M&A 'Guideposts'

In an address this morning in New York, Ashton Carter, the Pentagon's acquisition chief, encouraged the lower tiers of the defense industrial base to consider consolidating, offering "guideposts" for potential private-sector mergers and acquisitions that would be subject to approval by the federal government.

Speaking to industry executives, financial analysts and investors at a conference sponsored by investment bank Cowen Group, Carter outlined issues DOD will consider in reviewing proposed M&A activity, which is expected to increase as military spending flattens out after a decade of steady increases.

Here are Carter's comments on the seven guideposts, from his prepared remarks:

First, in the main we will rely on normal market forces to make the most efficient adjustments to the defense industrial base. This is not only in accordance with good economic theory, but necessary to prevent the defense industry from becoming further distanced from the main currents of 21st century technology, creativity, and capital markets. These forces will doubtless lead to an uptick in the volume of M&A and other industry adjustments in the coming period, and this is normal. For our part, the Defense Department welcomes needed adjustments that lead to greater overall efficiency but will require transparency with respect to all contemplated transactions. We will examine these transactions to ensure that the Department’s long-term interests in a robust and competitive industrial base dominate any near-term or one-time proposed savings, that potential organizational conflicts of interest are avoided or carefully mitigated, and that we have full visibility into restructuring costs and the potential for continuing capital investment and R&D. The interests of the taxpayer and the warfighter will be forefront in our minds as we review proposals that may result in the creation of weaker stand-alone firms less likely to thrive without the necessary capital structure that their larger parent company is able to provide. In such cases transparency will be essential so that we are confident the value created largely by the Department over the years is not lost to the detriment of the taxpayer or the warfighter. The Defense Department would not want to see its industrial base experience what has happened in some other sectors of the economy: poor risk management, unnecessary leverage, and excessively short-term behavior at the expense of long-term health. Transparency allows all these things to be addressed early in the process, which is in the interest of all involved.

Second, as President Obama made clear to all Federal departments and agencies when he took office and most recently last month in Schenectady, NY, competition is one of the key drivers of productivity and value in all sectors of the economy, including defense. Accordingly, the Department is not likely to support further consolidation of our principal weapons systems prime contractors. A number of our specific Better Buying Power initiatives are aimed at increasing competition among all our suppliers and throughout our procurement of goods and services. Sometimes competition is provided by having two or more providers of the same thing go head-to-head, but where this is not possible we can still harness this power through a wide variety of other competitive strategies that provide real incentives for increased productivity. Where program costs can be reduced, government and industry can share the savings, which will be directly reflected in earnings and profit.

Third, we will be looking at our industry sector by sector – from shipbuilding to professional services, and from stealth to space – because the dynamics are different in each sector. Deputy Secretary Lynn has directed a comprehensive sectoral study of our industry, which is being led by Brett Lambert. This will not be a one-time snapshot, but rather an ongoing guide to us as we seek to sustain the health, vibrancy, and efficiency of the industrial base upon which our security depends. While we cannot sustain the base in a given sector if it has the wrong size and shape for the new era, once it is right-sized and right-shaped, the government will take an interest in keeping it that way.

Fourth, our interest in the defense industrial base extends throughout its entire spectrum. Far too often, people view our industrial base as being made up of those who receive prime awards. The truth is that perhaps two-thirds to three-quarters of every dollar we award at the prime level is spent for subcontracted goods and services at the so-called “lower tier” of the industry. But while these companies might be “lower tier” in this sense, they are not of lower importance -- they are centrally important to a healthy industrial base. They are frequently rich in technology and dynamism. They are also important drivers of program cost – frequently down but sometimes up – and the sources of supply chain efficiencies or, alternatively, disruptions in major programs. So their health and performance are critical to us. Smaller firms, start-ups, and new entrants provide needed new technology, new faces, and new ideas to the defense industry. The nation’s small businesses add vitality to our base in both prime and subcontractor roles. Mid-sized companies are especially important and worthy of fostering, as they can grow into new sources of innovation and competition.

Fifth, the Better Buying Power Guidelines give heightened attention to the increasing importance of the “services” component of the “goods and services” we require – again provided by firms not often considered “defense companies.” These services are as essential as weapons systems to mission accomplishment, and Better Buying Power directs a number of steps to better understand and manage this part of the Department’s spend. Currently about half of our prime contract spending is in the services sector – and this does not take into account the portion of services required by traditional procurement programs. The “services” portion of the industrial base is correspondingly growing and changing. Some of the companies that provide these needed services have grown quite large and take an important place in our industrial landscape alongside the more familiar brand names. Others are innovative small businesses. As we improve our approach to services procurement, we will be attentive to its industry foundation.

Sixth, a key part of our defense industrial strategy is to encourage new entrants. These offer competition, renew and refresh the technology base, and ensure that defense is benefitting from the main currents of emerging technology. We must accordingly work constantly to lower the barriers to entry. We are addressing many of these barriers – such as needless or timeconsuming paperwork – as part of the Better Buying Power initiative because they impose unnecessary costs. But another objective of eliminating non-productive processes is to make it easier for companies to do business with us. We continue to seek industry feedback and ideas on how to do this.

Seventh and finally, globalization is affecting security and commerce in profound ways, and this trend has implications for our industry. In Afghanistan our troops fight alongside forces from a wide coalition of other friendly nations, and we anticipate that in the future it will be rare indeed that we fight alone. In the industry that supports these international security efforts, we likewise simply cannot avoid or wall ourselves off from globalization. Depending on the program, from a few percent to much more of the value-added in defense goods and services is sourced overseas – mostly to companies that serve as subcontractors to U.S. primes and that provide, for example, a particular specialized part. Sometimes that is where the best technology or best value can be found, and when it is, we owe it to the warfighter to do so. Globalization of our market is not an option - it is a reality. Our utilization of, for lack of a better term, “non-heritage” firms is essential for nearly all of the systems upon which we rely. We are committed to continue opening our markets while at the same time striking the appropriate balance with security concerns. Just as we have opened our markets to the leading firms from around the world, we urge our partner nations to do likewise. Exports obviously strengthen our industry’s competitiveness, but they also enhance our security – and international security – when they build the capacities of international partners. We are doing our part by implementing President Obama’s reforms of our antiquated export control regulations and procedures, and we expect our efforts will result in increasingly open and fair competitions around the globe.