(Also participating in this briefing is Mr. Kenneth H. Bacon, ASD, Public Affairs.)
Mr. Bacon: Good afternoon. This is briefing by Under Secretary Paul Kaminski will focus on ways to keep defense contracting -- the defense industrial base, highly competitive and responsive to the Department's needs. He will discuss the impact of what he calls vertical integration and following his remarks, he and John Goodman, who is the Deputy Under Secretary of Defense for Industrial Affairs and Installations, will take your questions.
Now I'll turn it over to Dr. Kaminski.
Dr. Kaminski: I'm pleased to release to you today the Defense Science Board report on vertical integration and supplier decisions. I have read the report, I endorse the report, and I have directed that their recommendations be implemented fully and immediately.
Today, I want to tell you a little bit about their findings and then also what we're doing about their findings. Let me start off by telling you what I mean by vertical integration, if I may.
A vertically integrated firm -- a fully vertically integrated firm would produce the entire system -- all the subsystems, all the components and the like -- whereas a firm with a lesser amount of vertical integration would buy subsystems and components for other firms.
This next chart really provides some of the motivation for why this issue of vertical integration was a concern and why I asked for this study. We have been allowing natural market forces to shape the future defense industry, but we have been taking the steps that we needed to be sure our defense products or competition wasn't harmed in this process.
Since 1993, we have taken several actions with this purpose in mind. I know many of you are familiar with these actions -- we've discussed them in the past. These include developing a policy and an active process to assist and work with our antitrust agencies in reviewing proposed defense industry mergers and acquisitions. We've been doing this in a systematic way. We established the policy and the analysis process to guide DoD managers in determining when they must take a special action to preserve an essential defense capability that might otherwise be lost. And we have also revised our policies to require our weapon system acquisition managers to more actively assess industrial capabilities for their programs.
We have also studied several major platform sectors to look at the industrial base. We've looked at helicopters, bombers, track combat vehicles -- to name three -- and we're increasingly studying key supplier areas. For example, one of the ones we've looked at recently are microwave power tubes and we've also looked recently at radiation hardened integrated circuits.
The evidence suggests that our measures thus far have been successful. We're realizing substantial cost savings from the restructuring of our industry and we still have access to the industrial capabilities we need. Overall, we still have effective competition that we need for our major programs.
This new DSB report describes our role in the antitrust process as, “working well and effective.”
May I have the next chart?
Our task force objective, here, comes to look at industry changes that are still underway -- still happening. And there is one element of the consolidation which, as I said, has the potential for some concerns.
About a year ago, I observed that one of the consequences of consolidation may be an increase in the tendency for vertical integration in our defense industrial base. I already described what I meant by vertical integration; that is, making all of the elements of a particular product.
This trend, as it's been going on, has raised some concerns for us to look at. As the industry downsizes, there will be fewer prime contractors in the industry. We prefer to have competition at the prime contractor level, but it isn't always economically feasible to do that. That is, our buying rate might be such -- for example, in areas like tanks -- where it just is not economically feasible to keep two full primes in production. So it's a matter, really, of not having programs or budgets to keep full prime competition going in all business areas.
If we therefore have limited competition among our prime contractors, then what we will want is vigorous competition at the sub-tiers. That becomes more important to us to ensure we have competition at the sub-tiers. And if there is excessive vertical integration, you can see now why it might be harder to have competition at the sub-tiers.
I wanted to know first whether or not vertical integration was really increasing and to be better able to understand its effects on our products and to know what actions we should be taking to address the issue of vertical integration.
I also wanted to know if there was a way we could get ahead of the potential problems -- set up what I would describe as an early warning system, so to speak, so that we could see the problems either before or as they were developing -- rather than being in a mode of having to deal with the problems after they had already occurred.
Next chart, please.
So we put together a Defense Science Board Task Force to address these issues. This chart shows the membership of the task force. With us today is Bill Howard.
Bill, would you stand?
Who chaired this effort. It includes, I think, a diversity of people with a balance of viewpoints: representatives of large and small firms, primes and suppliers, industry and antitrust analysts and legal consultants.
The task force first began meeting in September of last year and they continued meeting through January of this year, interviewing dozens of representatives of industry, government and academia. The resulting report reflects their consensus on this complex and somewhat controversial subject and I recommend the report to you, to read it in a little more detail.
If I may go now to their findings. What the report tells us, first, is that the task force found that some major defense firms are now more integrated -- more vertically integrated -- today than they were in the past. It helps in discussing this to picture the industry in terms of how they order themselves in supplying products.
