11

The Gathering Storm

Michael J. Bayer

January 20, 2010

22

2009 AUSA Exhibit Floor

33

France2.3%

Spain1.2%

UK2.3%

North Korea30.2%

Iraq14.4%

Jordan11.0%

Saudi Arabia8.1%

Israel9.3%

China3.0%

Russia3.8%

Japan1.0% Australia

3.1%

U.S.4.3%

NATO Combined

(Excluding US)

1.6%

0

50

100

150

200

250

300

0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

U.S. Investment In DoD Compared to Defense Spending of Other Industrial Nations

5.0% 10.0% 15.0% 30.0% 40.0%

$100

$650

% of Country’s GDP

2008 Defense Spending -- Billions

$50

$150

$600

* FY08 Total National Defense Outlays (includes Non-DoD defense), October 2009Source: Defense Intelligence Agency; The Military Balance 2009

9.3% 8.1%4.3% 3.8% 3.0% 2.2% 1.6%0%

6%

12%

Israel SaudiArabia

U.S. Russia China U.K. NATO

2008 Defense Spending as a % of Country’s GDP

SouthKorea2.3%

$320.3 $38.2$60.5$63.0$66.2$134.0$616.1

$0

$200

$400

$600

$800

U.S. NATO China France Russia U.K. SaudiArabia

2008 Defense Spending(Billion $)

$320.3

(Excluding US)

(Excluding US)

The U.S. invested more in Defense in 2008 than the combined national defense investments of China, France, the UK, Russia, Saudi Arabia, Germany, Japan, & Australia.

$200

Germany Italy

Canada 1.3%

44

SECRETARY GATES, “Even as we consider the future, I am prepared to respond to urgent needs and will keep pushing to get troops the equipment they need.” (October 2009 AUSA Speech)

GENERAL MCCHRYSTAL – When asked whether he would support scaling back the American military presence in Afghanistan: “The short answer is: no.” (London interview, 2009)

Government Accountability Office: Iraq withdrawal would be a "massive and expensive effort" that would likely increase war costs by billions. Estimated an additional $12 billion to $13 billion a year for two years following the withdrawal needed for maintenance, repairs, and replacement of returned equipment.

Defense Spending Predictions

5

Defense Spending Changes from FY2009 to FY 2010

Total % Change

• DoD Top Line $534 billion +4.0%• Procurement $107.4 billion +5.6%• Uniform Headcount* 2.249 million +2.0%• MilCon $21.0 billion -4.1%

5

66

Gathering Storm??

7

Briefing Agenda

• Long term trends in defense spending

• Erosion from within the DoD budget

• Pressure from competing demands

• Concluding thoughts

7

88

DoD Budget Top Line Trends

297 328365 377 400 411 432

480530 542 551 561 575 589

72

116166

187146 130

50 50 50 50 50

513

7

83

6

3

1317

91 76

639625611601592

660667667

601

535

479468437

345316

$0

$250

$500

$750

FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

316

73% Growth

36%Real Growth

Department of Defense Topline ForecastFY 2001 – FY 2015

Base Budget War Funding PositionBase Budget Position

Note: FY 2010 – 2015 reflects the FY 2010 President’s Request, May 2009; FY 2009 Non-War Supplemental is appropriated through American Recovery and Reinvestment Act of 2009

Source: Defense Appropriation Acts FY 2001 – 2010; OMB Historical Tables FY 2009

Base Topline in FY 2009 Constant Dollars

Non-War SupplementalWar Funding

(Current Dollars in Billions)

Numbers may not add due to rounding

1010

1111

Cyclicality of DoD BudgetU.S. DoD Budget Authority

(Including Supplementals and OCO)Constant $FY10 (billions)

100

200

300

400

500

600

700

1948

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Source: DoD FY2010 Greenbook

1212

DoD’s Approach to Building Budgets:

