The End of Merger Mania

jkitfield@njdc.com

Throughout the post-Cold War era, the operative metaphor for a rapidly shrinking defense industrial base has been an event since dubbed "the Last Supper." At that infamous 1993 dinner, Pentagon officials informed the assembled leaders of America's premier defense and aerospace companies that fewer than half would survive the Defense budget cuts to come. Each defense market segment, they said, would support no more than two suppliers where five or six had existed. The unmistakable message was that companies could merge, team together-or expect to wither on the vine for lack of contract nourishment.

The resulting period of radical downsizing in the defense industry was marked by massive consolidations and mega-mergers creating companies worth more than $100 billion.

That era may have officially come to an end, however, on July 16. On that day, top defense contractor Lockheed Martin withdrew its bid to combine with fourth-ranked Northrop Grumman to create a firm that would have had more than $16 billion in defense contracts in 1997.

Both the Pentagon and the Justice Department had strongly opposed the merger, which would have combined two companies that were themselves the byproducts of recent mega-mergers. On March 23, the Justice Department had filed suit to block Lockheed's effort.

"The proposed acquisition of Northrop by Lockheed would result in unprecedented vertical and horizontal concentration in the defense industry, which would substantially lessen, and in several cases eliminate, competition in major product markets critical to the national defense," Justice Department officials wrote in their brief.

Some industry analysts believe the Pentagon acted too late in putting the brakes on merger mania. "Washington is correct in stalling on the Lockheed Martin-Northrop Grumman combination because of what it will do to real competition in the aircraft and electronics areas," Lawrence Korb, a senior analyst at the Brookings Institution and a former Pentagon official, has written. "However, it should have used the same criteria to halt the Boeing-McDonnell Douglas and Hughes-Raytheon unions. One wonders why the federal government allowed the number of major defense firms to shrink to four from 50 before taking action."

Ever since the Justice Department's move to block the Lockheed-Northrop merger, defense industry executives have studied the antitrust case in an effort to discern the underlying message from its single, "monopolistic" customer. There's little question that the Pentagon has adjusted its philosophy of letting Darwinian market forces decide exactly how far the defense industry should contract.

"The Defense Department clearly signaled to the industry back in 1993 that they didn't have the programs to support the defense industrial base, so we had better effect mergers and rid ourselves of excess capacity," says Don Fuqua, president of the Aerospace Industries Association. "Now it seems they are taking a different look at the issue." While Pentagon officials have voiced concerns about "vertical integration," he says, "I still think you need to let market forces take care of that. We're hoping that the Lockheed-Northrop blockage was an isolated case, because we see more consolidation in the future in the sub-tiers of suppliers as companies attempt to find synergies and develop a critical mass of capability."

While DoD officials have not ruled out smaller-scale consolidations, they seem increasingly unwilling to let pure market forces dictate increased vertical integration, which occurs when there are fewer and fewer sub-component suppliers to compete at each tier of production because that work has been brought in-house by a few merged behemoths. A 1997 Defense Science Board study on vertical integration warned that it could become an increasing impediment to competition and advised the Pentagon to more closely monitor the health of sub-tier markets, devise programs to foster greater competition at both prime and sub-tier supplier levels, and improve understanding of the issue of vertical integration among DoD acquisition personnel.

"Both DoD and the Justice Department concluded that a Lockheed Northrop would cross the line in terms of vertical integration. There were enough warning signs that this kind of merger could eventually put a lot of second- and third-tier subcontractors out of business, and then you wouldn't get the kind of competition that saves the taxpayer money," said Defense Secretary William Cohen in an interview. "So it's not so much that we changed our policy. Rather, we started with a lot of defense companies and now we're down to three or so major ones, and you have to ask yourself what are the implications. The potential for an antitrust situation is there."

