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 February 2016 

Craig R. McKinley

New Blood May Stem Industry Consolidation

February 2016

By Craig R. McKinley

William J. Perry, the nation’s highly respected former secretary of defense, was recently in Washington, D.C., to present his latest book, “My Journey at the Nuclear Brink.” It is yet another contribution to a public career that has, by any measure, been extraordinary. I highly recommend it.

In comments he made to defense reporters in Washington, D.C., it was not Perry’s observations about nuclear strategy and force structure that caught my attention; rather it was his recollections of the defense industry consolidation that occurred during his time as defense secretary in the early 1990s.

He had hoped that the restructuring of the industry, which followed his famous 1993 “last supper” with senior industry executives, would have resulted in a leaner industry rather than one consolidated into a few large firms.

These comments are conceptually consistent with others recently made by Defense Undersecretary for Acquisitions, Technology and Logistics Frank Kendall expressing his discomfort with United Technologies’ (UTC) sale of its Sikorsky Helicopter unit to Lockheed Martin. Kendall observed that, “with size comes power, and the department’s experience with large defense contractors is that they are not hesitant to use this power for corporate advantage.”

What is the issue here? It is the concern expressed by both of these tremendous public servants that as the defense industrial base has contracted it has resulted in a structure that is — conceptually at least — less conducive to price control and technological innovation, conditions that flow from greater competition. I am sympathetic with the argument, but only to a point.

As many of my previous postings in this column have indicated, at the National Defense Industrial Association we are concerned about the shrinkage of the defense industrial base that has occurred over the past two decades. It is in the nation’s best interest to have a competitive and technologically vibrant defense industry that is geographically dispersed and diverse. Our nation, along with many of its close allies around the world, relies on America’s “Arsenal of Democracy.”

The U.S. defense industrial base is a major strategic asset and key competitive advantage that extends U.S. influence and enhances the nation’s capabilities. But this capability largely resides in the nation’s private sector, and government leaders must recognize that this circumstance results in their having only indirect influence over corporate decisions.

Private sector companies that are well managed are always seeking ways to become leaner. As Heidi Shyu, the Army’s former service acquisition executive, has stated, excess overhead in a company directly translates to extra costs and lower profits, making company management very “lean-conscious.”

In the early 1990s, when Perry convened his “last supper,” many defense companies had some excess capacity associated with programs they had committed to that were either being canceled or significantly reduced in scale. But much of their management overhead was tied to government accounting and auditing practices. Since some of it was unable to be reduced proportionately with program reductions, this meant that consolidation was the only viable pathway in the face of sharply declining acquisition spending. Company “miniaturization” was never a real choice, the result being some 50 companies — depending on whose data one uses — consolidating into five or six of today’s “top tier primes.”

Consolidations such as this can increase economies of scale, but increased size and market share can also shift pricing power toward the firm and away from the consumer.

This was the concern expressed by Kendall, who noted that he was “neutral” on the Lockheed-Sikorsky deal so long as, “it doesn’t affect our prices much.” This comment basically acknowledges that U.S. anti-trust law does not limit company size or market share. As the Supreme Court noted in the 1920 case of United States v. United States Steel Corp., “[T]he law does not make mere size an offense, or the existence of unexerted power an offense.”
Where anti-trust law can come in to play is where companies are known to collude on price, or otherwise control them, by creating barriers for other firms to enter the market.

Regarding prices, this does not seem to have happened as the Pentagon recently reported that program cost growth has been greatly reduced over the past decade. And as for barriers to entry, many would argue that the Pentagon’s own intrusive reporting and auditing requirements are themselves the greatest barrier to new firms entering the defense market. This seems to be the major message Silicon Valley companies have passed to the Defense Department following Secretary Ashton Carter’s April 2015 outreach to them.

It may be that Perry’s recent comments are intended to signal that the Defense Department remains opposed to further industry consolidation, the Pentagon’s unstated position since its 1998 opposition to the proposed merger of Lockheed Martin with Northrop Grumman. If so, that is a useful clarification. As some industry experts have indicated, the government has almost no tools available to prevent a company making a strategic divestiture, such as UTC did with Sikorsky, and a tough case to make when opposing mergers on anti-trust or monopolistic grounds.

Therefore, the better focus is to attract new firms into the defense market, which means aggressively eliminating barriers to entry. But to do that, the Pentagon needs to look objectively at where those barriers are and who has created them.

  

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