Korea

Billi

ons

FY0

7$

Vietnam Drawdown

Reagan Buildup

Procurement HolidayBush

Transformation

$-

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

19471949

19511953

19551957

19591961

19631965

19671969

19711973

19751977

19791981

19831985

19871989

19911993

19951997

19992001

20032005

20072009

2011

RDT&E

Procurement

Source: DoD, Jane’s Analysis

John Kenkel – Gersen Lerman Group

1313

Budget Cuts by Secretary Gates• Generation Guided Missile Cruiser – CG(X) was deferred beyond the FYDP

• Future Combat System (FCS) Manned Ground Vehicle (MGV) – terminated

• FCS Non-Line of Sight - Cannon (NLOS-C) – terminated

• FCS basic program – restructured

• Kinetic Energy Interceptor (KEI) – terminated

• Airborne Laser (ABL) aircraft – truncated to one aircraft

• Combat Search and Rescue (CSAR-X) helicopter – terminated

• VH-71 presidential helicopter program – terminated

• Transformational Satellite Communications (TSAT) – terminated

• F-22 was ended, not terminated – reached the inventory objective of 187 aircraft

• DDG-1000 was truncated from 7 ships to 3 ships

• Ground Based Interceptor (GBI) stopped buying additional interceptors for deployment in Alaska

• FCS - Class IV unmanned aircraft system program and two variants of the Multifunction Utility/Logistics and Equipment unmanned ground vehicle program terminated

1414

Erosion from Inside the Budget

The Growing Cost of Hardware

15

1616

Major Defense Acquisition Program Portfolio1978 - 2007

2007 Year $ (B)

1979-1986:245% Spending Growth

Source: OUSD(C) Study, DoD Selected Acquisition Reports,1978 – 2007 (2nd Quarter)

Overall 30 year MDAP Growth Rate*: 4%

Recent buildup is characterized by fewer new programs, increases in existing baseline budgets, and increases in engineering and estimating costs

Reagan Buildup

Recent Buildup

2000-2007:170% Spending Growth

‘79-’86 ‘00-’073% 13%

21% –

– 7%

13% 5%

Total 14% 8%

Program Cost

Changes

Program Baseline

Baseline Changes**

(2007 Constant Dollars in Billions)

Numbers may not add due to rounding

** Includes all changes between a program’s initial ‘baseline estimate’ and its current ‘baseline estimate’ (as of 2Q 2007 SAR); BMDS engineering cost changes were reclassified as ‘baseline changes’ due to unique program budgeting process

* Figures reflect Compound Annual Growth Rates (CAGRs)

Annual Growth Rates*

1717

91 Additional MDAPs ($195B)

Future Combat Systems

$69.7

Joint Strike Fighter (F-35)$66.8

SSN 774 Attack Submarine$27.3

Chemical Demilitarization**$23.4

Evolved Expendable Launch Vehicle (EELV)$18.5

$401B

$328B

$190B

Program Cost Growth

Baseline Changes*

New Programs

$401B

Including:• C-17A ($17.6B)• EFV ($7.2B)• DDG 51 ($6.9B)• C-5 RERP ($6.4B)• SBIRS ($5.8B)

Numbers may not add due to roundingSource: DoD Selected Acquisition Reports, 2000 – 2007 (2nd Quarter)

* Includes all changes between a program’s initial ‘baseline estimate’ and its current ‘baseline estimate’ (as of 2Q 2007 SAR); BMDS engineering cost changes were reclassified as ‘baseline changes’ due to unique program budgeting process:

** Combines 3 Chemical Demilitarization programs into 1 to match earlier SARs

Cost growth in Only Five Programs accounted for $206B or 51% of the total

Major Defense Acquisition Program Portfolio Cost Growth by Program

2000 - 2007 (Dollars in Billions)

1818

Generational Cost Growth in Major

Weapons Programs

“In the year 2054, the entire defense

budget will purchase just one aircraft. This

aircraft will have to be shared by the Air

Force and Navy 3-1/2 days each per week

except for leap year, when it will be made

available to the Marines for the extra day.”

