Consolidation of the U.S. Defense Industrial Base

Acquisition Review Quarterly, Fall, 2001 by John M. Deutch

The U.S. government has promoted defense industry consolidation in the past decade as part of its acquisition reform policies, to help control costs and promote efficiency. But when the Department of Defense (DoD) reversed its pro-consolidation policy, defense firms were left financially less secure from the acquisitions and mergers -- and the hoped-for reductions in tangible assets have been marginal. What is the best way forward?

As the administration of George W. Bush considers national security priorities for the 21st century, it will necessarily address the health of the U.S. defense industry and consider policies designed to ensure an industrial base adequate to meet U.S. security needs. During most of the post-Cold War decade, the industry has faced a relatively stagnant defense budget. Not withstanding improvements in efficiencies, the net return on invested capital has been inadequate for many of the leading firms. Share prices, which tumbled in 1998 and 1999, have recovered somewhat during the past two years, as a result of improved performance by several firms and the expectation of near-term defense budget increases. However, I believe there is a crisis in the defense industry with origins that need to be better understood if effective policies are to be adopted.

The first Clinton administration acknowledged strains on the defense industrial base and put into place two policies to address this problem: acquisition reform (1) and an industry consolidation policy. Although much remains to be done, there has been considerable progress on acquisition reform. On the other hand, the success of the consolidation policy that attempted to balance the number of competing firms with efficiency has been more controversial.

In 1993, analysts assigned by Secretary of Defense Les Aspin to conduct a "bottom-up review" of U.S. defense posture concluded that the defense industry needed to be restructured. Then Deputy Secretary of Defense William J. Perry announced to industry leaders, at what has come to be referred to as the "Last Supper," the Department of Defense (DoD) policy to encourage consolidation.

In July 1993, serving as the Undersecretary of Defense for Acquisition and Technology, I introduced rules for sharing savings from consolidation between DoD and industry. The Defense Science Board formed a task force, composed of defense industry executives and government lawyers, to address the antitrust issues raised by the consolidation policy. In the five-year period of 1993-1998, many major defense firms merged or were acquired.

In 1998, DoD unexpectedly reversed the pro-consolidation policy and urged the Department of Justice (DOJ) to reject the proposed merger of Lockheed Martin and Northrop and the proposed General Dynamics acquisition of Newport News Shipbuilding. The absence of a clear signal ending the consolidation policy is unfortunate because it left several defense firms stranded on a different course. In the spring of 2001, both General Dynamics and Northrop! Litton made offers for Newport News Shipbuilding, thus re-opening the industry consolidation question for the Bush administration.

Here I will review the reasoning behind the pro-consolidation policy, to assess what went right and what went wrong, and speculate on the way forward for the U.S. defense industry. (2) My purpose is to stimulate thinking about one central proposition: Given the likely level of defense expenditures over the long term, the health of the U.S. defense industry depends on reducing the asset base devoted to defense by both the commercial and government sectors.

RATIONALE FOR THE PRO-CONSOLIDATION POLICY

The Aspin-Perry team proposed the necessity of consolidation because of the more than 40 percent drop, in real terms, of DoD investment expenditures -- procurement plus research and development (R&D) plus construction -- and the expectation that these expenditures would not return to the mid-1980s Cold War levels. If the industrial base was properly sized during the higher level of expenditures of the mid-1980s, the inevitable conclusion was that, in the 1990s and beyond, the defense industry infrastructure had to shrink by as much as 40 percent to remain in balance with declining post-Cold War defense budgets. It followed that it was necessary to reduce the assets allocated to defense, in both private and public sectors.

The purpose of the consolidation policy was to encourage mergers that reduced the level of assets allocated to defense. At the time, DoD focused on reducing physical assets: property, plant, and equipment. Total assets include tangible assets (physical assets plus working capital) and intangible assets or "goodwill."

If assets were not reduced, smaller defense budgets would mean unit costs would rise, inevitably placing downward pressure on profit margins available to industry. If returns on capital declined, defense aerospace companies essential to a strong defense infrastructure would be in trouble, and this was not in the interest of the nation, DoD, or stockholders. The policy intent was to encourage the companies, through normal capital market mechanisms, to make rational business decisions that would result in fewer assets devoted to defense.