We contract for weapon systems from the prime contractors here at the top of this notional pyramid. The primes buy products from their various suppliers, who in turn buy from other suppliers. We call these tiers here, as shown in the pyramid. And each tier represents additional engineering or product value added of some sort.
The task force found several firms who traditionally performed at the prime contractor level now have increased their capabilities in the first, second, and third tiers. These major systems, subsystems, and components are critical to our weapon systems costs and their performance. Many such areas more traditionally provided by suppliers can now be produced inside the several firms that also build platforms.
The DSB findings are that, first, the task force does not believe that firms in their consolidation have been purposely pursuing vertical integration as a strategy. Generally, firms appear to be buying business units to diversify and to gain horizontal product synergy -- to be able to share overhead functions, for example, in supplying different products to amortize, to share, that overhead base. And their assessment is that vertical integration and vertical capabilities have largely been a byproduct of the deal of consolidation.
The good news is the task force also found very little evidence that the firms are using their newly acquired internal vertical capabilities to harm defense products or other defense firms today. However, the task force validating my early concerns believes that vertical integration poses potential future concerns for our defense products.
The climate has changed. Industry is more concentrated today. There are fewer new DoD program opportunities and our budget is not growing. This potentially static business climate might in the future encourage firms to leverage their vertical business units for competitive advantage.
In doing this, firms may disadvantage their competitors or other sub-tier suppliers. Over time, this could, in fact, reduce competition and innovation for our important defense sub-tier products.
The task force looked at how our current processes deal with vertical integration. It concluded that our process to work with our antitrust enforcement agencies is today effectively addressing vertical concerns that arise in proposed mergers and acquisitions.
The task force also confirmed that we are asking the right questions when we look at vertical concerns in proposed transactions.
Although our antitrust review process has been judged to be effective, on the other hand, the task force concluded that we are not as well postured in our ongoing acquisition management processes to deal with this issue. DoD acquisition managers may have difficulty today identifying evidence of a growing vertical integration concern.
We need to be better able to identify and address the problems that may emerge as a result of vertical integration during our ongoing acquisition process as it runs. The task force here recommended several actions we could take to improve our acquisition processes in this regard.
After a careful review of these recommendations, I now endorse them and have directed our acquisition authorities and policy organizations to begin implementing them.
I would like to describe the major issues raised by the task force, and then our actions to respond to them.
The first one really deals with visibility. The task force concluded that DoD may have difficulty identifying the problems that could be emerging due to vertical integration due, in part, to our reductions in people in our acquisition system and to some of our oversight reforms.
Today, our managers have less interaction with suppliers below the prime level than they did in the past. Here, we need to consider the example of successful commercial firms, and how they are dealing with these issues.
They are delegating more of the job to their first-tier contractors but, while they are doing that they are increasing their visibility of the lower tier suppliers to protect themselves. And they are especially doing this in areas that are critical to product cost, quality, or performance. So they've set up a means to, in essence, actively surveil these areas that are critical to them.
I have now initiated several actions that will work to increase our visibility in a similar way.
First, I have asked our corporate DoD industrial office, led by John Goodman -- and I credit John, really, for most of the work in coming up with the policies to implement these recommendations and also for having worked with the task force here these several months -- I've asked John to monitor selected sub-tier product and technology areas -- those satisfying that same kind of commercial criteria really important to product cost, quality, or performance.
I've asked John to monitor those on an ongoing basis, and to assist our acquisition program personnel to improve their supplier insight. To select important areas to monitor, John will be working with our DoD program and our technology representatives. He will also be consulting with industry in this process -- that's very key.
We would also like for industry to identify vertical integration problem areas. One of the issues, here, is firms are reluctant to report exclusionary behavior on the part of other firms for a whole variety of reasons.
I have asked John to establish a focal point that firms can contact to report problems or issues -- with guaranteed anonymity in being able to do that -- so we have some element of this early warning net as a means for people who see problems affecting their business to be able to report it.
Second, I have asked our acquisition program managers to increase their scrutiny of prime contractors' proposed supplier choices and their teaming arrangements. In fact, this is an area where we have already taken some action. In a recent NRO competition on the imagery architecture of the future, we prohibited exclusive teaming in some key technical areas that, in our judgment, inhibited free and open competition. The net result was that we are able to get more and stronger proposals by stopping this exclusive teaming.
I have also asked our acquisition program managers to review how their prime contractors are partitioning their system designs, as this partitioning can be done in a way to restrict supplier choices.
The task force encouraged us to continue our open systems architecture initiative in this regard; that is, to create an open system environment which people are free to bid into.