Norman Augustine

The Growing Cost of People

19

2020

NDAA Authorized End Strength Levels for Active Components

(FYs 2004-2010)

Service FY04 FY05 FY06 FY07 FY08 FY09 FY10

ARMY 482,400 512,400 512,400 532,400 532,400 547,400 569,400*

USMC 175,000 184,000 184,000 184,000 189,000 202,000 202,100

*ARMY FY10 level based on July 09 SecDef Memo

ARMY authorized 592,400 for FY11-FY12Source: OUSD/P&R/MPP

2121

DoD Labor Costs are Substantial…

* Source: OSD(PA&E), OUSD(C) and WHS, excludes costs not on the DoD budget (e.g., VA)** Source: WHS, which categorizes contracts as Procurement, RDT&E, or Services*** Retirement, DHP, Family Housing

$0

$100

$200

$300

$400

$500

1963 1973 1983 1993 2003

Th

en Y

ear

$ B

illio

ns

0

1

2

3

4

5

Act

ive

Du

ty E

nd

stre

ng

th (

Mill

ion

s)

Contracts for Services**

DoD Topline

Military Benefits***

MilPers

CivPay

Active Duty Endstrength

2222

Projected Growth through FY 2015 in the DoD Unified Medical Budget

(No GWOT)Increase

over FY2000 $46.7B 168%

($M)

Source: OUSD/Health Affairs--Chart does not reflect DoD’s unfunded liability for TRICARE-for-Life

* Increase over FY2000 is $46.7B and ultimately 12% of the DoD budget

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

FY2000 Unified Medical Program Price Inflation Volume/Intensity/Cost Share Creep, etc.

New Users <65 Explicit Benefit Changes to <65 Explicit Benefit Changes to 65+

$18.0B – 39%

$9.0B – 19%

$5.2B – 11%

$2.5B – 5%

$12.1B – 26%

FY2000 Baseline $17.4B

___________

100%

2323

Congressional Actions Shape the Compensation Bill

Billions $

0

5

10

15

20

25

30

FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10

TRICARE for Life Healthcare for Non-Activated Reservists

Increased Family Separation Allowance Survivor Benefit Enhancements

Redux Repeal Concurrent Receipt

$22.8B

$17.4B

$12.7B

$21.3B$20.0B

$18.9B

$16.0B

$8.9B

$0.3B

2424

Generational Cost Growth of Uniformed Personnel

“In the year 2054, the entire defense

budget will be able to afford just one war fighter. This

war fighter will have to be shared by the Army, Air

Force and Navy 2 days each per week, only available

to the Marines on Sunday.”

Michael Bayer

2525

The Costs from the

Economic Crisis

26

Trends in Federal Spending FY1980 – 2019

Outlays in billions of current dollars

Defense Discretionary

Nondefense Discretionary

Mandatory

Net Interest

0

1000

2000

3000

4000

5000

6000

1980 1985 1990 1995 2000 2005 2010 2015

Source: Historical data from Historical Tables, Budget of the United States Government, Fiscal Year 2010 (February 2009) and projections from Mid-Session Review, Budget of the United States Government, Fiscal Year 2010 (August 2009).

2727

National Defense

Nondefense

Net Interest

Mandatory

0%

20%

40%

60%

80%

100%

Year

% C

ha

ng

e

NOTE: Graph shows the ever increasing percentage of mandatory spending (including interest on the debt)—another leading indicator of a declining Federal addressable market.

Federal Government Mandatory vs. Discretionary Spending Over Time

28

Low rates have helped keep debt service costs in check

29

2009 Federal BudgetNet Interest – 3.347%

(In Millions of Dollars)

$339,830.00 8.50%

$2,138,130.40 53.48%

$863,568.00 21.60%

$656,471.60 16.42%

Net Interest Payment

Non Discretionary

Defense

Other

Int Rate: 3.347%

Debt Net Int

2009 12,867,455 339,830

30

Administration forecasts anticipate significant increases in debt

31

Gross Federal Debt (as of October 2009)

 YEAR In millions of dollars

2008 9,985,757

2009* 12,867,455

2010* 14,456,303

2011* 15,673,873

2012* 16,565,716

2013* 17,440,160

2014* 18,350,010

2015* 19,000,000

2016* 20,004,000

2017* 20,990,000

2018* 21,990,000

2019* 23,132,000Source: OMB Historical Tables of the President's Budget Request. * - Estimated debt amounts

