New Pentagon Report Raises Alarm Over Industry Consolidation, Future of Competition

The Defense Department faces a future of high-price, sole-source contracts, reduced innovation, and possible critical shortages if it doesn’t take steps to increase competition and the number of suppliers in the defense industrial base, according to a new Pentagon report. But changing the conditions creating the situation won’t be easy, it said.

To prevent these issues, the U.S. must limit further defense industry consolidation; fix intellectual property issues; attract new businesses to the industry—especially small businesses—and put “sector-specific supply chain resiliency plans” into effect for critical items, ranging from missiles to castings, strategic metals, and microelectronics, according to the report, released Feb. 15.

The DOD noted that, since the 1990s, defense and aerospace primes have dwindled from 51 companies to just five mega-companies and that further consolidation “would have serious consequences for national security.”

Over the last 30 years, for example, “tactical missile suppliers have declined from 13 to three, fixed-wing aircraft suppliers declined from eight to three, and satellite suppliers have halved from eight to four. Today, 90 percent of missiles come from three sources,” the Pentagon said.

Reduced competition and fewer suppliers “may leave gaps” in filling defense needs and “remove pressures to innovate to outpace other firms.” The taxpayer will suffer, as “leading firms leverage their market position to charge more, and raise barriers for new entrants,” the Pentagon said. Single-point dependencies are also a strategic vulnerability if the supply chain is broken or a sole-source is “influenced by an adversary nation,” states the report.

The report answers a Biden administration mandate from last July to assess the state of competition in the defense industrial base and to recommend ways to increase it, as part of Executive Order 14036, “Promoting Competition in the American Economy.”

Source: “State of Competition within the Defense
Industrial Base” report.

The Pentagon offered a chart showing that defense spending on goods and services has grown less competitive in the last 10 years. In 2012, 57.1 percent of roughly $355 billion in contracts were awarded competitively, but by 2021, that number had fallen to just 52 percent of about $370 billion, meaning that only a little over half of what DOD buys, it buys competitively. The high water mark of competition was 58.3 percent in fiscal 2014, and the low was 50.1 percent in fiscal 2020.

The problem is not new and has its origins in DOD’s own policies. Charts in the report show that the bulk of defense industrial consolidation took place in the 1990s after the Pentagon’s so-called “last supper” meeting with industry chiefs advising them that post-Cold War defense budgets were about to get much smaller and that they should seek mergers and acquisitions.

The report also acknowledges that studies of defense industry mergers “have not found a strong correlation between consolidation and increased program pricing” but that the risk of reduced innovation and single-point supply chain failure is very real.

The Pentagon said it is already taking a less-accommodating posture regarding mergers and acquisitions, saying any such deals will come in for “heightened review.” It did not specifically mention Lockheed Martin’s recent attempted acquisition of Aerojet Rocketdyne, which the Federal Trade Commission sued to stop and which Lockheed dropped this week.

Low interest rates and healthy operating margins have given bigger defense companies the means to go shopping over the last decade, the Pentagon noted. It said the DOD is concerned with both horizontal mergers—in which two companies have overlapping business lines—and vertical mergers, in which a large firm buys a company in its supply chain. Vertical mergers have been the most numerous of late, and the Defense Department said it worries that those mergers allow the buyer to take “anticompetitive actions that provide an advantage over competitors.”

Northrop Grumman had to promise to be a “merchant supplier” of solid rocket motors and other products to its competitors when it acquired Orbital ATK in 2018.

Meanwhile, longer program cycle times “from initial requirements through design, prototyping, initial production, testing, full production, operational fielding, and sustainment” have led to fewer opportunities for new programs, “driving unsuccessful bidders to exit the market when it is unsustainable to maintain design and manufacturing skills” until the next requirements opportunity arises, states the report.

The Pentagon touted a number of initiatives to attract new entrants, and particularly small businesses, saying it sees opportunities to draw in many companies if it can convince them that it’s reducing red tape and can offer stable timetables for competitions, awards, and production contracts.