Tortured Competition

Nowhere were the dangers of a drastically shrunken defense industry more evident than in the Pentagon's recent attempt to create competition to build the Navy's next-generation DD-21 destroyer. When the service issued its request for proposals for the $25 billion program earlier this year, destroyer manufacturers Bath Iron Works and Ingalls Shipbuilding teamed up with industry giant Lockheed Martin to present a package bid-the only one the Navy received.

Part of the problem, analysts say, is that there are so few new defense programs coming down the pipeline that each manufacturer or shipyard has been forced to specialize in an attempt to dominate at least one niche market. So Newport News Shipbuilding has focused on nuclear aircraft carriers and, along with General Dynamics' Electric Boat division, nuclear submarines. Avondale Industries' shipyard specializes in amphibious and support vessels. Thus, when a contract for a new destroyer was offered, only destroyer makers Bath and Ingalls were considered viable competitors, and they decided it was better to team than fight.

"One of the factors that has contributed to the dearth of competitive bids is this increasing specialization as industry has consolidated and Navy contracts have dwindled," notes Chris Hellman, senior research analyst for the Center for Defense Information. "By pointing to their proven track record in these niche areas, each shipyard has a leg up in bidding on additional work, and this discourages other yards from trying to compete. They are all also becoming less willing to risk bidding on new programs, stifling innovation in the industry and reducing competition on development of new weapons systems."

In the case of the DD-21, Pentagon officials decided they simply could not afford to sole-source a new program with high demands both for innovation in design and efficiency in production. On May 13, the Navy announced that it was delaying by one month the deadline to submit bids. DoD officials set about twisting arms to establish two competing industry teams. The Navy announced on June 18 that those two teams would consist of Ingalls Shipbuilding and Raytheon; and Bath Iron Works and Lockheed Martin.

"There is a huge amount of empirical data that demonstrates that competition is better than sole-sourcing a program, both in terms of creating innovation and new ideas in development, and in reducing prices later on in production," says DoD acquisition chief Jacques Gansler.

With the defense industry having shrunk down to just a few companies in any given sector, Gansler says, the lack of natural competition will become an increasing problem. "The industry said we should let the market work, and then they team, and there's nobody left in the market and no competition," he says. "So as the sole, monopsony buyer, it's the Pentagon's responsibility to figure out a way to create competition by restructuring the request, and that's what we did on the DD-21."

Watching such convoluted attempts to create competition where little seems to naturally exist, observers of the incredible shrinking defense industrial base warn that it may no longer be robust enough to adequately respond to a major conflict. That was the conclusion reached by editors Terry Gander and Christopher Foss, writing in this year's Jane's Military Vehicles and Logistics.

"The world defense market, despite the recent spate of mergers and takeovers, is fast approaching a condition where defense industries in many nations are not in a position to meet operational demands in the event of war," wrote Gander and Foss, who noted that history is fraught with disturbing precedents, especially the dangerously dilapidated state of the defense industrial base in the United States and Europe just prior to the outbreak of World War II.

They speculate that if the current trend in declining defense procurement does not end soon, "a situation not too dissimilar to 1939-41 may well have to be faced."

Many experts believe, however, that the lethality of modern weapons has rendered obsolete the old "mobilization" scenario for an extended war like World War II. Major, high-intensity conflicts are unlikely to last more than a matter of months at most, in this view, and thus will essentially amount to "come as you are" wars.

DoD officials concede, though, that the defense-industrial base may not be robust enough to achieve the rapid production surge that a high-intensity scenario would demand in order to provide advanced munitions such as precision-guided missiles and major sub-components for use in repairs.

"The fact that we have very few companies involved in the defense business, and most of those are also heavily involved in the commercial world, is going to present a real challenge if we have to ramp up production at some point," says Cohen. "We already saw an early indication of that in our problems of producing enough Patriot missiles during the Persian Gulf War. Fortunately, we had six months in that instance to crank up production. We're not likely to have that much time in a future conflict."