Third, I've asked the executives who run my formal acquisition program review process -- that is, our Integrated Product Team and our overarching Integrated Product Team leaders -- to begin scrutinizing supplier choices and vertical supply relationships in critical product areas at our major program milestones and our decision points. So we look at these as a team.
Next chart, please.
Next, the issue of competition. The task force found that competition, along with our initiatives for best value and this principle of cost as an independent variable, which I've discussed with you in the past, creates a powerful market force to help mitigate potential vertical integration problems.
If this is done properly, primes cannot likely afford to select internal sources if there are better external sources which would enable them to win in a competition. The task force suggested that we bring additional competitive focus into our acquisition programs.
And here I've asked our service acquisition executives to devise acquisition program strategies to help foster competition at both the prime levels where it's economically viable and also at the supplier levels.
To do this, they will have to increase their understanding of markets for sub-tier areas that are critical to their planned programs and consider alternative strategies that could allow more competitors an opportunity to participate.
The task force cautioned us that vertical integration problems may emerge quite subtly through technology development or be unintentionally exacerbated by DoD's own science and technology and demonstration investment choices.
To better deal with these effects, I have tasked our director of Defense Research and Engineering to more explicitly address industry competitiveness and innovation in our technology strategic investment choices. I have also asked the director to work more closely with my acquisition program and our industrial organizations on the competitive outcomes of our technology investments -- it's looking at this here in the longer run.
Knowledge. I think one of the most important findings of the task force is that our DoD managers need much more savvy and knowledge about the elements of the industry if they are going to be smart and effective arm's-length buyers. I am now instituting a series of changes at our defense acquisition schools to increase and improve the curricula and faculty devoted to these industry issues. I have also asked the executives who manage DoD's acquisition career fields to emphasize industry knowledge and credentials for acquisition management positions. Some of this might also help by having us do a little more rotation in the industry with some of our program management personnel.
Indicators. Finally, to aid in narrowing our look at suppliers, the task force provided an initial set of broad indicators for DoD analysts and managers to use in looking at this problem. These are intended to help point out product areas where further investigation into vertical supply relationships may be warranted. They suggested the three potential indicators on the chart.
First, an indicator where competitors are declining below three for systems and critical subsystems for components product markets -- an area, when we're below three, we want to start watching this more carefully.
Second, notable increases in prime contractor's make-value as opposed to buy. That is, prime contractors making a decision to make the product in-house vice buying it externally: looking at the make-value in a contract as a percentage of the total program value and comparing it to previous or similar, current programs as a rule of thumb.
Third, sizable DoD investment in discriminating technology that has resulted in a limited number of competitors. By discriminating here I mean technology that could provide a notable performance edge as we were competing a system.
These indicators will not necessarily tell us that a real problem exists, but they are a barometer -- a warning net -- to help us know if the vertical integration pressure is increasing in a certain product that might merit a more thorough review.
I have asked John Goodman's Industrial Assessment Office to test these indicators in its analysis of some specific sub-tier areas and they may have to revise them as they begin to do some testing with respect to their application to see how well they work.
To implement the new actions -- I've described -- in a meaningful way requires adequate resources and focused management attention. I have directed that a program funding element be established for John Goodman's office as he manages the overall implementation of these new actions.
By taking these actions, I believe we are putting in place the foundation for this early warning system that I was looking for. I consider these actions to be an important addition to our ability to be smart, well informed buyers for the long term. We are doing this, I believe, without adding excessive bureaucracy or onerous oversight or new reporting demands on the industry.
In sum, I think this keeps us on a course to ensure our continued access to competitive, innovative subsystems and also to components that help provide us the leading edge in our future weapon systems.
I would be happy to take your questions.
Q: How do you know that industry is not going to tell you that it's going to cost more to do something because it has to comply with this policy and how much is the oversight going to add in cost?
A: I don't think the oversight is going to add any substantial cost to the effort. There are ways to deal with the issue of cost to the industry. For example, there are situations where we can direct that competition occur in various sub-tiers; there are actions we can take where a particular subsystem is leveraging and critical to a competition; or we can buy it and make it available as government furnished equipment to the various prime suppliers. So there are several kinds of actions we can take and those actions by themselves won't necessarily increase the cost.
Q: Page 11 of the report mentioned several big pending mergers. How do you expect the implementation of these recommendations to affect the Boeing-McDonnell Douglas deal and the Raytheon deals?
A: I don't expect these recommendations to affect the process of review of the merger in a significant way in that if you look at the conclusion of the report, they said basically the process we have in effect to review the mergers is fine. The issues they are raising is post-merger -- after we've looked at the various issues. We have taken steps to deal with vertical integration issues in mergers that we've looked at. I think as we look back on the history in seven different cases the antitrust agency involved recommended some consent decree to deal with the vertical integration issue and we didn't disagree with that action. So this has been addressed in some of the mergers we've looked at.
