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Panetta, defense industry meet as huge cost cuts loom

By Andrea Shalal-Esa

WASHINGTON (Reuters) - Nearly 40 U.S. aerospace and defense industry executives met with Defense Secretary Leon Panetta in Washington on Friday amid signs that huge planned cuts in military spending are already squeezing industry profits and prompting layoffs.

Panetta underscored his commitment to safeguarding the U.S. defense industrial base during a visit to a Maryland naval facility earlier on Friday where he strongly backed the Marine Corps version of Lockheed Martin Corp's F-35 fighter jet.

"We have to protect our research and development capability and we have to protect our industrial base," Panetta said. "If we cut back on that industrial base, it will weaken us for the future."

But top defense officials say there is no doubt there will be tough consequences for some companies as the Pentagon slashes spending by $487 billion over the next decade.

Dozens of weapons programs face termination or big cutbacks in the fiscal 2013 budget and a five-year plan to be submitted to Congress on February 6, defense officials say.

Panetta is due to preview the highlights at a Pentagon news conference next week, but aides said he did not plan to reveal many details during his second meeting with aerospace and defense industry chief executives since taking office in July.

"It won't exactly be a bloodbath, but $487 billion is a lot of money to cut," said one senior defense official. That number could double unless Congress and the White House find a way to avert automatic cuts triggered by lawmakers' failure to find $1.2 trillion in cuts to federal spending.

The Aerospaice Industries Association, National Defense Industrial Association and Professional Services Council warned Panetta in a recent report on the industrial base that even the smaller cuts "could cripple certain defense sectors."

Unless the Pentagon took steps to change the "way it interacts with industry," the cuts would reduce innovation, spark further layoffs, curtail investment and trigger consolidation and divestment, especially among small- to mid-sized companies, the report said.

Continuing uncertainty had already resulted in the loss of thousands of jobs and reduced investment, it said, and the situation threatened to get far worse.

GROWING TENSION ABOUT CONTRACT TERMS

Industry executives say they appreciate Panetta's openness and willingness to engage with industry, but the report underscored growing concern about Pentagon moves to cut overhead cuts, extract cost data on commercial-type contracts and shift risk for development of new programs to companies.

"There's certainly some tension between the Pentagon's approach and that of industry," said a second senior defense official, noting that industry executives seem increasingly driven by pressure to "increase shareholder value."

That pressure has already prompted some changes in the industry. Last year, for instance, Northrop Grumman Corp spun off its shipbuilding unit into a new firm, Huntington Ingalls Industries; L-3 Communications Holdings is spinning off its government services segment; and ITT Corp spun off its defense business.

Heidi Wood, top defense industry analyst with Morgan Stanley, said a review of the terms of recently signed contracts with industry confirmed that the Pentagon was increasingly imposing "draconian" new contracting terms.

Lockheed raised concerns about the amount of risk it was being asked to bear on the F-35 Joint Strike Fighter, while Boeing reluctantly accepted "a near zero margin" fixed price contract to develop a new refueling tanker, Wood wrote in an analyst report this week

She said Huntington Ingalls had revealed in its third quarter earnings that the Pentagon had withheld funds, Boeing had conceded that its new five-year contract for F/A-18 fighter planes had less than half its previous margins; and contractors were being asked to surrender their commercial cost structures.

Mike Petters, chief executive of Huntington Ingalls, last week told Reuters his company is working closely with the U.S. Navy to wring costs out of shipbuilding, but said the Pentagon needed to avoid delays in orders, which would drive up prices.

He underscored concerns raised by the trade groups about the Pentagon's push to make industry shoulder more of the risk of new development programs, noting that companies had to see sufficient return on investment, or they would back off, while defense officials were driven by budget pressures.

"We've got to work our way through this," he said. "As tight as the money is today, it's going to be tighter in five years."

Wes Bush, chief executive of Northrop Grumman Corp, lauded Panetta for his honesty and leadership at a difficult time, and noting that both sides were working hard to make weapons systems more affordable.

"That is the place we're all working toward," Bush told Reuters after unveiling a $2 million project with Conservational International aimed at getting more young people interested in careers in science, technology, engineering and math.

(Reporting By Andrea Shalal-Esa; additional reporting by David Alexander and Phil Stewart; Editing by Bob Burgdorfer)

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