Modernization Crisis

DoD officials, service and industry officials are nearly unanimous in agreeing that the best way to revive a flagging industry is to increase defense procurement spending. Largely because of a 1990s Robin Hood strategy of robbing from rich modernization programs to give to poorly financed readiness and quality-of-life accounts, procurement spending has declined a precipitous 70 percent below its 1985 peak in inflation-adjusted dollars, while overall defense spending dropped by roughly 33 percent.

The Clinton administration's fiscal 1999 Defense budget request of $257.3 billion represents a slight decline of 0.9 percent in inflation-adjusted dollars from last year. Over the remainder of the future years Defense program (1999-2003), the Defense budget is projected to be flat. And unless Congress and the administration decide to break last year's landmark balanced budget agreement, Congress will be unable to continue its practice of adding significantly to the administration's Defense budget request. (Congress added $6.8 billion in 1996, $10.4 billion in 1997, and $2.7 billion in 1998.)

For the first time since the end of the Cold War, however, the administration requested a real, 7 percent increase in Defense procurement spending. The fiscal 1999 budget includes $48.7 billion in procurement spending, which is projected to increase until it reaches the Pentagon's ever-elusive goal of $60 billion around 2001.

Defense hawks on Capitol Hill criticize the Clinton administration for continually failing to put its money where its out-year projections are. "Despite an expansive strategy, the administration's fiscal year 1999 Defense budget continues a 14-year real decline in defense spending. The President's request . . . is more than $54 billion short of keeping pace with inflation over the next five years, and is 39 percent lower than mid-1980s Defense spending levels. It represents the lowest real level of U.S. Defense spending since before the Korean War," Rep. Floyd Spence, R-S.C., chairman of the House National Security Committee, wrote recently. "The gap between the strategic requirements of the post-Cold War world and the levels of resources committed to U.S. national security continues to widen."

Independent analysts have warned for years that the gap between defense requirements and resources could lead to a funding train wreck early in the next century, when the Pentagon must embark on an expensive modernization effort to replace aging equipment. The Center for Strategic and Budgetary Assessments (CSBA), for instance, recently concluded that there is a $26 billion annual gap between the likely cost of the administration's current Defense plan and the long-term budget levels assumed under last year's Quadrennial Defense Review.

Some analysts argue that the Pentagon will soon need to either further cut its force structure-that is, Army divisions, Navy carrier battle groups and Air Force wings-or forgo weapons modernization programs. Either choice, notes CSBA analyst Steven Kosiak, involves additional risks. "Any of the options would result in some increase in the level of risk facing the U.S. military, at least over the short term," concludes Kosiak. "In any case, if DoD's plans have to be scaled back, it is far better to begin the task of cutting those plans today, rather than waiting until the crunch becomes acute, some years down the road."

Revolution in Business Affairs

Pentagon leaders insist there is a third path that will allow them to reach their goal of $60 billion annual procurement budgets early in the next century. They concede that it will require nothing less, however, than a "revolution in business affairs" and a breach in what has proven an implacable wall on Capitol Hill against further base closures.

"Our vision is clear in terms of the need to realize both a revolution in military affairs, which means changing the way we fight, and a revolution in business affairs, which means changing the way we purchase things and includes reducing our infrastructure," says DoD's Gansler. "We have no choice. Yet there's enormous cultural and political resistance to those changes. I'm frustrated that people don't seem to have a sense of urgency that I think this time period warrants."

To realize a business revolution, DoD officials are attempting to emulate best business practices in the commercial sector to facilitate a single, integrated production base that satisfies both commercial and defense needs. Getting there will require changing not only the way the Pentagon does business but also the attitude and culture that informs the Defense acquisition corps.

The first step in acquisition reforms was trying to weed out unique military specifications, or "milspecs." Milspecs are routinely blamed for forcing major corporations to establish totally separate production lines and organizations for defense programs. Procurement laws have also been scrutinized and streamlined to allow purchasers to buy more commercial products or defense products based on commercial manufacturing processes. And DoD officials have worked to jettison specialized cost accounting systems and red tape that characterized the Pentagon's overly bureaucratic acquisition system.

