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Industrial Base
To Defeat Today’s Threats, the Pentagon Needs Innovative ‘Mid-Tier’ Contractors
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By Michael W. Murphy
Defense Secretary Robert Gates has shown courage in making game-changing decisions such as canceling major weapons programs and holding officials accountable for their performance.
There is another area of critical concern to the nation’s security that Gates, as well as the leaders of U.S. intelligence agencies, have yet to tackle: How to ensure that the government gets the most value out of its industrial base so that the United States can defeat the threats it faces today and in the future.
Considering the enemies the U.S. military now must confront, national security is dependent upon the ability to “beat our enemies to the punch.” The insurgents and extremists know they cannot take on the U.S. military conventionally so they quickly adapt their tactics and equipment to counter U.S. forces, weapons and techniques.
The nation’s defense and intelligence industrial base, meanwhile, is not structured to provide the speed, innovation and flexibility that are now required to stay ahead of the threat.
Uncompetitive contracting practices, the Pentagon’s own explicit consolidation push in the 1990s, and its current blind passivity in allowing the large primes to acquire critical mid-tier contractors have created an oligopoly in the defense and intelligence sectors where only a handful of firms dominate the market. But much of the innovative technology and responsive services that the military and intelligence community need reside in mid-tier firms.
Mid-tier companies generally are characterized as those bigger than government defined “small businesses” but have less than $1 billion to $2 billion in revenue. By comparison, the largest four defense focused prime contractors averaged $34.1 billion in revenue over the last 12 months.
These smaller companies are unable to thrive because of government practices such as “bundling” work into mega-contracts that favor big companies. Under the current dynamics of the market, those mid-tier firms often end up being acquired by the large primes who have tens of billions of collective acquisition capital. This trend over time drains competitive forces and innovation out of the marketplace.
The problem was well articulated by a House Armed Services Committee report on acquisition reform that was published in March.
“The length and scope of weapon system programs has accelerated defense industry’s consolidation around a handful of aerospace firms that now control large amounts of production capacity across the entire span of the defense acquisition system. Only the largest firms have access to the resources and expertise to bid on the most complex programs, and it is difficult for firms of all but the largest size to survive losing them. As a result, competition is reduced at the front end of programs, and all but eliminated in the sustainment phase. … Small businesses are largely locked out of the process or accorded contracts only on the goodwill of one of the larger firms.
“Mid-tier companies are either absorbed or decide to abandon defense acquisition for the more competitive commercial sphere, especially after a large weapon system competition loss. Winning or losing individual contracts becomes such a critical matter that the incentives to protest contract awards are overwhelming. … The end result of this process is the gradual erosion of competition and innovation in the defense industrial base.”
The overall result is a government mid-tier “blind spot” which puts in jeopardy the very sources of innovation and responsiveness necessary to defeat adaptive enemies.
Federal agencies appear to be unaware or indifferent to how their procurement practices create structural limitations to mid-tier and subcontractor growth. The government has defaulted to allowing “market forces” to contract the industry around a handful of 20th century weapon systems manufacturers with large internal bureaucracies necessary to manage their economies of scale.
Those who argue it is not appropriate for the government to be tracking or managing its supplier base should study how Fidelity Investments analyzes its supplier base (investment banks) to answer the simple question: “Who is providing us the most value today?” instead of simply defaulting to Goldman Sachs and Morgan Stanley because they are the biggest or best known.
The Fidelity supplier base tracking and analysis voting system is simple, brutally efficient and fair. It determines which suppliers get a bigger piece of the Fidelity research service payments in the quarter and, as importantly, which ones get no payments. The supplier tracking and analysis system is simply good business and promotes a supplier base which is more innovative and responsive.
It is not clear why the government is incapable of this type of tracking, analysis or supplier base management — whether it is a lack of interest, ability or resources to undertake the effort.
The Defense Department, particularly, cannot afford to turn away from this debate or shy away from making the necessary but sometimes difficult changes in its relationship to its industrial base.
Given the government’s mid-tier blind spot and operating inefficiencies, its reliance upon “market forces” is ironic in a market where the government is simultaneously the predominant customer, regulator and influencer. Thinking the national security market is efficient (in economic terms) or “free” is not credible given the government’s dominance, including allowing a supplier oligopoly to form over the years. For the government to still rely on “market forces” to further harden this oligopoly is dangerous in today’s security environment.
The 2010 Quadrennial Defense Review and recent comments by Undersecretary of Defense for Acquisition, Technology and Logistics Ashton Carter underscore the government’s own realization of the existence and potential consequences of this mid-tier blind spot.
The QDR acknowledges the Defense Department’s relative blindness of the subcontractor base, where it relies upon prime contractors to pick “winners and losers” without the Pentagon knowing who these critical subprimes are, much less tracking and assessing their competitiveness and financial viability.
It has been groups outside government, such as Center for Strategic and International Studies and the Professional Services Council, which have shined a light on the government’s blind spot and provided key data, analysis and prescriptions. Considering the abundance of studies about the government/industrial base relationship — including several conducted by the government itself such as the House Armed Services Committee or by Pentagon affiliated panels such as the Defense Science Board in July 2008 — it is striking that there is such paralysis of action to create a more competitive and open national security market.
The government cannot remain paralyzed by a “paroxysm of fear.” Instead, it must build off the analytical foundation to date and act. It should identify and incrementally fix, as soon as possible, uncompetitive contracting practices and promote innovative ones that already exist in pockets of the government today.
In the private sector, corporate leaders and institutional investors act under the assumption that there is no such thing as “perfect information.” Inaction while waiting for perfect information or market certainty is dangerous in and of itself. Ask Microsoft about Google. It leads to suboptimal performance and negative market feedback.
