For a decade, the defense industry has been shrinking with
dizzying speed as Pentagon budgets plummet and contractors either
merge or team up to compete for the few remaining US procurement
programs. Civilian employment in the defense industry has tumbled
by more than 2 million workers--at one point dropping at the
rate of 1,000 jobs a day. Long-respected names in the business
have either disappeared or become mere divisions in a new family
of mega-giant contractors.
The changes have given rise to concerns in some quarters that
the shrunken defense industry won't be able to rise to the challenge
of another great military conflict and that the industrial base
can't be sustained, let alone reconstituted.
However, industry and Pentagon leaders contend that the tectonic
shifts in the defense business are neither avoidable nor disastrous.
They see the contraction as a realistic and necessary response
to a changing world and that the shifts ultimately will save
money and broaden the base of technology upon which the US military
can draw for future weaponry. These leaders conclude the era
of years-long wars of attrition are over and that there is no
need to maintain an extensive, costly capability to "surge"
the production of large platforms such as fighters and warships.
They believe that the consolidation will offer American companies
a competitive edge over foreign rivals in the contest to supply
allies with military and civil aerospace hardware.
However, even those leaders who trumpet the benefits of consolidation
include an important caveat. They maintain that, if this "new
and improved" military-industrial complex is to work, DoD
and its suppliers will have to shift their thinking on how to
do business. Specifically, they warn, the Defense Department
must continuously come up with innovative ways to preserve competition
when there are only two companies--or just one--making vital
products.
"The Last Supper"
One of the red-letter events in the recent wave of consolidation
is known to industry insiders as "the Last Supper."
The coinage refers to a 1993 Pentagon dinner for the chiefs of
the nation's biggest defense contractors, hosted by then-Secretary
of Defense Les Aspin and his deputy, William J. Perry (who later
succeeded Aspin in the top job). Along with the meal, Aspin and
Perry served a blunt notice-the level of defense spending, which
was already on a five-year slide, was going to fall much farther,
and fast. Most of the guests were savvy to the situation; defense
buyouts, mergers, and sell-offs had been proceeding apace since
1986. However, Aspin and Perry urged their dinner guests to take
consolidation much further and much faster.
At the same time, DoD's two top officials insisted the Pentagon
would not play a role in designating which companies should stay
in business and survive. Instead, they said, they would allow
the market itself to rationalize the industry.
Later, Perry flatly stated, "We expect defense companies
to go out of business. We will stand by and watch it happen."
At the time of the Last Supper, the defense industry was burdened
with "enormous excess capacity," according to Jacques
S. Gansler, the current undersecretary of defense for acquisition
and technology. "The budget was plummeting, particularly
[the] procurement account," he said. Gansler noted that
an in-house Pentagon study in 1993 determined that the nation
needed only two fighter aircraft makers, not five as was then
the case. Likewise, DoD concluded it needed only one bomber builder,
as opposed to three. It came to similar conclusions regarding
tanks, submarines, missiles, satellites, and the like.
Perry, upon taking over as Defense Secretary in early 1994,
further emphasized consolidation "in both private and public
sector," Gansler said. The guiding principles, according
to Gansler, were "that they wanted to encourage consolidation
in order to gain efficiencies, but they wanted to maintain competition
in all critical sectors." These guidelines "are basically
the same that Secretary [William S.] Cohen is using ... now,"
Gansler said.
Former Lockheed Martin chief Norman R. Augustine, in a 1996
speech to a joint session of the Association of the US Army and
the American Institute of Aeronautics and Astronautics, boiled
down the situation in blunt fashion. "It is much better
to have 10 strong competitors than two," he said. "Unfortunately,
that choice is basically irrelevant, since it is not among the
options we have been given. The choice we have been given is
more precisely characterized as one between having 10 weak competitors
with dubious futures or two strong ones with hopeful futures."
When 51 Equals Five
Today, some of those defense contractors with "hopeful
futures" are four of DoD's five largest aerospace and electronics
suppliers, and they illustrate the magnitude of the contraction
the defense industry has just gone through. Today's big five
in aerospace--Lockheed Martin, Boeing, Northrop Grumman, Raytheon,
and Litton, ranked one, two, three, five, and nine in defense
contracting last year--consist of what were, just 14 years ago,
51 separate companies, nearly all of which counted as prime contractor
or major subcontractor heavyweights in their own right.
With size comes clout. Last year, Lockheed Martin alone was
paid 10 percent of all defense procurement dollars. The top five
contractors accounted for more than 25 percent of the total.
That was roughly the same amount that DoD expended on the next
95 defense contractors combined.
Now, Lockheed Martin and Northrop Grumman wish to merge into
a single firm. If the deal is consummated, the number of "megas,"
as some in the industry call the big four contractors, will shrink
to just three, and the new company would receive 28 percent of
the combined Pentagon procurement and research and development
budgets.