"DoD has labored under support systems and business practices that are at least a generation out of step with modern corporate America," Deputy Defense Secretary John Hamre told the House National Security Committee earlier this year. "Adopting the best practices of the private sector will enable the department to cut operational costs, improve accountability and improve service to the warfighter. Initiatives to reengineer DoD business processes are being pursued throughout the department and encompass virtually every aspect of the way we do business-from the way we move service members, their families and household goods to the way we acquire and pay for everything from aspirin dispensed in military health facilities to major weapons systems."

As part of the resulting streamlining, the Pentagon has pledged to significantly reduce headquarters staffs. The Office of the Secretary of Defense will be reduced by one-third (from 3,000 to 2,000) by the end of this year, for instance, while the Joint Staff will undergo a 29 percent reduction by fiscal 2003. By the end of fiscal 2002, each service headquarters and the warfighting commands will have reduced their staffing levels by 29 percent and 22 percent, respectively.

"One of the messages we heard from the private sector is that headquarters should perform policy and oversight functions, but not day-to-day management. I agree with that philosophy and we intend to follow private industry's lead in this area," said Hamre, chairman of the new Defense Management Council, which oversees Defense reform initiatives. "As a result, the Secretary of Defense has made a series of decisions to streamline, reduce and eliminate DoD headquarters elements, beginning with those closest to him-the OSD staff and Joint Staff. We believe it is important to clean our own house first in order to set an example for the rest of government."

Not surprisingly, defense industry executives give the acquisition reforms positive reviews. By dropping many milspecs, they say, the Pentagon is getting out of the business of micromanaging how the industry builds weapons and is focusing instead on what those weapons will be capable of doing.

"If you buy a watch, you want one that will tell time. You don't try and tell someone how to build that watch. Yet that's what DoD used to do," said Fuqua of AIA. "Today on the Joint Strike Fighter program, the Pentagon has told the two competing teams what they want it to do, but not how to build it. Then DoD will pick the best design. That's major progress."

Base Closures

Defense officials have made less progress, however, in convincing Congress to let them close more unneeded bases. According to DoD officials, the infrastructure of domestic military bases has shrunk by only 21 percent since 1989, significantly less than the cuts in personnel (32 percent) and overall Defense spending. As a result of four past rounds of base closures, the Pentagon estimates it will have saved $25 billion by 2003 and will save roughly $5.6 billion each year thereafter.

Because many lawmakers believe the Clinton administration politicized the base closure process in 1995 by deciding to privatize-in-place the work performed at two large Air Force depots slated for closure, Congress has steadfastly resisted persistent calls from Pentagon and uniformed leaders for two more rounds of base closings. Defense officials say they desperately need the roughly $21 billion those closures would save them between fiscal 2008 and 2015.

"Our reason for asking for more base closings has to do with the savings, as well as our need to reorganize," said Air Force Chief of Staff Gen. Michael Ryan in an interview with defense reporters recently. "Our forces are stretched very thin on bases that don't have a lot of support depth on them."

After Congress refused the Pentagon's request for new rounds of base closings in 2001 and 2005 earlier this year, an obviously frustrated Cohen publicly warned that he may unilaterally allow some bases to simply fall into disrepair rather than waste precious dollars on keeping them up.

"I have not suggested that as an alternative, but only as a last recourse," Cohen said in his interview. "Because it's not really fair to neglect repairs and maintenance and allow a facility to wither on the vine. Morale goes down, and the community loses out from not getting the federal help offered to bases that are closing. On the other hand, I've got tough choices to make. It's been written that having won the Cold War, the United States no longer seems to be willing to pay in national treasure the price necessary to preserve the peace. I'm concerned about that, because the history of democracies has been to undercut their defense forces in times of peace."

James Kitfield is a staff correspondent at National Journal.

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