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National Defense > Blog > Posts > Analysts: Procurement Reforms Strengthen Prime Contractors, Weaken Mid-Tier
Analysts: Procurement Reforms Strengthen Prime Contractors, Weaken Mid-Tier
By Sandra I. Erwin



Efforts by the Defense Department to lower the cost of contractor services have led to unintended consequences, including a realignment of the industry in ways that could squeeze the government’s purchasing power.

A trend in defense contracting to select the lowest price, technically acceptable bids, known as LPTA, has been a powerful catalyst for change, although not necessarily the change the Pentagon envisioned, concludes a new study by the analytics firm Govini.

By favoring LPTA contracting, the Defense Department and other agencies have commoditized many products and services, sparking a wave of corporate consolidations and spinoffs as some defense contractors have moved to unload their less-profitable service businesses. Meanwhile some IT and professional services providers have acquired competitors to achieve economies of scale and become more viable in the cutthroat LPTA environment.

Manufacturers of major weapon systems that own the technical data, however, can still command premium prices, which creates incentives for companies to acquire other prime contractors and further reduce competition in the market.

“Agency reliance on LPTA has inadvertently fueled monopoly positions for larger contractors while squeezing contractors and suppliers in the middle of the supply chain,” the Govini report says. The company, based in Arlington, Virginia, analyzes contracting data for clients in the federal market.

“In the past several years, emphasis on LPTA has changed behavior in the marketplace, prompting shaved margins, spinoffs and consolidation to achieve economies of scale in low-priced markets,” the study says. “This drives more monopolistic positions for the few remaining contractors, allowing them to command a higher price.”

Prime contractors that own the rights to major platform designs will find favorable winds whereas service-only providers face a tough climate, Govini CEO Eric Gillespie says in an interview. For the Defense Department, this could mean paying higher premiums for logistics support of its major weapon systems, creating the opposite effect sought by LPTA contracting.

“Primes that own the platform, the supply chain, and the accompanying intellectual property will increase their competitive advantage,” he says. “Competing on IP allows contractors to command a price that disrupts the LPTA efforts and allows margins to be increased.”

The use of LPTA has inadvertently positioned platform owners to have "more leverage and be able to circumvent the intentions of LPTA,” says Gillespie.

This could create problems for the Pentagon as it will become more dependent on monopolies, says Arun Sankaran, managing director at Govini. “Once you own the IP, you can command a higher premium for your services, and you have a lot more bargaining power with the government against their LPTA approach.”

The government’s behavior has created winners — weapon producers that are original equipment manufacturers, or OEMs — and losers that have little leverage to price their services. While the government will be able to get better deals for commoditized services like civilian IT, it probably will not see reduced prices for specialized work such as upgrades of weapons systems and logistics support, says Sankaran. “It puts the Department of Defense in a hard spot. I think it’s a result of squeezing the services industry on price so much.”

The most visible example of how the market is changing in response to LPTA contracting is Lockheed Martin’s purchase of Sikorsky Aircraft. “It goes beyond just helicopters; it creates a giant in the defense logistics support market,” Sankaran says. The outsized dominance by large contractors that own platforms leaves “little opportunity for those not currently allied with them to break into the market, or even maintain their share. If you don’t have a platform, the government is going to dictate their terms of affordability to you. If you own a platform you have more control of your own destiny.”

These market forces could trigger moves by defense contractors that currently do not own platforms to acquire companies that do, Gillespie says. Prime candidates now are unmanned aircraft manufacturers like General Atomics, he says. “UAVs are the last platforms standing. Companies that desire to own a platform should be evaluating UAV manufacturers.” General Atomics — maker of the Predator UAVs that are widely used by the U.S. military and are expected to be acquired by other nations — has rebuffed takeover attempts in the past but may have to reconsider in the current market, Gillespie says. “If there was ever a time for the owners to maximize the value of that platform, now is the time.”

Govini’s findings could throw a wrench into the Pentagon’s calculations that it could save billions of dollars on weapons logistics support and maintenance costs by opening up the market to new competitors. To do that in a market that is dominated by single-source manufacturers, the government would need the OEM to grant intellectual property rights to the technical data so the Pentagon can seek competing bids for maintenance or production of that equipment. In the spare-parts and equipment repair business, particularly, Pentagon program managers are seeking lower-priced deals but cannot legally release design data to competitors without the manufacturer’s permission.

Friction over data rights has ebbed and flowed in cycles in recent decades. “It’s a conversation that has been going on for a long time,” says Sankaran. “I think that’s where the government sometimes doesn’t truly understand business motivations,” he adds. “If a company develops a technical data package, they’re not going to give it away. It diminishes their competitive advantage.”

Gillespie doubts that the Pentagon’s efforts to turn the tables will succeed. “I don’t think it will ever happen, to be honest,” he says. “The Defense Department uses the private sector for R&D. If there is no incentive for the private sector to innovate, if they remove the upsides from the equation, then you do have a problem. DoD on its own can’t develop the innovation it requires to stay ahead.” The same argument could be made about the Pentagon’s plans to develop weapon systems with “open architectures,” observes Gillespie. “I don’t know how you maintain military dominance if you open source all of the IP and technology.”

This creates a real dilemma for the Pentagon, says Sankaran. “DoD is struggling with how to create affordability without commoditizing the industry that supports it. LPTA contracting is the easiest resort to create affordability. They are trying more creative measures like opening up the architectures, but once you start doing that, the industry will perceive that as giving away their secret sauce and becoming commoditized. This doesn’t resonate well with shareholders.”

A similar challenge lies ahead for the Pentagon as it seeks to attract nontraditional suppliers, says Sankaran. “DoD is trying to communicate the message that they’re trying to be a friendlier place for commercial suppliers. What they’ll find is the further you get away from the traditional supply chain, the less tolerance commercial providers will have for stringent procurement rules that restrict their profit margins.”




Photo Credit: Thinkstock,
Govini

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