The Pentagon’s supply chain faces an economy under siege

By: Valerie Insinna and Aaron Mehta

WASHINGTON — On the morning of April 2, companies up and down the Pentagon's supply chain got an email from Eaton Aerospace, a mid-tier supplier that provides parts such as fuel pumps and hydraulics to defense primes for aircraft like the KC-46 tanker and F-35 Joint Strike Fighter.

“The truly unprecedented situation with [the coronavirus] COVID-19 is jointly affecting our business, families and communities we live in,” said one such email, which was obtained by Defense News. “While the health and safety of our employees and those of our supply partners remains paramount, our industry is significantly impacted. ... As a result, our Eaton Grand Rapids, [Michigan], plant will [be] closed starting April 4, 2020 and will reopen on April 13, 2020."

Similar emails for other locations followed.

In a statement, Eaton Corp. spokeswoman Margaret Hagan acknowledged that the company was temporarily implementing closures “at a few sites,” but maintained that there would be no impact to the “critical support” provided to the U.S. military.

“We've made the important decision to maintain operations during the COVID-19 crisis because Eaton products are critical to our global infrastructure,” she said. “As a strategic supplier of aerospace fuel, hydraulic, motion control, electrical and engine solutions for the aerospace and defense sector globally, Eaton's aerospace products and support services are vital not only to the military, but to the transport of passengers and goods around the world.”

Although perhaps not a household name in the defense sector, Eaton is far from a small business, bringing in more than $21 billion in sales in 2019. However, the quiet closure of its production lines illustrates how widespread the impacts of COVID-19 have reached — past the major prime contractors like Boeing, or even its major subcontractors like Spirit AeroSystems, and to the large and small companies that populate the middle and lower tiers of its supply chain.

“The whole supply chain is a mess right now,” said an employee of one electronics manufacturer that provides components for both commercial and defense products. The source, whose name and company affiliation Defense News is withholding to protect the individual from reprisal, described challenges with working from home and retaining workers on the production line. Some colleagues, the source said, are choosing to take paid leave or voluntary layoffs rather than risk exposure to COVID-19.

“We are at 20 percent capability,” the source said.

According to Jeremy Bash, a former Pentagon official now with Beacon Global, “there is deep concern among industry and department leaders that the second- and third-tier suppliers need to be protected."

“There's a sense DoD [the Department of Defense] needs better visibility into the supply chain, mapping out how a part makes its way into a plane or ship," Bash added. “There is a growing number of tech companies providing software to illuminate supply chains, and since COVID, the phones of those companies have been ringing off the hook because the department now realizes supply chain concentration is a huge risk.”

ndustrial shock waves

But one doesn't have to dive down the supply chain toward Eaton to see that the defense market is taking a beating, particularly the companies that also have a strong exposure to the commercial market.

Up until last month, financial analysts would have seen commercial sales as a major boon to the overall health of a defense supplier, but that has changed, as the economy has taken a nosedive, said Richard Aboulafia, a defense and aerospace analyst with the Teal Group.

“The commercial market is under siege, which means of course there is excess inventory, slumping revenue, major challenges on many levels,” he said. "On top of that, everybody faces the immediate impact of social distancing and workforce concerns. And on top of that, if you're heavily exposed to commercial, the harder time you might have getting credit. All of these are big issues.

"The defense-industrial base, if it could somehow be removed from commercial aviation, we'd be in pretty good shape by the standards of the world economy. But we can't. They're intertwined.”

Bloomberg reported Monday that Airbus sent a letter to employees over the weekend, warning that gaps in the supply chain, among other issues, will impact the company's ability to resume normal operations.

Also on Monday, simulation firm CAE announced it was temporarily laying off 2,600 of its 10,500 global employees, while placing another 900 employees on a reduced work week. The company also instituted salary freezes and reductions for remaining staff, ranging from 50 percent for the CEO and executive team down to 10 percent for regular employees. Roughly 40 percent of CAE's overall revenue comes from defense contracts, according to the Defense News Top 100 list.

Boeing, meanwhile, extended a shutdown of its Puget Sound, Washington, facilities, while also stopping work at its rotorcraft production line in Philadelphia, Pennsylvania. As a result of the Puget Sound shutdown, Spirit AeroSystems announced last week that it is halting work at a number of locations.

Small businesses that form a core of the Pentagon's future technological development may be particularly vulnerable, according to government data and analytics firm Govini. In a new data sheet, the company noted there are roughly 50,000 small businesses that provide innovation support for the DoD, all of which is vulnerable to economic upheaval.

“If this ecosystem suffers widespread failure due to COVID-19, the resulting impact will stretch well beyond short-term disruptions,” Govini said. “These vendors are not just critical links in the DoD supply chain important for immediate purposes. They are also vital for the development of both next-generation systems in the midterm and revolutionary capabilities that will shape the competitive landscape for decades into the future.”

