FINANCING OF DEFENSE CONTRACTS A Boon For Prime Contractors

37 Nash & Cibinic Rep. NL ¶ 43

Nash & Cibinic Report | June 2023

The Nash & Cibinic Report

Procurement Management

Ralph C. Nash

¶ 43. FINANCING OF DEFENSE CONTRACTS: A Boon For Prime Contractors

In 2019, the Government Accountability Office issued a report Contract Financing:DoD Should Comprehensively Assess How Its Policies Affect the Defense Industry, GAO-19-406 (June 27, 2019), noting that the department had not performed a comprehensive review of contract financing since the Defense Financial and Investment Review (DFAIR) in 1985. See our discussion of that report in Contract Financing and Profit Policy: A Forgotten Topic, 33 NCRNL ¶ 51; 61 GC ¶ 202. As a result, the DOD initiated a new study in 2019, commissioning studies by the University of Virginia, Darden School Foundation, the University of Tennessee, the George Mason University, Center for Government Contracting, and the Institute for Defense Analyses. Based on the results of these efforts plus its own internal analysis, the DOD issued the Contract Finance Study Report in April 2023, available at https://www.acq.osd.mil/asda/dpc/pcf/finance-study.html. See 65 GC ¶ 95. The long report contains a mass of information on the financing arrangements for contractors and subcontractors and contains peripheral information on the resulting profits earned by these companies. We will comment on some aspects of the report but we recommend reading the entire report to absorb all of the information that it contains.

The “Defense Industry”

The report’s summary finding is that the “defense industry” is doing well:

In aggregate, the defense industry is financially healthy, and its financial health has improved over time. Operating in the DoD environment has its advantages, especially with respect to cash flow through DoD’s contract financing policies, and this result is demonstrated by traditional major defense contractors out-performing commercial counterparts in many key financial metrics. While profit policy per se was not significantly assessed by this study, the analysis of contract financing is integral to profit and incentive policy. This report concludes that the Department does not find a need to modify its weighted guidelines structured methodology of arriving at objective profit positions for negotiation.

This finding is based on two different definitions of the defense industry. The Darden study looked at data on 124 publicly traded U.S. firms categorized as Defense (32), Hybrid (40) and Commercial (52). The Tennessee study analyzed Aerospace and Defense financial metrics for 146 firms divided into the “Top 10” firms and “Rest of Industry.” The study does not indicate how this data was merged but it provides the following figure as “the weighted average of defense firms in the study:”

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Although this unknown group of companies serve as subcontractors some of the time, the study seems to assume that most of their work is done as prime contractors. At least it assumes that they are beneficiaries of the generous financing terms afforded to prime contractors, including progress payments on fixed-price contracts and quick reimbursement of costs on cost-reimbursement contracts. As can be seen in Figure 2-1, the result has been that the “defense industry” has done very well in recent years—which the study applauds. The study also contains a quick look at the 2020–2022 data on a large segment of the industry and determines that it was not impacted in any significant way by the COVID-19 pandemic or the subsequent inflation.

The study then discusses now the cash generated by these policies has been spent, as described in Figure 2-2:

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The inclusion of independent research and development(IR&D) in this category is very misleading because, to a large extent, it is not funded by corporate funds but is a reimbursable cost. However, the data is rather distressing because it shows that even when these defense contractors are generating very positive cash flows on their contract they are reducing the amount they spend to develop new technology. The report contains no explanation for this trend.

The other distressing feature in Figure 2-2 is the increased use of this positive cash flow to increase dividends and buy back shares, Thus, the companies in this category are increasing their financial standing in the stock markets rather than putting more money back into the business. Assuming that they are well managed and investing in the business as necessary to maintain their status as capable contractors, we assume this indicates that they are earning more than is necessary from their defense contracts. But the study makes no such finding, suggesting that the status quo is fine.

Finally, the study shows how healthy the “defense industry” is by comparing it to comparable commercial companies in the following findings:

In 8 of 9 key financial metrics, defense contractors out-performed commercial counterparts. Those metrics include Total Shareholder Return (TSR), Return on Assets (ROA), Return on Equity (ROE) and Cash Flow Return on Net Assets (CFRONA). (Darden)

Although profit margins are somewhat lower than commercial counterparts, the gap is more than offset by lower asset and investment requirements for defense contractors. (Darden)

Defense companies have higher total returns to shareholders compared to their commercial analogs, or when compared to broad equity market indices such as the S&P 500. (Darden)

Subcontractors

The study contains a separate section on subcontractors that is short on data but long on analysis. Its general conclusion is that subcontractors do not receive the same financing benefits afforded to prime contractors and that they are paid much more slowly than prime contractors. As a result, it reaches the following interesting finding:

In lieu of waiting for a future payment, subcontractors may have to resort to some type of private financing in order to provide needed cash flow. One such private financing type is accounts receivable factoring, a form of borrowing wherein the subcontractor sells an account receivable to a factoring company at a discount, in exchange for cash. The cost of accounts receivable factoring is borne by the Government (if it is passed on), or the subcontractor (through reduced profit).

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To the extent that subcontractors have leverage to do so, they can be expected to increase their proposed prices to prime contractors to cover the costs associated with the fees charged by the factoring companies. As a result, the costs of accounts receivable factoring will, in many cases, ultimately be passed on to the Government, to be borne by the taxpayers.

The sparse data in the report on the amount of financing provided to subcontractors indicates that between 10% and 25% of them may receive some financing but there is no data on whether this is reimbursement of costs on cost-reimbursement contracts or progress payments on fixed-price contracts. The data on the timing of payments is even more striking. The report indicates that prime contractors are paid on the average of 13.9 days for performance-based payments, 12.3 days for cost vouchers, and 12.4 days from receipt of progress payments requests. In contrast, subcontractors are paid from 30 to 120 days (or more) from receipt of the payment request.

