Industry pushes back against DOD's payment plan changes

Trade groups representing government contractors and the House and Senate Armed Services committee chairmen have lined up to oppose a rule change the Defense Department proposed in late August that would cut progress-based payments to companies performing on contracts with the Pentagon.

DOD is holding a public meeting on Oct. 10 to further discuss the rule and is accepting public comments through Oct. 23. DOD plans to put the new rule in place by the end of this year. But that relatively short window leads some industry observers to believe that the change is likely to not go forward as planned and anxiety may be overstated.

Analysts at investment bank Cowen & Co. instead see the rule as “difficult to implement by Jan. 1, 2019, and won’t be adopted as currently written,” according to a Friday note for investors.

What DOD wants to do is cut the baseline progress-based payment rate for other than small businesses from 80 percent to 50 percent. The payment for small businesses would stay unchanged at 90 percent. This would apply for DOD solicitations issued on or after Jan. 1, 2019.

Instead of progress-based, DOD wants to link payments closer to performance measures such as delivery timeliness or quality. These changes would largely apply to fixed-price contracts typical in long-cycled platform development work and some highly-complex IT jobs.

But a coming time crunch may disrupt DOD’s ability to get the rule in place. As Cowen defense policy analyst Roman Schweizer pointed out in that note, companies have to submit their justification for next year’s payment rates by Dec. 1 at the same time that DOD has to evaluate industry comments on the proposed rule and make changes.

“It will be a scramble for companies and DoD to compile the necessary data to evaluate the rate request,” Schweizer wrote. As such, he suspects “that will be very hard the first time and suggests this year may be too hard.”

Some investor anxiety over the proposed change cropped up in the past week as the S&P Aerospace & Defense index fell 2 percent Sept. 19-Sept. 20. But that reaction was “overblown” given how the change would not apply to current contracts and the low likelihood of the new rule going forward before 2020, Cowen’s defense equity analyst Cai von Rumohr wrote.

Government services companies would also see few risks given that a majority of their sales typically come from cost-plus or time-and-materials contracts versus fixed-price, he wrote. Von Rumohr sees the rule as not applying to time-and-materials and fixed-price commercial terms contracts, while only some cost-plus contracts would be affected.

This contrasts with defense primes that could see some risk, but the proposed rule’s “impact would begin the longer duration of their contracts,” he wrote.

It should be noted that publicly-held government services companies have increasingly sought to grow their share of fixed-price contracts given their higher-margins versus other types. This is evident given renewed increases to IT modernization funding and how agencies are packaging those jobs into larger, consolidated procurements at scale.

The Professional Services Council, Aerospace Industries Association and National Defense Industrial Association have all voiced their opposition to the proposal and asked for it to be rescinded at a Sept. 14 public meeting hosted by DOD.

In essence, they see it as disruptive to how companies manage and plan their cash flow -- long seen as a point in the industry’s favor by investors given the continuous nature of government spending. The groups also view the proposed rule as limiting industry’s ability to push innovation and also add more bureaucratic red tape.

And as Defense News reported on Tuesday, House Armed Services Chairman Mac Thornberry (R-Texas) and his Senate counterpart Jim Inhofe (R-Oklahoma) have joined the fray and spoken out against the proposal in a letter to Deputy Defense Secretary Patrick Shanahan.