32

0.0001.0002.0003.0004.0005.0006.0007.0008.0009.000

10.00011.00012.00013.000

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

Source: US Dept. of Treasury

Average Rate1993 – 2009

5.899%

Average Rate September 2009

3.347%

Interest Bearing Debt

33

Projected Net Interest on the Gross Federal Debt

(In Millions of Dollars)

$339,830.00 8.50%

$2,138,130.40 53.48%

$863,568.00 21.60%

$656,471.60 16.42%

Net Interest Payment

Non Discretionary

Defense

Other

Int Rate: 5.8997%Debt Net Int

2009 12,867,455 598,941.49

2013 17,440,160 811,787.212017 20,990,000 977,021.63

2009: 3.347%

34

Comparison of Current Net Interest vs Projected Net Interest

2013 - Projected Net Interest, at 5.899%(in Millions of Dollars)

$811,787.21 20%

$3,186,212.79 80%

Net Interest Payment Other

2017 Projected Net Interest, at 5.899%(in Millions of Dollars)

$977,021.63 24%

$3,020,978.37 76%

Net Interest Payment Other

2009 Net Interest at 3.347%(in Millions of Dollars)

$339,830.00 9%

$2,138,130.40 53%

$863,568.00 22%

$656,471.60 16%

Net Interest Payment Non Discretionary Defense Other

3535

What Does it all Mean?

3636

THE HARD REALITIES

• Growing people related expenses are the heart of the purchasing power challenge

• Acquisition accounts are always the first source of funds to fill the gaps

• The service of the growing mountain of debt will soon eat away at Defense

• A real recovery will only accelerate this

3737

LEADERSHIP• Nine straight years of defense budget increases

• Few “flag officers” were “flags” at the $340 billion pre-9/11 defense budget

• Four or five rotations of staff officers since

• Systems and processes that worked poorly in up budgets are worse in flat or down budgets

• The skills needed for up budgets are distinct from those in flat or down budgets

3838

BOTTOM LINES • The “bad guys” are just getting started

• Thus, Gates' transformation will outlive him

• US defense budget is under real pressure

• “Big” is no longer an inherent advantage

• Advantage will be to the lean, smart, and fast

• High value people will matter most

3939

“If the Department of Defense can’t figure out a way to defend the United States on a budget of more than half a trillion dollars a year, then our problems are much bigger than anything that can be cured by buying a few more ships and planes.” -- Secretary of Defense Robert Gates

It’s Already Been Said:

4040

Questions?

Backups

41

4242

NDAA Authorized End Strength Levels for Active Components

(FYs 2004-2010)

Service FY04 FY05 FY06 FY07 FY08 FY09 FY10

AIR FORCE

359,300 359,700 357,400 334,200 329,563 317,050 331,700

NAVY 373,800 365,900 352,700 340,700 329,098 326,323 328,800

Actual end strength as of 30 Sept 09:

Air Force = 333,408

Navy = 329,044 Source: OUSD/P&R/MPP

USAF Strategic ChoicesUSAF Strategic Choices

These forces are driving us to change—status quo is not an option These forces are driving us to change—status quo is not an option These forces are driving us to change—status quo is not an option These forces are driving us to change—status quo is not an option

Resources Active Duty end strength down 7%,

but Personnel spending up 16% AF inventory down 10%, but O&M

spending up 19% Approx 40,000 personnel deployed

Strategic Challenges Current conflicts Nuclear proliferation by state and

non-state actors

New Technologies Cyber Unmanned aircraft

Personnel Costs Personnel Costs vs vs End StrengthEnd Strength

O&M Costs O&M Costs vs vs InventoryInventory

April 19, 2023

297 328365 377 400 411 432

480530

72

116166

187146 130

513

7

83

6

3

1317

91 76

660667667

601

535

479468437

345316

$0

$250

$500

$750

FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10

316

80% Growth

38%Real Growth

Department of Defense ToplineFY 2001 – FY 2010

Base Budget War Funding RequestBase Budget Request

Note: FY 2009 Non-War Supplemental is appropriated through American Recovery and Reinvestment Act of 2009

