Defense Industry: Consolidation and Options for Preserving Competition
(Letter Report, 04/01/98, GAO/NSIAD-98-141).

Pursuant to a legislative requirement, GAO provided information on major
defense market areas that have been affected by contractor business
combinations since January 1, 1990, and described the changes in the
number of businesses competing in those market areas.

GAO noted that: (1) the sharp decline in spending by the Department of
Defense (DOD) since 1985 has resulted in a dramatic consolidation of the
defense industry, which is now more concentrated than at any time in
more than half a century; (2) as the single customer for many products
of the defense industry, DOD must have the ability to identify and
address potential harmful effects of mergers and acquisitions; (3)
questions have been raised about whether the consolidation has gone too
far--adversely affecting competition in the industry; (4) many defense
industry mergers and acquisitions are recent, so there is little
evidence that the increased consolidation has adversely affected current
DOD programs; (5) antitrust reviews have identified some problems, and
remedies have been implemented; (6) however, the consolidation could
pose future problems unless DOD improves its ability to identify problem
areas and devises alternative ways to maintain competition in defense
acquisition programs; (7) DOD can take several approaches to maintain
competition; (8) for example, it can design acquisition strategies to
compete missions rather than products and provide funding to help
develop alternative suppliers or technologies; (9) however, DOD cannot
know what action to take unless it has adequate visibility into the
industrial base--especially at the lower tiers; and (10) progress has
been slow in gaining that visibility.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  NSIAD-98-141
     TITLE:  Defense Industry: Consolidation and Options for Preserving 
             Competition
      DATE:  04/01/98
   SUBJECT:  Defense contracts
             Department of Defense contractors
             Military aircraft
             Advanced weapons systems
             Defense industry
             Defense procurement
             Competitive procurement

             
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Cover
================================================================ COVER


Report to Congressional Committees

April 1998

DEFENSE INDUSTRY - CONSOLIDATION
AND OPTIONS FOR PRESERVING
COMPETITION

GAO/NSIAD-98-141

Defense Industry

(707341)


Abbreviations
=============================================================== ABBREV

  DOD - Department of Defense

Letter
=============================================================== LETTER


B-279557

April 1, 1998

Congressional Committees

Section 804 of the National Defense Authorization Act for Fiscal Year
1998 (P.L.  105-85) directed us to report to the congressional
defense committees information identifying major defense market areas
that have been affected by contractor business combinations since
January 1, 1990, and describing the changes in the numbers of
businesses competing in those market areas.  This report responds to
that direction and comments on approaches the Department of Defense
(DOD) can take to preserve and monitor competition in the defense
industry.  It summarizes our March 4, 1998, testimony on defense
industry consolidation before the Subcommittee on Acquisition and
Technology, Senate Committee on Armed Services, and incorporates
DOD's comments where appropriate. 


   BACKGROUND
------------------------------------------------------------ Letter :1

The end of the Cold War dramatically affected the size and structure
of the U.S.  defense industry.  Decreased defense spending, declining
sales, and excess capacity prompted many defense companies to
consolidate to remain competitive and financially viable.  While DOD
has encouraged consolidation, it has also attempted to ensure that
capabilities to produce defense unique products continue to exist and
that innovation and competition do not suffer. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

The sharp decline in spending by DOD since 1985 has resulted in a
dramatic consolidation of the defense industry, which is now more
concentrated than at any time in more than half a century.  As the
single customer for many products of the defense industry, DOD must
have the ability to identify and address potential harmful effects of
mergers and acquisitions. 

Questions have been raised about whether the consolidation has gone
too far--adversely affecting competition in the industry.  Many
defense industry mergers and acquisitions are recent, so there is
little evidence that the increased consolidation has adversely
affected current DOD programs.  Antitrust reviews have identified
some problems, and remedies have been implemented.  However, the
consolidation could pose future problems unless DOD improves its
ability to identify problem areas and devises alternative ways to
maintain competition in defense acquisition programs.  DOD can take
several approaches to maintain competition.  For example, it can
design acquisition strategies to compete missions rather than
products and provide funding to develop alternative suppliers or
technologies.  However, DOD cannot know what action to take unless it
has adequate visibility into the industrial base--especially at the
lower tiers.  Progress has been slow in gaining that visibility. 