Q: I guess my question is do these recommendations make divestiture or some kind of consent degree on the pending mergers more likely?
A: I don't think these recommendations do by themselves. But, Tom, I also want to tell you that's an important issue in some of the mergers that we're looking at.
Q: In some ways isn't this going to be increasingly problematical? I mean, mergers and consolidations on second- and third-tiers are going to be continuing, perhaps even between the primes, through the end of the century. I mean, yesterday, you had Northrop Grumman move on Logicon. I mean, it's good to have an early warning net, but, I mean, isn't this going to sort of potentially get overloaded as firms become increasingly vertically integrated as you move towards the end of the decade?
A: Not necessarily. I think the industry consolidation is not done. There's still some consolidation ahead. That particular acquisition of Logicon isn't necessarily a principal vertical integration move. I would tell you that as I look at the trends and tendencies in commercial industry, most commercial companies are moving to a smaller number of suppliers, but they are not increasing their tendency to vertically integrate. In fact, in most cases, quite the opposite.
Q: You mentioned it a little bit, R&D and the lack of competition has been pointed out as something that is going to be affected by this. If you don't have the competition, there's not the incentive to be as creative. You talked about this briefly, but could you give us a little more detail about how you're going to encourage innovation?
A: Some examples as to how you might create some competition?
A: The whole process we have in place for ACTDs -- if you think about that -- brings some of this to bear. It creates room, in many cases, for smaller companies to come forward with a different idea, a different way of performing a current mission. Replacing a manned aircraft, for example, by an unmanned. Taking on a job from a different perspective. That's a good example of what I mean by a longer term technology investment or demonstration to create a dissimilar competition for a particular capability. That's a tool that I think we can use from time to time. It's a tool to reach out to smaller companies to provide some base. There are situations where teaming between larger and smaller companies may make some sense in aspects of doing this.
I think my bottom line here is, though, that this is something that's going to have to be actively managed over a period of time in our whole acquisition system. We're going to have to give more attention to this downstream in our acquisition system. It's really a fact of life of what a given budget will support in terms of the number of suppliers.
Q: Perhaps one of the best examples of a large vertically integrated defense company is Lockheed-Martin. Have you found any examples in which Lockheed-Martin has in any way disadvantaged lower tier competitors?
A: I have not found any examples in which they have done that today with lower tier competitors. In fact, for a company to be competitive, they actually have to be careful about that because, for example, if they are disadvantaging lower tier competitors who have a better product, what they're doing is driving those lower tier suppliers to a competitor. And if they're not being fair with those suppliers over a period of time, those suppliers will take their business elsewhere. So there is a balance to be performed in this process overall.
Q: If a company decides to perform work in-house, even though it's more expensive, but simply to keep a line warm and to keep those people on the payroll, would DoD in the future step in and say, no, no, that's not competitive, you can't do that?
A: What we want, Tom, is a set of conditions so that we can see that happening. I'm not prepared to tell you yes or no, what we would decide in that situation. In the short term, that might be a fine situation -- a lower cost. In the long term, it could lead to an anti-competitive situation, so it really does depend on the details. But overall, as a practice of buying internally when there is a better, lower cost supplier outside, that's a practice I would be looking to discourage on a policy sense.
Q: Since you mentioned the budget, I can't help but ask you to put on your acquisition hat and ask you about the defense budget in terms of a balanced budget. If you have a balanced budget agreement, how is that going to affect DoD acquisition over the next five years?
A: It's not really clear to me ultimately on that, Tom. We have been working in the QDR to stabilize our acquisition program, to be able to deliver some growth in the acquisition budget that we've been talking about. I do expect us to do that.
Q: Even within the context of a balanced budget?
A: Even within the context of a balanced budget.
Q: You mentioned that you have to train your program managers to be more in touch with industry issues.
A: The sub-tier suppliers.
Q: Yes. How are you going to do that in the short term? I know in the long term you're going to do that through the schools, but how are you going to do that immediately?
A: We won't be able to do it immediately in the short term. We'll be able to do a little case study work. Here's a place where we may be able to leverage a little bit off some of the commercial lessons learned, to be able to do a little interaction with commercial companies. But it takes time to propagate this through a whole acquisition workforce. That's one of the reasons, as we are looking at our defense education structure, I believe we have to have a more responsive structure.
