The Department of Defense has issued guidance on how it will handle contractors that fall behind due to the ongoing COVID-19 coronavirus pandemic, reinforcing the Pentagon's push to make sure supply chains aren't crippled by the virus.
Defense contractors don't have the same concerns as consumer-facing businesses like airlines and restaurants, and should be expected to hold up well compared to many other industries if the pandemic sends the U.S. economy into a recession. But with companies, and their employees, navigating local shelter-in-place rules and other restrictions, the industry has been pressing for clarification on what contract rules will be enforced and how the Pentagon might view disruptions.
Kim Herrington, the Pentagon's acting principal director for defense pricing and contracting, in a memo to contracting officers urged flexibility in dealing with individual requests.
"Many contractors that ordinarily work side-by-side with the DoD workforce may be unable to access their work sites, and most contractors are coping with employees who are unavailable for work due to quarantine and state and local requests to restrict movement of their personnel," Herrington said. "We must do our utmost to ensure that both the Department and the vital industrial base that support us remain healthy for the duration of this emergency and emerge as strong as ever from the challenges of this pandemic."
Shoring up the foundation
Herrington's memo, in short, authorizes contracting officers to use common sense when evaluating individual requests, and generally recommends any request received be considered on favorable terms so companies are not penalized for issues beyond their control. While it is not blanket forgiveness and does allow for officers to determine if issues are the result of the pandemic or other factors, it should help alleviate contractor concerns.
Defense primes by and large have stable backlogs, ample cash reserves, and long-term contracts, but the Pentagon and its largest suppliers have signaled some concerns about the lower rungs of the supply chain.
Many second- and third-tier defense suppliers also have significant exposure to commercial aerospace, a sector that is expected to get hit particularly hard due to a dramatic slowdown in travel. Some of those companies are low-margin in the best of times.
The Defense Department on March 23 said it was increasing what it pays as work is done on contracts, a move designed to allow prime contractors to more quickly pay their subcontractors and help keep smaller companies liquid. The Pentagon is also working with the Small Business Administration on an emergency loan program for smaller contractors.
Lockheed Martin (NYSE:LMT) followed a few days later with an announcement that it intends to advance more than $50 million to small- and mid-sized suppliers to help keep them afloat during the downturn.
It's safe to get defensive
Defense pure plays like Lockheed Martin and Northrop Grumman (NYSE:NOC) are down more than 12% year to date, but that's about half the S&P 500's 2020 decline. Defense contractors are likely to be impacted by work stoppages and parts bottlenecks during the pandemic, but the government is unlikely to scale back its demand for armaments in a recession and the industry's tremendous backlogs appear safe.
The Pentagon is doing its best to keep business as usual through the slowdown, in March awarding a number of high-profile contracts on schedule. And just as important, the Defense Department is making it clear it is willing to work with the industry on any potential disruptions and is willing to spend to mitigate potential issues.
The industry's most important customer is sending a message it is willing to work with contractors through the crisis. Defense stocks are unlikely to rocket higher during a pandemic, but the sector appears a good safe haven for investors looking for opportunities while markets remain volatile.