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The Government Shutdown Is Beginning to Cause Chaos for Defense Contractors

By Lou Whiteman - Updated Apr 17, 2019 at 10:52PM

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With the Pentagon open for business, don't expect any major contractors to report disruptions. But the shutdown has real-world impacts, prompting concerns about larger budget battles still to come.

As the partial government shutdown continues into its third week, the defense industry trade group and at least one government contractor are warning that the stoppage is beginning to take its toll. Investors would do best to hold tight and weather the storm for now, though the ongoing fight can be viewed as a warning about uglier battles looming on the horizon.

Numerous federal agencies have been closed since Dec. 22 after Congress and the White House were unable to agree on a spending bill. The Pentagon was one of a number of agencies that already had its fiscal 2019 funding secured and has not been directly affected. That means we are unlikely to see a repeat of what happened when the entire government was shut down in 2013, when contractors crafted plans to furlough thousands of workers while the negotiations played out.

Still, the industry is feeling the pinch. The Aerospace Industries Association in a statement said that there are "ripple effects." For example, with the Departments of State and Commerce closed, contractors can't get export licenses needed for certain weapons sales and transfers.

An aerial view of the Pentagon

The Pentagon is not shut down, but contractors are still feeling a pinch. Image source: Getty Images.

In addition, research projects at NASA, the Federal Aviation Administration, the National Oceanic and Atmospheric Administration, and other agencies are stalled. Much of that research is a combination of in-house work and third-party contracts.

Overall, government contractors are estimated to be losing as much as $200 million per day due to the shutdown.

"Every day the shutdown lasts, the impacts grow and become more difficult and more expensive to fix," AIA CEO Eric Fanning said in the statement. "It's time to get these dedicated public servants back to work."

Uneven impact

Generally speaking, during a shutdown outside contractors working on specific projects can continue work to a point where civil servant participation becomes necessary. But the government services businesses that provide IT, consulting, and related work to a range of agencies, including those impacted by the shutdown, face the difficult choice of either continuing to pay their workers to sit home, or cutting off funds at the risk of losing employees.

For large contractors, such as Lockheed Martin (LMT 0.67%) and Boeing, that have massive contracts with NASA and elsewhere, the work is likely complex enough that it can continue uninterrupted. Others, like Leidos Holdings (LDOS 1.57%) and General Dynamics (GD 2.34%), the two largest government IT vendors, should have enough scale and resources to ride out payment delays.

But some smaller contractors might not be so lucky. Execs at Science Applications International (SAIC 1.57%), for example, on Jan. 7 told investors that the government is nearly $50 million behind in payments, adding that payroll for workers affected by the shutdown comes to $10 million per week.

SAIC, which is in the process of acquiring Engility Holdings (EGL), is particularly exposed to this shutdown because its fiscal year closes at the end of the month. If the shutdown continues well into January, or if the government is slow to get back up and running and reimburse contractors, the company could fall short of the consensus analyst estimate of $1.13 billion in quarterly revenue.

"If we get through this quickly, they could catch up," SAIC CEO Tony Moraco said at during a pre-planned investor event. But given the current stalemate in Washington, the company appears to be working hard to prepare investors for a negative impact.

Other similarly sized or smaller contractors, including CACI International, ManTech International, and Perspecta, could also feel the effects of a prolonged shutdown, though all of them are well past the end of their fiscal years and therefore should have more time to recoup lost revenue.

Tread carefully

At some point the current shutdown will end, and the federal government is likely to catch up on the contractor payments it missed. Investors should be mindful of the potential impact on the current quarter and not overreact, but there should be no permanent damage.

Still, investors should take heed. The 2020 fiscal year budget negotiation, which does include the Pentagon, is on the agenda for the months to come, and there's been nothing out of Washington in the last six weeks to suggest that larger deal will come easy. Lawmakers need to reach an agreement to avoid a return of budget caps, which could cost the Department of Defense upwards of $100 billion in spending annually. If that were to happen, no contractor, no matter how big, would be immune.

There's an argument to be made that the shutdowns could eventually be a net plus for contractors. Longtime industry analyst Byron Callan, a managing director with Capital Alpha Partners, in a note following the SAIC meeting said Washington budget battles over time could make it harder for the government to recruit and retain skilled individuals, potentially deepening the reliance on third parties.

But that possibility is not immediate. For now, investors in contractors as big as Lockheed and as small as SAIC should batten down the hatches and hope lawmakers find a way to compromise.

Check out the latest SAIC earnings call transcript.

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Stocks Mentioned

Science Applications International Corporation Stock Quote
Science Applications International Corporation
$86.65 (1.57%) $1.34
Lockheed Martin Corporation Stock Quote
Lockheed Martin Corporation
$451.00 (0.67%) $3.01
General Dynamics Corporation Stock Quote
General Dynamics Corporation
$226.44 (2.34%) $5.18
Engility Holdings, Inc. Stock Quote
Engility Holdings, Inc.
Leidos Holdings, Inc. Stock Quote
Leidos Holdings, Inc.
$105.25 (1.57%) $1.62

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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