Source: Defense Appropriation Acts FY 2001 – 2010; OMB Historical Tables FY 2009

FY 2009 – FY 2010Base Growth

Nominal Growth 4%

Real Growth 2%

Base Topline in FY 2009 Constant Dollars

Non-War SupplementalsWar Funding

Numbers may not add due to rounding

(Dollars in Billions)

April 19, 2023

FY 2010 Base Budget(Enacted)

(Dollars in Billions)

Military Construction: $21.0

Procurement: $104.8

$530.7B

Military Personnel: $135.0

RDT&E: $80.1

Revolving Funds: $3.1

Family Housing: $2.3

Numbers may not add due to rounding

Operation & Maintenance: $184.5

April 19, 2023

46

FY 2010 Overseas Contingency Operations(Enacted)

(Dollars in Billions)

IED Defeat: $1.8

Coalition Support: $1.9

Force Protection: $8.7

$129.6B

Reconstitution: $15.5B

Continuing the Fight: $109.9B

Operations $70.9 MRAP: $11.3

CERP: $1.2

Military Construction: $1.4

Military Intelligence: $4.7Non-DoD Classified: $4.2B

Numbers may not add due to rounding

Afghan National Security Forces: $6.6

Temporary ArmyEnd Strength: $1.0

Navy IAs: $0.4

47

Entitlements Squeezing Out Defense Spending

% Distribution of Total Federal Outlays: FY1962 – FY 2014

0%

20%

40%

60%

80%

100%

1962 1970 1980 1990 2000 20092014

National Defense, 16%

Discretionary, 15%

Net Interest, 11%

Entitlements, 58%• Income Security• Medicaid• Medicare• Social Security

Share of spending in 2014

Source: Historical data and projections from Historical Tables, Budget of the United States Government, Fiscal Year 2010 (February 2009).

48

Source: DoD FY2010 Budget Request, USD (Comptroller), May 2009

49

Estimated Net Interest Payment Calculations

1. Baseline Scenario

  2009 2013 2017

Current Avg Int Rate 3.3470% 3.3470% 3.3470%

Est Gross Fed Debt $ 12,867,455,000,000.00 $ 17,440,160,000,000.00 $ 20,990,000,000,000.00

Net interest payment $ 339,830,000,000.00 $ 460,595,321,514.63 $ 554,346,737,563.88

"Discount Rate" 0.789066 0.789066 0.789066

       

2. Projected Hist Int Rate      

  2009 2013 2017

Hist Avg Int Rate 5.8990% 5.8990% 5.8990%

Est Gross Fed Debt $ 12,867,455,000,000.00 $ 17,440,160,000,000.00 $ 20,990,000,000,000.00

Net interest payment $ 598,941,490,887.36 $ 811,787,212,911.50 $ 977,021,632,772.43

Discount Rate 0.789066 0.789066 0.789066

       

5050

Fiscal Year 2009 Budget by Category

Source: Office of

Management and Budget

5151

Impact on industry

• The downturn will be harder on the larger than small companies

• Easier on those who can create genuinely new technology

• Easier still on those who can think an idea through to fully operational integration

• Those who can add leverage to the inventory of legacy gear

5252

$400

$101

$411

$116

$433

$165

$480

$192

$513

$147

$534

130*

$-

$100

$200

$300

$400

$500

$600

$700

Bill

ion

s

GFY05 GFY06 GFY07 GFY08 GFY09 GFY10

Year

Supplemental*

Baseline

Defense Budget Account Spending Over Time Graph profiles baseline and recent supplemental budget spending. *Referenced as, “Overseas Contingency Operations,” in GFY10 budgetSource: Current year budget requests and emergency funding appropriations Budget Authority, Current dollars, military functions only (051)

5353

We Emphasize “Non-Cash” Compensation

Current In-Kind12%

Current Cash59%

Deferred Cash14%

Deferred In-Kind

15%

Deferred Cash7%

Current Cash84%

Current In-Kind

9%

Military Personnel Benefits*(including both DoD & Treasury Costs**)

