Tough Balancing Act for Defense in Shaping Industry Consolidation

When Bell Labs was acquired by the French technology conglomerate Alcatel-Lucent, the Pentagon was not happy. It could not legally stop the acquisition but it had the prerogative to no longer do business with the company.

The question of how much power the Pentagon really has to compel its contractors to merge or to not merge came under scrutiny last week when Undersecretary of Defense for Acquisition, Technology and Logistics Frank Kendall criticized the recent takeover of helicopter manufacturer Sikorsky Aircraft by the nation’s largest military supplier Lockheed Martin Corp.

Kendall lamented the lack of legal means available to the Pentagon to prevent such deals. “The Department of Defense is concerned about the continuing march toward greater consolidation in the defense industry," he said. "The trend toward fewer and larger prime contractors has the potential to affect innovation, limit the supply base, pose entry barriers to small, medium and large businesses, and ultimately reduce competition — resulting in higher prices to be paid by the American taxpayer.”

But there is much the Pentagon could do to shape corporate consolidation simply because of its huge leverage as the industry’s largest customer.

The suggestion that the Department of Defense has no control over industry mergers is off base, said Kevin Kelly, CEO of LGS Innovations. “They can exert power with their checkbook like a consumer does,” Kelly said in an interview. “If they don’t like what they see, they can stop buying.”

In the case of the Lockheed-Sikorsky deal, the Pentagon may not have that option because both companies are sole-source suppliers of many key weapon systems the military buys. In other instances of contractor mergers, however, the Pentagon could exercise its buying power to show displeasure, Kelly said. “I’ve seen this personally.”

Dulles, Virginia-based LGS Innovations was previously owned by Lucent Technologies and was later spun off after Lucent combined with Alcatel. The Pentagon was directly involved in the review and approval process of that transaction because it involved foreign investment.

“When we were part of Lucent Technologies and Lucent and Alcatel combined, LGS was then owned by Alcatel Lucent, a foreign entity,” Kelly explained. The Defense Department did not like the merger because it did not want Bell Labs to come under French ownership, but could not legally prevent it from happening. “Even though DoD couldn’t disallow that merger, they just stopped buying,” he said. "Certainly if the DoD sees a combination of companies that makes them uneasy, they can vote with their feet and take their business elsewhere.”

Corporate mergers are closely reviewed by the Commerce and Justice Departments for antitrust concerns, as well as by the Securities and Exchange Commission. The Defense Department does not necessarily get a vote but it has other means to exert influence. “Usually before companies merge, they go talk to their customers to find out if they’re going to have a problem with the merger,”

Kelly said. “The best thing the customer can do is be honest and say, ‘I don’t like this combination.’ That would be taken into account.”

LGS Innovations, an intelligence and information technology supplier, recently acquired another defense contractor, Axios Inc., a provider of communications and signal processing systems. Such acquisitions are going to continue and the government is unlikely to stop them because of the strong market forces that are moving in that direction. “We’re evaluating several companies for potential acquisitions,” Kelly said. “Now it’s a good buyers market, a fluid and stable market. There are a lot of companies for sale.”

The Pentagon faces a tough balancing act as it tries to preserve competition, Kelly noted. “You have to avoid monopolies, and we have plenty of laws and regulatory approvals in place for that. Apart from that, you have to allow businesses the freedom to maneuver, or you are effectively legislating inefficiency,” he said. “You don’t want to pull all the stops out of the system. At the same time, you have to give business some flexibility to combine when it makes sense for efficiency.”

Kendall last week softened his initial disapproving reaction to the Sikorsky acquisition. “I was not trying to be negative about anybody,” he said at an industry conference. “Lockheed made what is probably for them a good strategic move.”

But it is clear that the Pentagon is becoming alarmed by the potential ramifications of this trend. Not only will there be fewer companies that can provide specialized military equipment but the government might lose its leverage vis-à-vis an industry dominated by a small number of corporate giants. “It’s a fact that with size comes the influence over things like the budget, over how acquisitions go,” Kendall said.

Pentagon officials also have been frustrated by the propensity of large defense contractors to spend their cash buying back their stock to keep investors happy rather invest in next-generation technology the Pentagon needs. The Sikorsky acquisition and the stock buybacks are a reminder that the Pentagon has limited means to manage the defense industrial base, Kendall said. “The tools we have to manage that trend are inadequate based on my recent experience. The tools we have are more limited than I realized.”

The Pentagon’s industrial policy office was created precisely to monitor trends and recommend actions to the secretary of defense. The office collects loads of data about the Pentagon’s supplier base, but has little ability to predict trends.

“We have to take a more proactive and predictive approach to how we look at the industrial base, so we can understand where the base is heading and figure out where we would like it to head,” said John G. (Jerry) McGinn, principal deputy director of manufacturing and industrial base policy at the Defense Department.

His office regularly conducts surveys and assessments of different sectors of the industry, McGinn said last week at the Heritage Foundation. Analysts try to identify fragile points in the supply chain so the government can ensure it will not lose critical suppliers. Those studies are important, McGinn said, but are not always useful because they are a “snapshot in time” that don’t provide insight into what comes next. “What we’re trying to do it turn those ideas into something more dynamic and predictive.” When it comes to mergers and acquisitions, the government’s traditional approaches to weigh company capabilities and antitrust implications also are inadequate, McGinn said. “These are not always sufficient given the global trends that are impacting the national security environment.”

Topics: Business Trends, Mergers and Acquisitions, Procurement, Acquisition Reform, Defense Department