Curiously, although the study notes the fact that elimination of the “paid cost” rule contributed to this stark contrast, it takes no blame and makes no recommendation in this regard. It states:

Prior to March 2000, the Progress Payment clause only authorized large business contractors to request financing for costs which the contractor had already paid. This was referred to as the “paid cost rule.” A May 1993 GAO report titled “Techniques to Ensure Timely Payments to Subcontractors”25 characterized the paid cost rule as providing a significant payment protection for subcontractors, because the large business prime contractors receiving progress payments were “required to make payment to subcontractors before billing the government.” In March 2000, the paid cost rule was replaced with the “incurred cost rule”, which authorized contractors to request progress payments against both paid costs and those which are determined to be due and will be paid in accordance with the subcontract terms and conditions, and ordinarily within 30 days of inclusion of the cost in a progress payment request to the Government.

Since the Progress Payments clause authorizes a prime contractor to claim on their progress payment request both amounts that have been paid, and those that “are determined due and will be paid” ([Federal Acquisition Regulation] 52.232-16(a)(2)), it is recognized that some or all of the subcontract financing and delivery invoice amounts included in a prime’s progress payment request may be unpaid as of submission of the progress payment request to the Government.

This is a gross understatement. In 2012, we traced the history of the elimination of the paid cost rule in Elimination of the “Paid Cost Rule”: Undocumented History, 26 N&CR ¶ 14. We noted that its impact was that prime contractors were financing their contracts with subcontractor money (and banking some of it), with the result that subcontractors were raising their prices (giving the contractors even more profit). The study bears this out but gives up, concluding:

While it is neither feasible nor meaningful to perform robust oversight of subcontract payment timeliness in the context of pre-payment reviews of progress payment requests (because there is no requirement that the claimed subcontract costs actually be paid yet at the point when such a review would be conducted), the extent of apparent late payments indicated by a review of the subcontract payment data…is cause for concern. If a pattern of late payments is identified, the [Administrative Contracting Officer] may take steps to increase oversight on an exception basis, and to implement available contract remedies, including possibly reducing or suspending progress payments or increasing the liquidation rate.

Note that this assumes that late payment not the originally negotiated (or imposed) payment time is the issue.

Small Business Subcontractors

The study contains a separate section on small business subcontractors that details the steps that have been taken by Congress and the department to ameliorate these problems with this category of subcontractors. This is the required inclusion of the “Providing Accelerated Payments to Small Business Subcontractors” clause in Federal Acquisition Regulation 52.232-40 in all solicitations and contracts (including commercial acquisitions). This clause requires contractors that receive accelerated payments from the Government to make accelerated payments to their small business subcontractors, “to the maximum extent practicable and prior to when such payment is otherwise required under the applicable contract or subcontract, after receipt of a proper invoice and all other required documentation from the small business subcontractor.” The report identifies several problems with this effort:

1. The clause requirement to attempt acceleration of payments to small business subcontractors is predicated upon the prime’s receipt of accelerated payment from the Government. If a prime is either unaware of receipt of an accelerated payment or uncertain as to whether it has received an accelerated payment, it is unlikely the prime will accelerate payments to its small business subcontractors as a result of this clause.…

2. Lower tier small business suppliers are not eligible to receive the potential benefit if there is a large business supplier at any point between the lower tier small business supplier and the prime.…

3. The clause structure links acceleration of a small business subcontract invoice payment to the prime contractor’s payment event. As of the time of this writing, [Defense FAR Supplement] 252.232-7017, a companion clause to [FAR] 52.232-40, defines an accelerated payment as “a payment made to a small business subcontractor as quickly as possible, with a goal of 15 days or less after receipt of payment from the Government or receipt of a proper invoice from the subcontractor, whichever is later.”…

4. The subcontract payment acceleration is not mandatory.…

5. The clause does not explicitly state whether the acceleration requirement applies only to delivery payments, or to both financing and delivery payments, at either the prime or subcontract level.…

6. The clause does not account for the complexity of delivery payments.…

The report contains a complete description of these problems and discusses some other issues with the general conclusion that this policy needs some work to make it effective. See our criticism of this policy in Slow Payment of Subcontractors: A Solution?, 26 N&CR ¶ 60, with Postscripts at 28 NCRNL ¶ 4 and 31 NCRNL ¶ 29. We continue to doubt if this is an effective way to help small business subcontractors.

The Report’s Recommendations And Our Conclusion

The report contains a mass of data and analysis (some of which we have not addressed) but it is thin on recommendations to fix the problems that it identifies. It summarizes its recommendations as follows:

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These modest recommendations are not likely to change the current situation in any significant way. But the most striking thing here is what is missing. The quickest and easiest way to deal with the prime contractor/subcontractor imbalance would be to go back to the paid cost rule. That would not solve the entire problem but it would go a long way by inducing contractors to make timely payment to their subcontractors in order to recover the money from the Government. It’s a mystery why the drafters of the report decided to stay with the current unfair and counterproductive rule.

The two recommendations that we did not address are retaining the current weighted guideline approach to profit negotiation and the current treatment of interest as an unallowable cost. As to the latter, the report contains a detailed analysis of the reasons for this policy. As to the profit policy, the report makes no effort to determine whether adoption of the current weighted guidelines played any role in the higher profits that the defense industry has been earning since it was adopted. This is the result of the fact that the study was of financing not of profit.

Read the full report and come to your own conclusion. Our conclusion is that the status quo is here to stay. Buy stock of the major defense contractors and stay away from companies, large or small, that serve primarily as subcontractors. RCN

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