National Average (Source: BLS, March 2005)

* Source: OUSD(PA&E) – Includes current and former active duty, national guard and reserve personnel. ** Include outlays from Dept of Treasury of $4 B, excluding unfunded liabilities

FY 05

Often Driven byUnsolicited Inputs

“Default” strategy DOES NOT always “incentivize” desired behavior or provide return on investment – not getting better

5454

Potential Fiscal Outcomes Under GAO’s Alternative Simulation: Revenues and

Composition of Spending

0

10

20

30

40

50

2009 2019 2030 2040Fiscal year

Net interest Social Security Medicare & Medicaid All other spending

Percent of GDP

Source: GAO’s Fall 2009 analysis based on the Trustees’ assumptions for Social Security and Medicare.

55

Potential Fiscal Outcomes UnderGAO’s Baseline Extended Simulation:

Revenues and Composition of Spendingas Shares of GDP

0

10

20

30

40

50

2008 2018 2030 2040Fiscal year

Percent of GDP

Net interest Social Security Medicare & Medicaid All other spending

Revenue

Source: U.S. Governmental Accountability Office’s Fall 2009 Baseline Extended simulation.

56

Potential Fiscal Outcomes Under GAO’s Alternative Simulation:

Revenues and Composition of Spending as Shares of GDP

0

10

20

30

40

50

2009 2019 2030 2040Fiscal year

Percent of GDP

Net interest Social Security Medicare & Medicaid All other spending

Revenue

Source: U.S. Governmental Accountability Office’s Fall 2009 Alternative simulation.

57

II. Experience in the 1990s

A. The 1990s Budget drawdown – top line down 25%1. Procurement funding down 50%

2. S&T funding declined slightly

B. Major industrial companies (GE, IBM, Ford, Westinghouse, Texas Instruments, etc.) divested their defense businesses

58

II. ExperienceC. Defense focused companies responded using various

strategies1. Commercial Diversification (limited success)

2. International Markets (Middle East)

3. Other Government Markets (State, Local and non-DoD Federal)

4. Divestiture (General Dynamics was the leader)

D. Consolidation emerged as the primary strategy (per “last supper”)1. A handful of large Primes were created with a broad range of

lines of business, and deep resources to weather the downturn

2. The number of mid-sized firms declined sharply

3. Independent Systems Engineering firms were acquired by major primes

59

II. ExperienceE. Financial Conditions of Major Companies in late 1990s

1. Limited opportunity for organic top line growth

2. Acquisitions caused high levels of debt and sharply lower credit ratings

3. Reduced cash flow and profitability

4. Sharply lower stock prices

5. Result – access to capital was limited

F. DoD’s response (senior leadership focused on the issue)1. Policy changes (e.g. Profit Policy)

2. Enhanced cash flow measures (e.g. progress payments)

3. Consolidation costs made allowable

4. Centers of excellence were rejected in favor of trying to maintain competition

60

III. Industrial Base TodayB. Current financial condition of the Industrial Base

1. Low debt/solid credit ratings

2. With few new program starts, companies are maximizing profits and cash flow

3. Stable profitability and good margins

4. Regular dividend increases are the norm for primes

5. Despite this, stock prices are down 30 to 40% due to “street” doubts about the future

C. Increased presence of U.S. based, Foreign-owned companies1. BAE Systems, Cobham, Thales, QinetiQ, Fijnmechanica, etc.

2. Use SSAs, Proxy Boards to protect U.S.-only technology

3. Rules discourage access to foreign technology

6161

0

20

40

60

80

100

120

140

160

180

200

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

$K /

Act

ive

En

dst

ren

gth

[F

Y10

Co

nst

ant $

]

DoD Operations & Maintenance Per Capita(Excludes Supplemental Funding)

~3% growth per yearFY81 – FY01

Why the growth?• Medical• Quality-of-Life initiatives• Environmental• Equipment complexity• Aging equipment

Smoothed FY03 end-of-yearSupplemental appropriation