The Pentagon’s industrial policy leaders are planning meetings with mid-tier company representatives and a series of industry studies. This would be promising if it were a new initiative but it is not. Detailed industrial base studies were completed by the Defense Department industrial policy office in 2004 and 2005 and, yet again, by the Defense Science Board in 2008 and the House Armed Services Committee in 2009 and 2010. The United States cannot afford to wait for another series of government studies when there is already so much published data and analysis.
As noted by the Defense Science Board, the urgency of the situation cannot be overstated. Consider that a terrorist or militant can buy online a $26 piece of satellite TV software to tap into a multimillion-dollar unmanned aircraft video feed, just as they can hack into critical national security and infrastructure networks. Our technological strength can quickly turn into weakness at the hands of just a small cell of terrorists.
In one of the few studies of its kind, the Pentagon’s industrial policy office in 2005 identified the critical, innovative technologies which are needed for 21st century wars and found that 35 to 45 percent of the companies supplying those key technologies had fewer than 100 employees. It is unclear what further percentage came from other mid-tier companies with more than 100 employees.
Many of those mid-tier firms are being squeezed and consolidated out of the market. In a study of professional services government contractors, the Center for Strategic and International Studies found that mid-tier firms’ market share fell from 44 percent of total contract value in 1995 to just 33 percent in 2007, and that large companies increased their share from 37 to 46 percent during the same period.
Additionally, there have been at least 56 acquisitions since 2001 of mid-tier government services firms with annual revenues between $100 million and $1 billion, with a combined transaction value of $18.6 billion.
There is clearly nothing wrong in a capitalist system when a company founder or investor decides to sell and receive a financial return. It’s the American way.
The problem is not the financial markets, but the unintended consequences of government procurement policies and practices that limit the growth prospects of mid-tier companies and artificially depress their “go it alone” or acquisition valuations. Mid-tier companies are under intense pressure from their investor base, especially if they reach the public markets, to grow revenues and profits at a high rate.
Often mid-tier firms in the defense market are highly prized by the large primes whose organic growth rates are much lower, as public investors pressure the primes for growth as well. At an industry conference in 2006, one topic of discussion was Veridian, a publicly traded, mid-tier network security contractor that had been acquired by a large prime in 2003. The discussion was around whether the government was better off with Veridian being acquired by the large prime or remaining as an independent company. The buyer paid approximately 18 times
Veridian’s trailing 12 months’ earnings before interest, taxes, depreciation and amortization expenses, which was one of the highest merger multiples to date in the sector. Still, the acquirer said that the deal would be financially accretive to its shareholders immediately given how fast and profitably Veridian was growing at the time.
Veridian was as good a mid-tier candidate to eventually become a prime. But it was virtually impossible for the Veridian board of directors to reject that offer or for the Veridian shareholders not to approve the acquisition given the premium pricing multiple offered and the existing structure of the industry.
A relevant question in 2010 is whether the government and the nation are better off without Veridian, Essex, Overwatch Systems, EDO, Axsys, BBN Technologies and scores of other mid-tiers that were acquired by multibillion-dollar defense companies. It is worth noting that two other innovative mid-tier companies, Argon ST and L-1 Identity Solutions, recently hired investment bankers to review “strategic options.”
What is happening today amounts to major transplant surgery of 21st century mid-tier technology innovation and responsive services onto 20th century weapons focused companies optimized for economies of scale with a large, supporting bureaucracy. Some key mid-tier management and their key technical personnel end up leaving the large prime contractor right after the acquisition closes or whenever their retention employment contracts end.
For a 29-year-old systems engineer who worked on key technologies within a 1,000 employee mid-tier firm, it makes a big difference when he becomes employee number 90,251 within the bureaucracy of a large prime. The resources available may be greater, but the prime’s multiple layers of management and bureaucracy are oftentimes stifling to the most creative and innovative technologists and program managers. Many reject the transplant into the large prime and leave. This has negative consequences for the company, the government customer and, by implication, national security. Large defense companies are optimized for economies of scale going back to World War II and the Cold War, not for agility.
Given the potential threats from nations such as North Korea, Iran, Russia and China, the United States will always be dependent upon large primes to build big-ticket weapons. It also goes without saying that their employees are just as committed to national defense and work as hard as any small and mid-tier employee. But it is difficult to operate flexibly and responsively within a bureaucracy supporting 75,000 to 150,000 employees.
Imagine if the government influenced the commercial sector as much as it controls the defense industry and, for instance, it limited the ability of companies such as Google to become the next Microsoft or the ability of some other company to become the next Google.
It is worth asking why there has not been a new name within the top five defense contractors over the last 20 years.
Overall, the government could create a more efficient “free market” by eliminating the structural limitations to mid-tier growth.
From purely an investor perspective, this would allow mid-tier entrepreneurs and shareholders to capture a fuller return of the mid-tier value, which would potentially be greater over the long term than they are receiving today via acquisitions. In the vast majority of cases, if the mid-tier entrepreneur or shareholder decided to sell anyway, that is their choice.
Today, the large primes collectively have tens of billions of ready cash and available credit to acquire the entire publicly traded mid-tier sector at a high multiple. Given the huge resources of the large primes, the government probably would not be able to alter the existing oligopoly and mid-tier consolidation trends. But the nation’s leaders cannot afford to turn away from this debate as has been the case for decades or shy away from making the necessary changes in the government’s relationship with the industrial base to shape a more open and competitive market.
The nation cannot continue to wait for the government to act.
Michael W. Murphy is managing director of Millville Consulting Partners in Boston, Mass. This article is adapted from a white paper, titled, “National Security, Wall Street and the Government’s Mid-tier Blind Spot.”
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