Industry Tees Up Policy Issues for 2016

The Beltway establishment is looking to a new administration to take on issues that have long been festering among defense contractors.

The industry is gearing up for a renewed push after the 2016 election in hopes that new leaders in the executive and legislative branches of government will tackle policy reforms in areas like foreign investment in U.S. companies, industry globalization and technology spending.

The defense sector faces daunting financial and political challenges and, meanwhile, the government continues as if it’s business as usual, said John Hamre, president and CEO of the Center for Strategic and International Studies and a former deputy secretary of defense.

Industry concerns extend beyond the day-to-day budget battles that have hit most defense contractors’ bottom lines. One of Washington’s most influential think tanks, CSIS, wants to turn the spotlight on government behavior that industry CEOs believe is weakening the defense sector. “We want an industrial base that has all the energy and dynamism of the private sector,” Hamre said, and yet national security policies continue to make it difficult for the industry to attract global investors and to partner with foreign suppliers.

The regulatory process for foreign investment in U.S. companies is one area that should be reviewed, said Hamre. “These are private entities that have to compete for capital in the global markets.” The Defense Department apparently does not “understand this dynamic.”

Pentagon contractors also are unhappy about the allocation of defense research-and-development dollars. The Defense Department spends “a hell of a lot of money in R&D, but it’s funding institutions, not getting research developed,” Hamre said. “We don’t have a healthy balance between what we want done in laboratories versus what we want done in the private sector.”

A new report by the Congressional Research Service shows why this is a big deal for the defense industry. Contractors’ share of the Pentagon’s R&D budget has been falling for almost 20 years, with R&D contracts dropping from 18 percent of total contract obligations in fiscal year 1998 to 10 percent of the $285 billion in contracts obligated in 2014.

Despite increased spending on R&D from 2000 to 2007, adjusted for inflation, DoD allocated less money to R&D contracts in 2014 ($28 billion) than it invested more than 15 years earlier ($31 billion in 1998), according to CRS. And more than half of the Defense Department’s basic research budget is spent at universities.

The Pentagon worries that innovation is lagging in the industry and is urging contractors to increase corporate spending on defense technology. “Industry is getting pretty turned off at putting its own money at risk,” Hamre said, as more programs are canceled and contractors are left to eat the losses. “Tell me who’s going to spend the next $500 million developing a UCAS [unmanned combat air system] if at the last minute it gets shot in the head.”

Companies are in a tough spot as the Pentagon demands more innovation and management is compelled to pay out more cash to investors to shore up stock prices. If this trend continues, “how are we going to have the technology to keep refreshing the military?” asked Bill Lynn, CEO of Finmeccanica North America and DRS Technologies Inc., and a former deputy secretary of defense.

The defense industry no longer is a top player in global R&D. Of the world’s largest 20 industrial spenders, none are defense firms. Further, if one combined the R&D budgets of Northrop Grumman, Raytheon, Lockheed Martin, Boeing and L-3, that wouldn’t crack the top 20 either, Lynn said.

Lynn, who runs the American subsidiary of an Italian defense conglomerate, has been a long time critic of U.S. industrial policies that disregard the globalization and commercialization of the defense business. The Pentagon talks about “lowering barriers” to commercial firms so they can enter the defense market and challenge the status quo. Lynn questions that approach. “Google and Microsoft aren’t that interested in the defense market.” But defense firms could bring innovation into their supply chain by partnering with commercial and foreign firms.

Government officials agree that the Pentagon has been slow to catch up to these business realities, but they do not foresee sweeping change any time soon.

“The defense industrial base is increasingly more commercialized and more financially complex,” said Stanley Sims, director of the Defense Security Service. The agency oversees the National Industry Security Program Operating Manual that sets procedures and requirements for how government contractors must handle classified information. Foreign investments in U.S. firms are overseen by the multi-agency Committee on Foreign Investment in the United States.

“I think we are adapting, though not as fast as most of us would like,” Sims said. The government has to weigh the risk of allowing an American firm to share classified information with foreign counterparts. “How do we manage those risks?” he asked. “We are trying to use our authorities to help enable policy change.”

The dilemma for DSS is that it can’t always trust contractors to understand the risks. The agency recently investigated top contractors’ knowledge of their supplier base. “It was ugly,” said Sims. There is ample evidence that the “industrial base is not managing the supply chain in a risk managed approach,” he added. “If you’re looking for the United States government to do that, you are looking in the wrong place. Industry owns the supply chain.”

Defense CEOs, though frustrated, understand there is little they can do on these fronts, especially during the last year of a lame-duck administration. “We want to lift these topics up so they are part of the debate for the next president,” said Hamre. “We’re not trying to change policy now. These topics aren’t understood or mature enough.”

Topics: Defense Contracting, Procurement