Hold Until Released
By the Committee
JOHN B. GOODMAN
DEPUTY UNDER SECRETARY OF DEFENSE
(INDUSTRIAL AFFAIRS AND INSTALLATIONS)
SENATE ARMED SERVICES COMMITTEE
SUBCOMMITTEE ON ACQUISITION AND TECHNOLOGY
MARCH 4, 1998
Hold Until Released
By the Committee
Mr. Chairman and distinguished members of the Committee, thank you for this opportunity to
present Department of Defense (DoD) views on industrial base issues, and, in particular, the
question of vertical integration in the defense industry. In my remarks today, I will first highlight
the Department's broader policies regarding the industrial base. I will then discuss the
Department's concerns regarding vertical integration in the defense industry, the treatment of
vertical issues in analysis of mergers and acquisitions, the implications of vertical integration for
acquisition strategies, and, finally, research and studies to monitor the health of important
Industrial Base: Requirements and Strategies
The Quadrennial Defense Review highlighted the three strategic challenges facing the
Department of Defense. DoD must seek to shape the international environment, respond to the
full spectrum of crises that threaten U.S. interests, and prepare now for an uncertain future. To
meet these challenges and support the required revolution in military affairs, DoD must be able
to draw on a supplier base that can design and produce next generation weapons, innovate to
preserve our technological leadership, reduce cycle times to respond to evolving threats, lower
costs significantly, and support interoperability for joint and coalition warfare with our allies.
Maintain effective competition (both horizontal and vertical) in the defense industrial base.
Improve commercial-military integration to gain access to world class suppliers, reduce costs by sharing overhead with commercial products, speed response times, and broaden the competitive base for components and subsystems.
Expand international engagement to leverage allied government investments, build alliance cohesion, and support interoperability.
The importance of competition and the questions raised by vertical integration is the main
focus of my testimony today.
Consolidation and Vertical Integration in the Defense Industry
The competitive environment within the defense industry has changed considerably in the
past five years in response to the dramatic decline in procurement spending. From the peak of
the Cold War, DoD reduced its defense budget by some 36 percent, its force structure by 35
percent, and its procurement programs by 62 percent. In response to this decline in procurement,
defense firms initiated a series of actions to restructure their operations to maintain profitability.
They reduced excess capacity and workforce levels to match reduced demand, streamlined
processes, and revamped supplier relationships. In addition, they began a process of industry
consolidation via mergers and acquisitions.
The Department generally supported the process of consolidation, because it enables
firms to eliminate excess capacity, reduce costs, and provide better value for DoD and the U.S.
taxpayer. At the same time, we did not support those parts of transactions that adversely
impacted effective competition for DoD programs. Competition is a proven means of speeding
innovation and reducing cost.
Overall, the restructuring of the defense industry has been successful. Mergers and
acquisitions have helped consolidate the industry. There have been no significant bankruptcies
or bail outs of defense firms. DoD has maintained competition for defense products. And DoD
is saving money.
In 1996, the Department became concerned about one particular trend in the process of consolidation. Specifically, the overall restructuring of the defense industry also appeared to be increasing vertical integration within the defense industry. The fields of economics and law suggested that this development could lead to two potential, yet conflicting, outcomes. On the one hand, firms acquiring vertical capabilities may be able to become more efficient and provide their customers with more cost-effective products and services. On the other hand, vertically-integrated firms also may tend to rely on their own internal capabilities without consideration for, or despite the superiority of, the capabilities of outside sources. This could lead to less innovative, more costly, products.
The Department needed to better understand whether industry consolidation was,
in fact, increasing vertical integration in defense firms, how such a trend might affect product
competition or innovation, and what actions it should take. For these reasons, then-Under
Secretary of Defense for Acquisition and Technology Paul Kaminski asked the Defense Science
Board an independent advisory body of distinguished defense experts, business leaders, and
academics to form a Task Force on Vertical Integration and Supplier Decisions.
In May 1997, the Task Force issued its report. It found that vertical integration in the
defense industry was increasing. In the Task Force's view, this trend appeared to be less the
result of specific strategic decisions to integrate vertically, than the collateral effect of efforts to
improve positions in particular markets and increase diversification. The Task Force noted that
vertical integration had not yet created any specific or systemic problems; firms questioned
during the review process, for example, provided little evidence of companies changing their
business practices as a result of increased vertical capabilities. However, the Task Force also
was concerned that vertical integration could create potential problems in the future.