We need to be able to take education and training to the workforce and the work site. We'll get a better response time by doing that, rather than people having our program managers queue up with a two-year waiting list to go to an acquisition school. We need a little more responsive education system, using our science and technology to actually take the education and training to the field. That will help us deploy this more quickly.
Q: Do you already have actual measures that you can use when you talk about evaluating this, or will that be part of this whole process to create better -- I just hope that those who are studying the potential for a problem know what they're looking at.
A: We have the measures I described. I will tell you those are early test measures. One of the reasons this report took a little longer to get is that I kept leaning on the director of the task force to do some work in preparing these measures for us to look at. I believe they're still candidate measures today. I think we have to test them a little bit more in the marketplace. That's what I've asked John Goodman to do. I believe they'll be refined as time goes on.
No measures are going to be perfect, but what I want to do first of all is get a way to alert ourselves to home in on a problem and focus on it before it gets out of control. I think these have to be tested some more.
Q: A couple of questions. One question is in some ways, regarding competition, there are two combat plane makers in the United States, there are a couple of missile makers, there's one tank maker, there's, you know, two sub makers. I mean, aren't we sort of heading in the direction of having already limited competition? I mean, how much competition do you still need, you know, at the monopsony buyer, in this industry as it continues to downsize?
A: Given my choice of no competition and competition, I'll always pick competition where it's economically feasible. But as I said to start off, there are situations where it's just not economically feasible. There's a critical mass that you need to be a supplier and when the market is not much greater than that critical mass -- to be pragmatic about it -- there's only going to be one prime supplier. But once again, I come back to the policy here, if we're going to deal with one prime supplier I believe we have means to deal with that: we have a monopoly supplier, we, too, are a monopsony buyer. So there are some means to regulate conditions there. But under those conditions, I will then want the maximum amount of competition that I can get at those supporting tiers. What I'm doing is just dealing with reality and pushing the competition down then one level where there are multiple firms who can still compete.
Q: How much is Mr. Goodman's office going to be getting in additional funding?
A: We haven't determined that finally for '99. John really is putting together a plan as we speak. It won't be a large amount of funding. It won't be a percent of the defense budget, it will be something, a few tenths of a few hundredths of a percent.
Q: And since Tom raised the question of budgets and all that, there were all kinds of rumors circulating about the TACAir debate, the numbers and everything else. Without sort of giving the cat away, could you talk a little bit about how that's going? I mean, should we gird for large drops in numbers coming out or - -
A: I cannot talk about that a little bit without giving the cat away.
Q: Well, give the cat away.
Q: Has there been any reaction from Capitol Hill on these kinds of moves? I know there's been talk, again, depending on what size companies are in a particular district. In general, though, how is Congress reacting to these initiatives?
A: Congress really hasn't had a chance to react to this initiative yet. I think there has been some general concern in the Congress about excessive consolidation in the industry. There really hasn't been much concern that I've seen, particularly on this vertical integration issue. This began bothering me about a year ago. I think, though, we did have hearings on consolidation in the industry which John Goodman and -- in fact, a good piece of this team sitting before you testified at. About two months ago, John?
Mr. Goodman: About a month ago.
Dr. Kaminski: About a month ago. And we have not been having hearings on the subject routinely. So, that tells me the interest in the Congress is growing, as I think it should, to oversee this. And I think we'll have some review of this set of policies that I've just described. Yes?
Q: Funding follow-up for the office -- ballpark? I know we don't have a specific number but, you know, $10 million, $5 million, $2 million, $300,000, I mean --
A: It will be less than $10 million.
Q: You mentioned divestitures as a concern of the pending mergers. Can you be more specific about which sort of divestitures are being considered in which mergers?
A: You mean those under current review? No, I can't. I really don't want to comment, Tom, on the ones that are currently under review. One more. Yes.
Q: Isn't this an indication of DoD is raising red flags about consolidation? The attitude is beginning to change. That there is a growing amount of concern as to how far its gone?
A: Absolutely not. I don't see this as a red flag. I see what's happened in the consolidation of the industry for us this far to be generally good. What this is raising for me is a set of considerations that say here is a problem. We're not having a big problem with this yet but this could become a problem. We need to watch it carefully.
Q: Can you specify what sort of areas you see potential problems?
A: It's in areas where there is a critical enabling component, for example --
A: Let's look at some of the areas that we've looked at recently, microwave tubes. If we saw a situation develop where a company developed an internal capability to supply microwave tubes and through that process basically pushed out all the other competitors, they would then have an unfair advantage as a prime. And even though we are trying to conduct competitions as a prime, if they teamed exclusively with themselves -- didn't offer that microwave tube to other suppliers -- we would be having a problem.
Thank you very much.