• 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 performance.

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 capabilities.

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.

Conclusion

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.