Specifically, vertically-integrated firms could change their business practices to exclude other
suppliers, disadvantage their competitors, and exploit the design process to promote their internal
capabilities and limit external supplier opportunities.
The Task Force concluded that DoD needed to pursue three broad courses of action to
protect its interests. First, the Department needed to continue to work with the antitrust agencies
to identify and remedy vertical concerns raised by proposed transactions. The Task Force
believed that this process had worked effectively. DoD and the antitrust agencies were asking
the right questions and taking the appropriate actions. Second, it noted that DoD needed to
ensure that its acquisition strategies maintained effective competition. Finally, it recommended
that DoD improve its understanding of supplier issues to be able to address any problems
emerging as a result of vertical integration. Let me now turn to how the Department is
addressing each of these issues.
Reviewing Mergers and Acquisitions
Since March 1995, the Department has supported the Antitrust Division of the
Department of Justice (DoJ) and the Federal Trade Commission (FTC) in reviews of over 40
defense industry mergers and acquisitions. The Department's merger and acquisition review
process is delineated in DoD Directive 5000.62, issued October 21, 1996. The DoD General
Counsel and the Under Secretary of Defense for Acquisition and Technology lead DoD's review.
When we learn of a transaction, we begin by identifying each and every program (from those in
the research and development phase to those in full production) and every market where the two
companies are competing, are likely to compete in the future, or are involved in a potential
supplier relationship. Specifically, we examine:
Horizontal concentration in programs or market areas.
Vertical integration in program or market areas where one party to a merger or acquisition is, or is likely to be, a key supplier to the other party or its competitors.
Organizational conflicts of interest where one company is providing systems integration or technical assistance to a program office, and the other company is either a future competitor for programs managed by that program office or is currently performing work for that office.
Savings that may result to the Department from the merger or acquisition.
Throughout all of these reviews, the policy of the Department of Defense has remained
the same. We believe that we must maintain effective competition for our defense systems. We
have supported, and will continue to support, consolidations in the defense industry when such
transactions do not adversely affect our ability to maintain that competition.
As FTC Chairman Robert Pitofsky noted in his testimony before this Committee last
year, the structure of the defense industry has changed considerably in recent years. Past mergers
and acquisitions have reduced the number of both primes and subs, so that each new transaction
is more likely to raise competitive issues. In the past year, therefore, it is perhaps not surprising
that the antitrust agencies have regularly made their approval of specific defense transactions
contingent on the agreement of the parties to remedy antitrust concerns. In addition, these
consent agreements have more frequently required divestiture of key business units.
Three of the most recent transactions reviewed and approved by the Department of
Justice and the Federal Trade Commission required divestiture. First, in the case of Raytheon's
acquisition of Texas Instrument's Defense and Electronics business, the DoJ required that
Raytheon divest Texas Instrument's Monolithic Microwave/millimeter-wave Integrated Circuit
(MMIC) business. MMIC technology and production capability is critical to the performance of
many of DoD's advanced radar systems. Second, in the case of Raytheon's acquisition of
Hughes Aircraft Company, the DoJ required Raytheon to divest its infrared sensor and electro-optic ground systems businesses, which are critical to many targeting and surveillance
subsystems. Absent these divestitures, the new Raytheon would have been able to exercise its
newly-acquired vertical capabilities and adversely affect downstream competition for key combat
systems. Third, in the case of TRW's acquisition of BDM international, the FTC required TRW
to divest BDM's system engineering and technical assistance contracts in support of the Ballistic
Missile Defense Office to eliminate a potential conflict of interest; the Ballistic Missile Defense
Office had contracted with BDM to provide technical assistance in assessing and reviewing
contracts in which TRW was, or could be, a party.
In their testimony before this Committee and the Senate Judiciary Committee last year,
both FTC Chairman Robert Pitofsky and Assistant Attorney General for Antitrust Joel Klein
expressed great satisfaction with the level of cooperation that now exists with the Department of
Defense. These agencies are appropriately charged with the responsibility to review antitrust
matters. DoD has worked diligently to support their efforts and will continue to do so.