Intellectual property has been a sticking point in recent years. The Pentagon wants to own as much of the technical baseline for new programs as it can get, which in turn would promote competition for upgrades under an “open mission systems” or “open architecture” approach. Doing so helps prevent “‘vendor lock” and “other undesirable results.” But in the report, it admitted that this policy deters some companies from doing defense work.

The National Defense Industrial Association, in its annual “Vital Signs” report on the health of the industry, released Feb. 2, cited the IP issue as one of the key issues deterring companies from doing defense work; the others being red tape and unreliable long-term funding.    

To address the problem, the Pentagon said it will adopt “best practices” from the commercial world to deal with IP needs “early in the competitive phases of the acquisition process.” It will be an “evaluation factor” in competitive contracts and a “negotiation objective” in sole-source awards. Although it will favor those willing to sell the government IP, the Pentagon will create “procedures that do not result in unnecessary anticompetitive consequences.”

The areas where the DOD is most worried about the number of new suppliers are in missiles and munitions; castings and forgings; energy storage and batteries; strategic and critical materials; and microelectronics. These problem areas haven’t changed much since a 2018 assessment, and industry ideas to address the situation were sought last September in the Federal Register.

The conditions pressing on these special-interest areas are much the same as across the industry. For forgings and casting, “low margins, low and unpredictable demand, and little incentive to add new capabilities” are chronic issues, as is the fact that it is a “capital intensive” business “fiercely competitive on price, but access to capital can be poor.”

The DOD admitted that it increasingly relies on “a constantly shrinking set of small job-shop suppliers, making razor-thin margins, one contract loss away from bankruptcy.” The problem is only growing worse “as older workers with extensive tacit knowledge retire.” The business is also dependent on specialty materials whose supply is unreliable.

The DOD didn’t offer much in the way of solutions for castings and vendors companies, saying it has tried to align its needs with the larger commercial industry to broaden the business base. But when the need is specialized and the required volume small, the pool of suppliers “has often been far too small to support meaningful competition.”

The report noted that even though it has seven missile primes—down from 30 in the 1990s—it’s got only one in the hypersonic weapons systems sector. The Pentagon will be keeping a key eye on mergers and acquisitions among missile companies, it said, but it admitted that it inadvertently discourages investment because of the boom-and-bust way it typically buys munitions.

Munitions companies also face special challenges for doing defense work: storing or using “energetic materials” means extra investment to physically space out operations and “explosion-proof” buildings. These costs, as well as high technology, proprietary designs, and trouble challenging established vendors make it hard to bring new entrants into the business.

The Pentagon is particularly worried about hypersonics, fearing many primes and first-tier subcontractors will try to buy up suppliers for vertical integration. This “will likely lead to reduced competition and may eliminate it altogether.” As the demand for hypersonic systems grows, so will the “the need for specialized manufacturers and suppliers.”

Vertical integration of solid rocket motors from Northrop Grumman’s acquisition of Orbital ATK gave it such a price advantage on the Ground Based Strategic Deterrent missile system that Boeing claimed it could not compete and declined to bid, the report noted, leading to Northrop Grumman “receiving a sole-source contract.”

In batteries, the Pentagon warned that it’s got no domestic suppliers of “raw materials and battery components.” China, it said, has 80 percent of the market in cell phone and other battery materials, “including lithium, graphite, cobalt, and battery-grade nickel.” This constitutes a profound U.S. vulnerability.

Because startup and materials costs are so high to re-establishing these capabilities in the U.S.—as well as “a long pay-back period on investments”—the Pentagon said it would consider “supply chain risk and logistics security” more heavily than simply low cost in awarding battery contracts.

In microelectronics, the Pentagon’s dependence on foreign foundries is just as pronounced as that of the U.S. commercial base overall. Because it’s only one percent of the customer base, DOD has little influence over producers. The U.S. participation has been trending toward design-only in recent years.

It will take a “whole of government response” to get companies to invest in domestic and secure production capabilities in microelectronics, the report said, because of the high capital startup costs and the challenge of competing with established, lower-cost foreign suppliers.