Mighty Pentagon Can’t Deny Market Forces

Top defense contractors are merging or looking to buy up their competitors. Key suppliers are exiting the military market, leaving the Pentagon with fewer options. And while innovation flows freely in the civilian economy, the Pentagon struggles to exploit commercial technology as it seeks to modernize Reagan-era weapons and protect military networks from cyber attacks.

Market forces are such that the Defense Department could be headed toward a future of greater dependence on fewer and increasingly more powerful monopolies, and the likelihood that it may have to pay higher prices if there are fewer competitors. An even greater concern for the Pentagon is how to ensure access to the cutting edge talent it needs to compete in a globalized arms race, where advanced disruptive technologies are available to rival militaries, terrorist groups and other adversaries.

Pentagon procurement chief Frank Kendall for years has championed the cause of increasing competition and injecting innovation into the defense market. He has frowned on mergers of top-tier contractors and has called on defense firms to step up investments in research and development.

But as much as the Defense Department would like to “manage” the defense industrial base, it has relatively few tools to do so, says former Pentagon acquisition official Andrew Hunter, now at the Center for Strategic and International Studies.

The recent U.S. government approval of Lockheed Martin’s acquisition of Sikorsky Aircraft was too much to take for Kendall. He let it be known that this was bad news for the Pentagon, as it would invite other prime contractors to follow suit. Even though the merger passed the federal antitrust review process, it would not have met Kendall’s threshold. Current antitrust rules do not provide “tools to manage the defense industrial base in the way Kendall might like to,” says Hunter. The Defense Department often wishes it could more effectively shape the decisions made by major corporations, but there are limits to what it can do.

With its buying decisions, though, the Pentagon has been the primary catalyst of industry consolidation even if it doesn’t like the end result. “There has been contraction, there has been less competition and I think we’ve come to an era of really big platforms, which made winners and losers out of industry,” says Paul Francis, managing director for acquisition and sourcing management at the Government Accountability Office.

It is doubtful that that trend can be reversed. With fewer competitors in play and pressures to modernize, the Pentagon has to take a realistic view. There is a backlog of programs that are scheduled to ramp up production in the 2020s, and the industrial base may not be able to meet these demands, notes Todd Harrison, defense budget analyst at CSIS. “We have put off replacements for many years. Programs are stacked up right now. Even if the money is available, that will stress the capacity of the defense industrial base.” Defense leaders, he says, need to “get more involved in understanding the defense industrial base and being prepared to actively manage when needed.”

It has been known for years that the Pentagon’s supply chain is vulnerable to “single points of failure” as when a key component is made by just one supplier. If push came to shove, the Defense Department could stop a corporate merger, but has no levers to pull if a company wants to exit the market.

A stark illustration is found in the industry known as “trusted leading edge microelectronics.” Market trends in this sector have put the Pentagon in a bind, according to Marie Mak, director of the acquisition and sourcing management team at GAO. Once dominated by domestic sources, microelectronics manufacturing has migrated to Asia and is focused on high volume production and short life cycles driven by demand for consumer electronics. IBM, the Pentagon’s only supplier sold its semiconductor plants to Abu Dhabi-owned Global Foundries in July, “resulting in increased uncertainties about DoD’s access,” Mak says at a congressional hearing. To fill this gap, GAO might recommend that the Defense Department build a government-owned manufacturing facility.

Microelectronics is one among several defense industrial base issues that Congress is watching. Others include rare earth materials, specialty metals and counterfeit parts. Lawmakers have chided defense officials for lacking an industrial base strategy that is proactive rather than reactive. Mak agrees. “There are definitely trusted suppliers in the U.S. but they don’t provide the leading edge. Could they get there? Potentially. But it’s going to cost and it’s going to take time.”

Defense industry consultant Tom Davis warns the Pentagon to not naïvely assume that companies are going to make decisions based on national security concerns rather than profits. “Major companies are run by the descendants of Jack Welch, not Jack Northrop. They are not going to operate at a loss. They’re focused on shareholder value. They will be quick to get out of an industry that is not making money.” In some areas, the Pentagon can get by with one provider or two, “as long as they are healthy companies.”

Harrison echoes that view. “DoD has to think strategically about where to apply competition and admit that in some areas it should manage the defense industrial base like a public utility.”
These trends are coming to the fore as the Pentagon comes under pressure to step up its technology game. The top four U.S. defense contractors combined spend only 27 percent of what Google does annually on research and development. And yet, the defense acquisition system “all too often serves to repel, rather than attract, producers of disruptive new technologies,” notes Sen. John McCain, R-Ariz., chairman of the Senate Armed Services Committee.

Howard Rubel, industry analyst at the investment bank Jefferies, wonders if the Pentagon understands “how the capital markets work,” he writes in a CNBC column in which he criticized Kendall for his stance against the Lockheed-Sikorsky combination. Such statements, he adds, are “really devoid of understanding economics.”

Topics: Business Trends, Doing Business with the Government, Defense Department, Science and Engineering Technology