Between fiscal 2015 and fiscal 2019, roughly 28 percent of defense spending on underwater unmanned vehicles — a key part of the U.S. Navy's plan to build a fleet of the future — went to small businesses, according to Govini numbers. Small business contracts also accounted for 30 percent of the DoD's research on artificial intelligence during that same time period.

Martijn Rasser, a senior fellow at the Center for a New American Security, warned Defense News last month that “for small business, a shutdown would be extremely difficult to get through because even with bailouts and economic stimulus, once those businesses close up, its really hard to get those started again.”

“If an airline goes out of business, the planes don't disappear — you can start over. If it's a highly specialized manufacturing company, those employees are going to disperse and try to find other work. So I think that's something to be very cognizant of because of all the consolidation in the defense industry,” he added. “If they have to curtail operations for an extended period of time, it's extremely difficult to get it going again.”

What's the Pentagon's response?

Starting March 20, the Pentagon began issuing guidance on how to support industry. But a three-day span last week showed how those efforts remain a moving target, particularly in relation to the smallest suppliers.

On March 30, the department's acting director of defense pricing and contracting, Kim Herrington, issued guidance to contracting officers that essentially said industry should not be penalized for missing performance targets as a result of the ongoing pandemic.

“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,” Herrington wrote.

But some in Congress feel the department is still not doing enough to clarify policy changes for contracting officers and defense companies. On April 1, a group of Ohio lawmakers wrote to Defense Secretary Mark Esper and Under Secretary of Defense for Acquisition and Sustainment Ellen Lord, warning that “we are concerned that guidance to the defense contractor workforce remains ambiguous and lacks uniformity in application,” particularly in terms of communication from department contracting officers to small companies.

Over the past several years, the Pentagon has worked to delegate decision-making authorities to low-level contracting officers. But while that may work to empower contracting officers to find creative solutions to problems under normal circumstances, during a pandemic, these officials are ill-prepared to decipher “uncertain, often conflicting guidance,” the lawmakers said.

The lawmakers asked that contracting officers be directed to ensure that contractors are allowed to work remotely to the maximum extent possible; that contractors be given “maximum flexibility to meet their contractual obligations”; that efforts be made to not have “avoidable reductions” in the workforce; and that companies involved in research and development work be clearly labeled as essential personnel.

And on April 2, two trade groups — the National Defense Industrial Association and the Professional Services Council — asked Congress to instate a six-month delay for a legal requirement included in the 2019 National Defense Authorization Act that prohibits the government from doing business with companies that work with vendors Huawei and ZTE.

That language “will impose significant financial and operational costs on medium- and small-sized firms at a moment of substantial uncertainty and hardship,” at a time when they are dealing with the economic impact of the coronavirus pandemic, the letter stated.

Later in the day, the DoD released a statement providing clarification on previous announcements.

The department confirmed that higher progress payment rates — which had been jumped the previous week — will apply to already completed work, and not just future production. The new cash-flow rules should result in more than $3 billion in new cash moving into industry, according to department estimates. But that prediction came with a warning: The Pentagon “has high expectations that that prime companies are ensuring cash flow is moving to small businesses in their respective supply chains who need it most.”

So far, the Defense Contract Management Agency has modified approximately 1,400 contracts with increased rates, the announcement noted. Contracting officials are working to ensure invoices at the higher progress payment rate keep arriving on time, with the department claiming there have been “no reported delays on contractor submitted invoices.”

The announcement also stated that any delay related to COVID-19 issues will result in “an equitable adjustment of the contract schedule and cost,” meaning the department will adjust the contracts so that the vendor does not take an economic hit.

The steps taken by the department are important, said Bash, the former Pentagon official. “The most powerful force the government can bring to help these companies is to say to industry: ‘We have money,' ” he said.

A wildcard, Bash noted, is the $17 billion in national security-focused funding made available under the most recent stimulus package passed by Congress.

However, Byron Callan, an industry analyst with Capital Alpha Partners, warns that more money doesn't necessarily mean less problems.

“The DoD faces the same issues as any other branch of the government or the Fed that is providing more cash to address the crisis — if people aren't at work because of COVID-19, that cash won't help much in keeping a factory or office open and all projects on schedule," Callan said.

For Aboulafia, increasing the value of progress payments is a good first step for increasing the flow of cash to suppliers.

“In times like this, it really is about access to cash because of the risk of credit markets freezing up for commercial companies. Accelerated payments, maybe loan guarantees should be considered," Aboulafia said.

But he's realistic that the defense industry isn't the only issue on the table for the Trump administration.

“I think there's a lot that government can do,” Aboulafia said. "Unfortunately there's a lot that government has to do because the entire economy has been put into a medically induced coma.”

https://www.defensenews.com/coronavirus/2020/04/08/the-pentagons-supply-chain-faces-an-economy-under-siege