The Justice Department and Defense Department moved to thwart
the Lockheed Martin and Northrop Grumman merger, however. They
do not necessarily think the new company would be too big; rather,
they are concerned that the combination would create a virtual
monopoly in some areas-most notably, in the field of electronic
warfare. The lack of competition, the government said, would
cause innovation in this vital area to languish and would endanger
"our soldiers' lives and our taxpayers' wallets," in
the words of Attorney General Janet Reno.
The government has asked Lockheed Martin to sell off some
of its electronic businesses in order to preserve competition
in these areas. The company has declined, wants to pursue the
merger as now structured, and the issue is scheduled to be settled
in court later this year.
The problem underlying the Lockheed Martin and Northrop Grumman
merger, according to the government, is one of "vertical
integration." When a company has in-house capabilities down
to the second- and third-tier supplier levels, it can not only
bid on new platforms as the prime contractor but as a "package
deal," essentially selecting itself to provide subsystems.
The problem with this is that other second- and third-tier suppliers
might never get a chance to bid on the subsystem work dominated
by the prime, and the in-house division, facing no competitor,
has little incentive to innovate or keep costs low. As time goes
on, the critics claim, competitors disappear from lack of work,
and innovation is further stifled.
The federal government argues that this proposed merger would
"reduce competition in the sale of advanced tactical and
strategic aircraft, airborne early warning radar systems, sonar
systems, and several types of countermeasures." Lockheed
Martin is the prime contractor for the Air Force's F-16, F-22,
and F-117 fighters, while Northrop Grumman is the prime contractor
of the Air Force's Joint Surveillance Target Attack Radar System
and B-2 stealth bomber.
No to Monopoly
"At some point, the logical extension of consolidation
is monopoly," Gansler said. "When you get down to the
point where consolidation from two to one eliminates total competition,
then it's obvious you blow a whistle and you stop."
Gansler emphasized that the government's move on the Lockheed
Martin deal doesn't signal a shift in policy and that consolidation
probably should continue.
"We're ... trying to let the market operate and not try
to say to firms what they should and shouldn't do," he asserted.
"We simply want to get down to the point with market forces
operating whereby we still have competition left, but we have
greater efficiency. ... We're going to look at each case separately."
Ironically, the federal government was warned about the vertical
integration problem two years ago and by none other than Augustine
himself. In a 1996 speech, Augustine pointed out that vertical
integration threatened to provide mega-companies "the opportunity,
if they wish to pursue such a course, to ... shut out as sellers
those traditional second- and third-tier component suppliers
who, operating at the lower end of the manufacturing 'food chain,'
normally sell to the 'primes.' "
Augustine warned then that there were "disturbing signs
that some in the aerospace community have elected to follow"
the shut-out route, which he said would prompt competitors to
follow suit in self-defense. "This is a trend," he
said, "about which our government, as both a large purchaser
of aerospace products as well as the guarantor of free-market
practices, should be evidencing a great deal more concern than
it has indicated thus far."
Northrop Grumman CEO Kent Kresa, addressing the AIAA in Washington
in May, said industry will avoid shut-out practices "not
... out of the goodness of our hearts" but because "it's
good business." Any major contractor who "freezes out
competitors by denying them access to components" or "shuts
out those traditional vendors selling second- and third-tier
components up the value-added process," Kresa observed,
"will cut its own throat in the long run. It will stifle
its access to innovation and give huge advantages to its competitors."
Augustine, in his speech, also made a key point about the
efficiencies to be realized from consolidation. The merger that
created Lockheed Martin, he said, eliminated 14 million square
feet of unneeded factory space and cumulatively produced savings
of $1.8 billion a year, most of which would be passed on to the
government in the form of lower overhead costs and lower bids
on new systems. Such savings, he noted, were equivalent to what
the government says it will eventually save "as a result
of the rather monumental effort of the Base Closure and Realignment
Commission--or BRAC."
Kresa asserted that adding his company to Lockheed Martin
would produce additional savings each year of some $1 billion,
"a majority of which will accrue to our government customers."
The General Accounting Office, a congressional watchdog agency,
said in an April report that there is "little evidence"
that the Pentagon has been harmed by industrial consolidation
so far. The Defense Department, it said, encouraged consolidation
to "eliminate excess capacity to remain competitive and
financially viable," adding that DoD expects "significant
cost savings" from the shakeout.
Putting it more simply, Augustine noted that "two full
factories" running at full capacity are more efficient "than
four half-full" ones.
The New Industrial Way
Part of the solution to maintaining a healthy defense industrial
base, according to Gansler, is to limit, as much as possible,
the strictly "defense" aspect of it. By using more
off-the-shelf commercial technology, and by using new computer-run,
adaptive production methods, the base of technology--and suppliers--upon
which the Pentagon can draw would be broadened so that "we
only have one industrial base."
As an example, Gansler noted that certain electronic cards
used in the F-22 fighter and Comanche attack helicopter are made
on the same assembly line as those made for use in automobiles.
"The computer knows" when the next item on the line
is defense-specific and builds it accordingly, Gansler pointed
out. Using such a process, an item that might have been very
expensive due to the need to set up tooling and facilities for
a low-volume run suddenly becomes relatively cheap because it
is made alongside high-volume items.
