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Are Offsets Becoming Unaffordable?

Oct. 27, 2012 - 09:41AM   |  
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International offset obligations, in which a contractor agrees to invest in a country as part of a deal, have long been the interest of international trade devotees and ignored by business heads.

But with increased attention on the international market — and countries in a position to demand greater investment — offsets have become a big business. Now, industry sources and analysts are questioning whether the stockpile of obligations that are mounting might be headed toward a point of implausibility.

Annual global offset obligations are projected to pass $50 billion by 2016, according to a recent study by Avascent, up $10 billion from this year.

Offsets take the form of technology transfer, the development of manufacturing capability or indirect investment. And while companies routinely failed to meet obligations in the past, and paid a penalty, the penalties have grown along with the obligations, forcing companies to confront offsets directly.

“The key issue facing companies in the defense sector around offsets is the sheer scale of obligations. This has a balance sheet impact which we have already seen affect behavior as corporate centers become increasingly focused on the obligations being built up in the business units,” said Grant Rogan, CEO of British-based offsets advisers Blenheim Capital.

Vern Clark, a retired admiral and former U.S. chief of naval operations, said the “scope of this area of discussion has already changed dramatically.”

“People didn’t care about them and got tired of hearing about them,” he told audience members at an Oct. 23 conference on offsets sponsored by Squire Sanders. “Listen to any of the quarterly earnings reports from the major players in the aerospace and defense industry, and every single one of them is speaking about the importance of them increasing their focus on international revenues, and they clearly see the international market as a path to a successful future. The days when offsets aren’t closely related to the project are gone, and if they’re not gone, then they should be gone.”

But a senior industry executive said at the same conference that the customer’s demands may be reaching a tipping point.

“Part of this is the unrealistic expectations of offset costs that they’re placing,” the executive said.

In particular, the executive pointed to the United Arab Emirates (UAE), where offsets are valued based upon the profitability of local companies developed by contractors.

“Companies look at offsets as a cost. If it was a good idea where you are going to make money, you would do it as a stand-alone business,” he said.

The likelihood that companies will be able to meet these mounting demands is low and companies must know it, said James Hasik of Hasik Analytics.

“We know what’s going on, they have to think that they’re going to be able to back out of them later,” Hasik said. “These offset obligations are going to take a haircut. It’s unrealistic. In the end, it’s like being a bondholder for the Greek government.”

But wriggling out of offset obligations is not an option as buyer nations tighten their guidelines, Rogan said. Regardless, contractors will be missing an opportunity if they try to walk away from agreements, the offsets veteran said.

“Haircuts are not on the table, and the UAE is an example with their restructured guidelines. If haircuts were a genuine possibility, we wouldn’t be seeing the level of concern at chief financial officer and chief executive levels,” he said.

“Companies that focus on haircuts are missing the point. Offset structures are designed to deliver long-term value to the procuring countries and are increasingly structured to develop long-term relationships with contractors. There is a major opportunity available to companies who understand that and work to support government objectives,” Rogan said. “The problem for contractors is that big spenders like the United Arab Emirates hold the whip hand these days as budgets in Europe and the U.S. decline.

“We are seeing governments strengthening their enforcement of obligations and the supporting documentation. In the UAE, they have introduced a supplemental agreement that accrues 50 percent of any unfulfilled offset obligation. This is a major shift from a liquidating to a non-liquidating situation for defense contractors, designed to ‘keep them on the hook’ to ensure they do fulfill their offset obligations. Companies need to think about this very carefully,” Rogan said.

The Avascent report predicted that the worth of global offset obligations will continue to rise even after reaching the $50 billion point.

“That number is likely to grow as emerging markets move away from penalty payment schemes. A greater emphasis on enforcement of these increasingly sophisticated policies amplifies this challenge,” according to the report from the business consulting firm. “Additionally, the new requirements are often complex, unpredictable and opaque. Some governments are even lowering the threshold for sales that are subject to offsets, and requiring obligations that exceed 50 percent of an awarded contract’s total non-indigenous value.”

However, Rogan, who was in Washington last week speaking at the National Defense Industrial Associations Quadrilateral Conference, has said he reckons Avascent’s estimation is on the high side. Whatever the number, Rogan said, the situation is “frightening, and chief financial officers are asking how the problem is going to be resolved.”

While customer countries’ knowledge that it’s a buyer’s market is driving growth in offset obligations, the other part of the equation may be a recognition that past offsets have not worked out as intended.

“The greatest problem is that the outcomes that were expected in the offset process have been largely unrealized,” said Clark, a member of the advisory board at international communications firm Fleishman Hillard.

In the past, companies routinely created bid proposals with no intention of meeting obligations, sources said. In the bid process, companies would budget for the penalties associated with failing to meet offset targets, assuming that paying away an obligation was a better solution.

But several countries have grown wise to the game, and now only allow companies to pay for part of the obligation. The rest is rolled over to a contractor’s next deal. With the obligations accumulating, eventually a contractor may find new deals underwater, where the contracts provide less revenue than the potential total offset obligation.

This situation lacks an obvious solution, analysts said. None provided an answer to what could be done in the immediate future. But both industry sources and analysts said that both countries and contractors need to arrive at a solution lest the obligations entirely fall by the wayside.

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