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Pentagon Acknowledges Problem of Contractor Mergers

(Frank Kendall III is an American lawyer serving under President Barack Obama and Secretary of Defense Ashton Carter as the Under Secretary of Defense for Acquisition, Technology and Logistics.)

Remarks by the Pentagon's acquisitions chief Frank Kendall have set the defense community abuzz. Highlighting a trend towards fewer and fewer prime contractors, Kendall followed it to its natural conclusion: “one can foresee a future in which the department [of Defense] has at most two or three very large suppliers for all the major weapon systems that we acquire,” he said. “The department would not consider this to be a positive development and the American public should not either.”

Lockheed Martin, in a statement to Reuters, responded to the comments, saying, “There is no evidence to support the view that larger defense companies reduce competition or inhibit innovation.”

But what has occurred is that the Pentagon now has fewer companies vying for its contracts, as The Washington Post reported in 2008:

In the 1980s, 20 or more prime contractors competed for most defense contracts. Today, the Pentagon relies primarily on six main contractors to build our nation's aircraft, missiles, ships and other weapons systems.

It is a system that largely forgoes competition on price, delivery and performance and replaces it with a kind of "design bureau" competition, similar to what the Soviet Union used—hardly a recipe for success.

Graphic 1
The Five Largest Defense Contractors. Source: Barry Watts, The US Defense Industrial Base: Past, Present and FutureThe US Defense Industrial Base: Past, Present and Future, Center for Strategic and Budgetary Assessments, Washington, DC: October 15, 2008, p.33. (Downloaded October 13, 2015)

“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,” Kendall said. That advantage can take many forms, including bullying sub-contractors, incredibly strong lobbying arms, and more executives participating in the revolving door of alternating corporate and government employment. Unfortunately, these issues are compounded by supersized and bundled contracts, which provide prime contractors with many advantages and reduce opportunities for subcontractors and small businesses not linked to them.

DefenseNews also emphasized that while the existence of large companies does not directly reduce competition, it can have negative effects:

But it’s not hard to envision a scenario in which a company becomes so big, and involved in so many sectors of the defense business, that smaller firms are afraid to team with one of the large firm’s rivals for fear of angering the giant and being frozen out of future business.

The Pentagon’s apparent change of heart comes after decades of encouraging mergers in the defense industry. Claiming that mergers lowered contract costs by reducing overhead and redundancies, the Pentagon even had taxpayers paying the defense companies’ restructuring costs for several years. Yet the Government Accountability Office found actual savings ended up being 85 percent lower than estimated in some cases. The Project On Government Oversight criticized the policy in 1997 as a system of “payoffs for layoffs” due to the fact that executives would receive excessive bonuses while laying off thousands of workers. This was evidenced by the case of Norman Augustine, who, after pushing for the bill to be passed, merged his company, Martin Marietta, with Lockheed—laying off 19,000 employees. According to a GAO report, newly formed Lockheed Martin (with Augustine as CEO) was reimbursed $400+ million. Other mergers during that time brought the total amount of taxpayer dollars spent to over $850 million. As POGO stated in 1997:

The government's policy of artificially encouraging more mergers than would occur naturally is unnecessary to achieve the goals it supposedly seeks, and it is also based on questionable assumptions that the Pentagon will receive short- and long-term benefits. Before taking the advice of industrial barons like Norman Augustine, the government's efforts would better be focused on making sure that old-fashioned monopolies aren't being built with the help of public funds.

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Source: Courtesy of the Office of Senator John McCain

Unfortunately, the government doesn’t seem to have heeded POGO’s advice. For instance, Huntington Ingalls Industries, the product of an acquisition, merger, and later spinoff in the 2000s, has a monopoly over the aircraft carrier market. The new Ford-class supercarrier program is already estimated to be well above $4.7 billion over budget, and behind schedule to boot. The enormous investment required to enter the market, combined with a limited number of massive contracts, makes it far too risky for anyone else to enter.

Another example of a monopoly in defense contracting is United Launch Alliance (ULA), the joint venture between Lockheed Martin and Boeing. This joint venture created a monopoly in the military satellite launching industry, which has since seen both schedule delays and the cost of the program more than double. With nowhere else to turn, the Department of Defense has had no choice but to accept any cost overruns and timetable adjustments, costing taxpayers billions of dollars. Thankfully, a ray of hope appeared last May when SpaceX, a start-up company owned by serial entrepreneur Elon Musk, finally completed the Air Force’s grueling certification process and is now allowed to compete for military contracts. With the reintroduction of competition, it is anticipated that prices will be brought down by at least 50 percent, as SpaceX currently charges just $61.2 million per standard launch, compared to ULA’s lowest reported figure of $164 million.

Kendall’s comments on decreasing competition follow hard on the heels of aerospace giant Lockheed Martin receiving approval to acquire Sikorsky, one of the nation’s largest helicopter companies. He clarified, however, that his comments were not aimed at any one particular company or merger. Yet they may also hint at the Pentagon’s upcoming decision regarding the contract for a long range strike bomber, estimated to be worth over $100 billion. The DoD is currently deciding between bids from a Boeing and Lockheed Martin team and a team led by Northrop Grumman.

According to RollCall, “if Lockheed Martin wins, the government may not have another company with comparable experience to turn to in a few years, when it comes time to design the next generation of fighters and bombers.”

This contract carries implications far beyond a lack of innovation. As POGO’s Daniel Grazier told RollCall, once a field lacks genuine competition, “the surviving defense contractors would have no motivation to deliver anything on time or on budget.” A POGO podcast from 2011 expresses a similar concern as it discusses how prime contractors have become “too big to debar.” The government simply cannot stop doing business with them—and they know it. These contractors can effectively become immune to the strongest weapon in the oversight arsenal, and have no incentive to stop even explicitly illegal activity.

POGO’s Danielle Brian also testified on the subject before the Senate in 2006, saying:

Industry representatives have been very good at blurring the distinction between what is in their client's interests and what is in the public interest. Ultimately, what is needed is for us to recognize this distinction and make a policy that is based on fact, not optimistic projections.

While it would appear the Pentagon is finally acknowledging that the lack of competition in the defense industry is dangerous, they have yet to do anything tangible to change it. Asking Congress for new rules stemming mergers between prime defense contractors, as Kendall has done, may slow the momentum of decline, but does little to reintroduce competition into the world of defense contracting.