlikely to feel the effects of any budget tightening for a year or two.
Purchases of hardware like aircraft carriers, strike fighters, transport planes and refueling aircraft are all "long-term in nature, so in any one given year it's very hard for a recession or decrease in funding to have a ... catastrophic effect on the industry," Captain said.
Signs of a defense budget cuts are likely to show up first in the business activity of service firms, McAleese said, because the Pentagon contracts for services within the year the funding is appropriated.
Service firms doing business with the U.S. Army are likely to be hit first, he added, because the Army will be hardest squeezed by reduced funding for the wars in Iraq and Afghanistan.
Budget cutbacks will inevitably hurt second- and third-tier defense firms, leading to pressure for consolidation as some less-profitable companies seek to exit the market and others look to gain scale to remain competitive.
"The stronger ones, the ones that have a more diversified customer base, the ones that are highly cost efficient and the ones that already have scale are the ones that are going to ... survive," Captain said.
Analysts said defense firms seeking ways to grow despite tighter Pentagon budgets would look increasingly to foreign markets or expanding areas of the U.S. military budget.
"You'll see quite a bit of effort being made in countries outside of the traditional Western alliance where sales of military weapons platforms are increasing," Captain said. "That's in the UAE, Saudi Arabia and India, in particular, and to some extent Japan and Brazil. India, for example, is going to be spending $80 billion over the next five years."
Defense companies also will be looking at new growth areas, such as cybersecurity, unmanned vehicles, mission software and intelligence, surveillance and reconnaissance. (Editing by Peter Cooney)