Establishing Acquisition Strategies to Promote Competition
Antitrust reviews address vertical integration issues in the context of industry mergers
and acquisitions. DoD's acquisition managers also need to ensure that acquisition strategies
promote competition on specific programs.
To emphasize the importance of competition in subtier markets, the Department is
revising DoD Regulation 5000.2-R, "Mandatory Procedures for Major Defense Acquisition
Programs and Major Automated Information System Acquisition Programs" to require that
acquisition strategies foster competition at prime and subcontractor levels and that program
managers focus on subtier competition during early exchanges of information with industry.
Under these guidelines, acquisition strategies will need to: (1) identify the potential industry
sources available to supply products and technologies critical to meeting the program's needs, (2)
highlight areas where potential prime contractors also are potential suppliers of these critical
products and technologies, and (3) describe the approaches to be used to establish or maintain
access to competitive suppliers for critical areas at the system, subsystem, and component levels.
In recent years, the Department has employed a variety of strategies to promote
competition at both prime and subtier levels. Specifically, we have taken steps to: (1) maintain
government flexibility in the selection of critical suppliers, (2) compete subsystems separately
from platforms, (3) supply critical subsystems as government furnished equipment, and (4) break
anti-competitive exclusive teaming arrangements. Examples of these strategies can be found in
the procurement of:
The Joint Strike Fighter. The Department of Defense decided to compete the Multifunctional Integrated Radar System (MIRFS) initial development separately from the fighter to promote greater competitive choice for this critical subsystem.
Aircraft engines. The Department regularly competes aircraft engines and supplies them as government furnished equipment to the aircraft manufacturer.
Future Imagery Architecture. The Under Secretary of Defense for Acquisition and
Technology recently directed that an exclusive teaming arrangement for this NRO
program be broken to ensure that multiple teams could have access to critical
capabilities from subtier suppliers.
Vertical integration problems also may emerge subtly through technology development,
or be unintentionally exacerbated by the DoD's science, technology, and demonstration
investment choices. To better deal with these effects, the Director, Defense Research &
Engineering is evaluating the Science and Technology planning process to determine whether
and how technology investments can shape and enhance competition.
We also have taken steps to improve our program managers' knowledge of
developments in the defense industry so they can be smart, effective buyers. Vertical integration,
for example, was one of the topics addressed at the October 1997 "PEO/SYSCOM Conference"
a top level meeting of our program executive officers and systems command commanders. The
Defense Systems Management College (DSMC) has already taken steps to expand its curriculum
in its program managers course. DSMC is now developing in-depth curriculum changes
designed to include information on defense industry structure, business strategies, and
Finally, in December 1997, the Department established a "helpline" a phone number
that firms can call to report, with anonymity, concerns regarding exclusionary behavior, such as
refusing to sell components externally; or selling such components selectively, at unfair prices,
or with lesser quality or performance.
Improving DoD Visibility into Industrial Capabilities
In recent years, DoD has undertaken a number of studies to improve our understanding of
developments in industry. Additionally, DoD has established a clear process to determine when
any action or funding is required to sustain critical and endangered industrial capabilities. As the
Defense Science Board recommended, the Department now needs to increase our visibility into
supplier capabilities and relationships to assist program managers in the development and
implementation of future acquisition strategies. Let me describe our progress in each area.
In 1994, the Department began a series of studies on industrial capabilities across a range
of weapon systems, including tracked combat vehicles, helicopters, bombers, space launch
vehicles, and torpedoes. More recently, studies also were completed on a few critical
components, including radiation-hardened electronics and microwave power tubes. In 1995, the
Department published a new directive and handbook designed to enable acquisition executives to
determine whether additional funding or other action was required to sustain particular industrial
The Department reported on these efforts in both its 1997 and 1998 Annual Industrial
Capabilities Report to Congress. These reports described: (1) the policies and procedures used
to identify and assess those industrial/technological capabilities needed to meet current and
future defense requirements, (2) the actual assessments conducted, and (3) the actions taken in
response to those assessments. In some cases, the assessments addressed areas of interest which
cut across Service boundaries. These assessments were performed in a cooperative manner with
the appropriate DoD Components and civil agencies. Additionally, DoD Components conducted
their own analyses when: (1) there was an indication that industrial or technological capabilities
associated with an industrial sector, subsector, or commodity important to a single DoD
Component could be lost, or (2) it was necessary to provide industrial capabilities information to
help make specific programmatic decisions.