"So you get the overhead absorption, you saved at least
50 percent on the cost of the defense goods, and you have a greatly
expanded industrial base," Gansler explained. While such
an approach does not apply to items such as aircraft stealth
technologies or submarine quieting technologies--which have no
commercial market--using such practices as much as possible and
adapting them to defense-specific products can produce enormous
savings, Gansler said.
Using this commercial--goods and commercial--practices approach
will help cut down the Pentagon's onerous cycle time of 10 to
20 years for introducing new technology, Gansler noted. The computer
industry, for example, doubles the power of its products every
18 months, and the Pentagon should emulate its success by pursuing
"something that's more like [a] spiral development process
... where you have a continuing evolution of requirements and
products that come along every few years," staying abreast
of technological developments.
He added, "Assuming we're successful" in acquisition
reform and in moving toward more commercial products, "we'll
have a far broader industrial base."
Forget About a Surge
Part of the savings to be achieved in the defense industry
lay in abandoning the practice of maintaining manufacturing lines
or tooling for the sake of being able to "surge" their
production in wartime, Gansler observed. In the 21st century,
he said, "it's not likely that, in emergency conditions,
you're going to start building airplanes or ships or tanks or
things like that" since such systems would probably take
far longer to build than the conflict would last. "You don't
need the same standby capability that we had envisioned for World
War III, where you have huge amounts of equipment coming back
for repair and maintenance and huge production increases,"
such as in World War II.
In Gansler's view, the US would be likely to surge the "expendables,
[meaning] munitions, spare parts, things of that sort. ... So,
you need some standby capability for those," he said, but
to the greatest extent, that should be accomplished "through
an integrated civil-military" production line, so the Pentagon
doesn't have to pay "for ... excess capacity sitting around
waiting for a surge requirement."
An integrated commercial-military line also provides for surge
by simply shifting the emphasis of production, he noted.
Gansler acknowledged, however, that in some areas-such as
submarine construction-"it may be just for the purposes
of maintaining an industrial base that you're willing to accept
the inefficiencies and the subsidies required to do it. So there
are going to be cases where that occurs."
The Pentagon has managed to keep competition alive as the
industry consolidates but will have to increasingly turn to nontraditional
means of doing so, according to Eleanor Spector, director of
defense procurement.
"We still have two sources in every sector that we need
to compete," Spector asserted, adding that consolidation
has been "very healthy" for the Defense Department.
"We have a strong, healthy defense industry in the face
of a 60 percent drop in the budget," she noted. As the supplier
base narrows, though, there are things that can be done to maintain
competition even if there is only one supplier left for a given
item.
"We can provide things as government-furnished [equipment],"
she said. "If teams form that don't allow for competition
in some cases, we can break up exclusive teaming. If teams form
that create [a] sole source, we can have international competition.
We can create firewalls within companies if we have to. We can
do dissimilar competition, as you saw with the non-developmental
aircraft vs. the C-17."
There is "a whole menu of things ... that we can do to
create competition," said Spector, "and we will."
Gansler observed that, if there is a sole-source situation,
"you can always start up an R&D effort for the next-generation
system to create an alternative, rather than depend on one supplier."
All these techniques "exercise the buying power of the government,"
he said.
The prospect of dissimilar competition has been used as a
lever in the Navy F/A-18 and Air Force F-22 fighter programs,
Gansler noted, and DoD has held out variants of the forthcoming
Joint Strike Fighter as competition. Similarly, "competing
missiles vs. airplanes" is an example of using different
approaches to the mission itself as the competitive prod.
Foreigners Can Play
Moreover, because the US will probably conduct most of its
future wars as part of a coalition, Gansler said, finding a foreign
supplier/competitor on some systems is acceptable, since it is
in the alliance's advantage to have interoperability.
Gansler said the Pentagon's policy on foreign ownership of
US defense firms is to treat such proposals on a case-by-case
basis. If a foreign company were to take an equity stake in a
US contractor doing sensitive work, "they would have to
set it up as a separate operating unit. They'd still have the
equity, but [they] wouldn't get the technology transfer."
Noting the competing interests of foreign and US companies,
Gansler said, "You run into the [fact that] they're your
ally in a military sense and then your competitor in an economic
sense, and where that line is drawn becomes more and more difficult"
to determine. Still, he warned against "the trend toward
'Fortress Europe' and 'Fortress America,' " in which protectionism
prevents the alliance from benefitting from its members' technologies.
Such a stance "is inconsistent with the concept of coalition
warfare." Gansler wants to see more "trans-Atlantic
linkages," but he prefers to let industry work out the structure
of such cooperation for itself.
The mega-mergers in the US defense industry are probably drawing
to a close, according to Denis A. Bovin, vice chairman of investment
banking and senior managing director at Bear Stearns & Co.,
an investment banking firm that has participated in many of the
deals that created the supercontractors.
"We're probably looking at the end of what I would call
the 'leadership mergers,' " Bovin said at a recent AIAA
conference, "but we'll pick up speed in [mergers among]
the secondary tiers."