These DoD and DoD Component assessments generally led to similar conclusions. There
were very few indications that essential industrial capabilities were at risk of being lost, even
given low production rates. When such industrial capabilities were at risk, the Department took
a variety of actions to sustain them. For example:
Microwave Power Tubes. Microwave power tubes are used to generate and amplify microwave energy for DoD, civil agency, and commercial applications. The assessment concluded that current microwave power tube industrial capabilities are adequate to meet DoD requirements. However, uncertainties in future DoD requirements and changing circumstances could endanger essential engineering and product development capabilities. Therefore, DoD designated the Navy as its executive agent to identify and maintain consolidated DoD requirements, monitor the major domestic manufacturers, and facilitate coordination among DoD Components and other federal agencies which use microwave power tubes.
Aerospace Grade Rayon. The National Aeronautics and Space Administration
(NASA) and DoD use carbonized rayon fiber-reinforced composites in solid rocket
motor nozzles and in reentry vehicle heat shields. North American Rayon
Corporation, the sole aerospace grade rayon supplier, advised that it would
discontinue rayon production upon completing its current orders. DoD decided that
the most cost-effective solution would be to procure sufficient rayon fiber to meet all
of its requirements until 2002 and for lifetime buys for most programs (a total of
about 1.5 million additional pounds at a cost of $16.2 million). NASA procured
enough material to meet its needs through 2005.
Depleted Uranium Penetrators. DoD uses depleted uranium penetrators for 120mm kinetic energy tank rounds and for 25mm Bradley Fighting Vehicle rounds, and expects to use them in the next generation 120mm kinetic energy tank round. Budget projections suggested there would be a gap in production from 1999 to 2003 that could result in the loss of the industrial capabilities required to produce these penetrators. To address the production gap, the Army is budgeting to spend up to approximately $40 million in FY1999. The Army is also initiating additional analysis to determine what additional funding, if any, is required in subsequent years.
Several assessments examined those products for which DoD peacetime requirements are
low, but projected military contingency (surge and replenishment) requirements are high, such as
Nerve Agent Antidotes in Autoinjectors. In such cases, DoD Components generally have
decided to restrict competition, for mobilization base reasons, to domestic sources and/or
acquired and maintained facilities, equipment, or materiel needed to rapidly accelerate
production to meet projected military contingency requirements.
The Defense Science Board recommended that DoD expand its visibility into key product
and technology areas. Our initial efforts have focused on products affected by recent mergers
and acquisitions, for example, MMICs and focal plane arrays. We need to intensify our efforts to
identify concerns posed by vertical integration and develop insight into key subtier capabilities,
competition, and innovation. However, broadening and deepening our knowledge and expertise
of subtier areas is difficult, time-consuming, and beyond the resources which the Department has
in-house. Accordingly, this year's budget includes a request for $3 million in a new program,
Industrial Capabilities Assessments (65122D). These funds would be used to identify and
evaluate industrial capabilities and competition issues across an array of sectors and subsectors.
We ask your support for this important initiative.
In closing, I would like to thank this Committee for the opportunity to describe the Department's actions in response to vertical integration and potentially at risk essential industrial capabilities concerns. As I have noted, the Department is pursuing three strategies to respond to vertical integration and ensure that we maintain the benefits of competition. First, we are giving strong support to the antitrust agencies in their reviews of mergers and acquisitions. Second, we are taking action to develop and execute acquisition strategies that promote competitive choices for key weapon systems. Third, we are taking the necessary steps to be able to increase our visibility into subtier developments. Together, these strategies represent a thorough and responsible approach to respond to the competitive issues presented by vertical integration. Finally, I believe the Department is taking those steps necessary to identify and address potential industrial capabilities problems wherever they occur including the subtiers within our regular budget, acquisition, and logistics processes.