   CONSOLIDATION IN THE DEFENSE
   INDUSTRY HAS OCCURRED IN MOST
   MARKET AREAS
------------------------------------------------------------ Letter :3

Since 1990, there has been a dramatic reduction in the number of
prime contractors in 10 of the 12 markets DOD identified as important
to national security.  The largest number of reductions have been in
the tactical missile, fixed-wing aircraft, and expendable launch
vehicle markets.  For example, the number of contractors producing
tactical missiles has dropped from 13 to 4.  Only two contractors now
compete in such key defense markets as expendable launch vehicles,
tracked combat vehicles, strategic missiles, and torpedoes.  Appendix
I shows changes, as of March 1, 1998, in the number of contractors in
defense markets identified by DOD as important. 

This concentration was not unexpected.  DOD has encouraged the
defense industry to consolidate facilities and eliminate excess
capacity to remain competitive and financially viable.  DOD expects
that significant cost savings will result from the consolidation. 

Three large firms--Boeing, Lockheed Martin, and Raytheon--have
emerged from recent mergers and acquisitions.  Together, the three
firms receive a substantial portion of what DOD spends annually to
acquire its weapons and other products. 


   APPROACHES TO PRESERVING
   COMPETITION DURING DEFENSE
   INDUSTRY CONSOLIDATION
------------------------------------------------------------ Letter :4

DOD can take several approaches, acting alone or in cooperation with
the government's antitrust enforcement agencies, to ensure
competition in today's more concentrated defense industry.  The
government's antitrust review process has identified and remedied
potentially adverse effects of several proposed mergers or
acquisitions.  Responsibility for conducting antitrust reviews and
approving mergers and acquisitions lies with the Department of
Justice and the Federal Trade Commission.  In recent years, DOD has
become more involved in antitrust reviews by sharing information and
working more closely with the antitrust enforcement agencies. 

Through collective efforts, the Department of Justice, the Federal
Trade Commission, and DOD have identified a number of situations
where proposed mergers or acquisitions could adversely affect DOD
programs.  In such cases, they used consent decrees\1 to address
potential problems. 

A major concern addressed by these consent decrees was the potential
compromise of a company's financial, business, or technical
information.  The usual remedy in these situations has been to
require "firewalls"\2 to prevent the disclosure of such information. 
Consent decrees have also addressed concerns about exclusive teaming
arrangements and organizational conflicts of interest that could be
anticompetitive.  In these cases, the merging or acquiring companies
were required to not enforce the exclusive arrangement or to divest
certain assets. 

In the long term, DOD's ability to address the potential adverse
effects of consolidation will depend upon its ability to identify
problem areas and devise alternative ways to maintain competitive
pressures in its acquisition programs.  DOD can do so in several
ways.  For example, DOD can encourage new companies to enter the
defense market through the use of science and technology investment
funds.  DOD can also

  -- fund alternative technologies to meet the warfighters' needs;

  -- devise strategies to compete various approaches and missions,
     for example, using a missile rather than an aircraft;

  -- require major defense contractors to use open-system
     architectures\3 in designing weapon programs;

  -- make subtier competition a specific source-selection criterion
     and contract requirement; and

  -- explore opportunities to meet military needs through greater
     cooperative efforts with international partners. 


--------------------
\1 Consent decrees are agreements by the parties to a proposed
transaction to take specific steps to alleviate antitrust concerns. 

\2 The term "firewalls" refers to arrangements created by a company
to limit or prevent the exchange of competition-sensitive information
among parts of the company. 

\3 Open-system architecture refers to a design approach where the
contractor defines system interfaces to a set of standards that a
number of suppliers agree to meet.  This makes supplier products more
interchangeable in the design and allows a wider range of suppliers
to participate in producing defense systems. 


      INITIATIVES TO MONITOR
      COMPETITION
---------------------------------------------------------- Letter :4.1

In May 1996, DOD tasked the Defense Science Board to determine
whether problems were being created as a result of vertical
integration, that is, mergers or acquisitions that add supplier
product lines to a firm that also makes products at a higher tier. 
The Board reported that it could not measure the extent of vertical
integration because industry analysts and antitrust agencies neither
measured it nor had a mechanism for measuring it.  The Board
concluded, however, that DOD was not in a position to recognize
emerging problems because it lacked visibility at the lower levels of
the industry.  Consequently, the Board made a number of
recommendations to improve DOD's visibility over the industrial base. 

DOD agreed with the Board's recommendations and initiated plans to
(1) increase acquisition program managers' scrutiny of prime
contractor teaming and supplier choices, (2) devise acquisition
strategies to promote alternative concepts and new supplier entry,
(3) improve the amount and quality of industry knowledge and
experience of DOD acquisition managers, and (4) monitor a select
group of technological areas to determine the impact of vertical
integration.  DOD also agreed with a Board recommendation that it
continue to carefully scrutinize ongoing antitrust reviews for
potential harm from vertical integration.  Most of the
recommendations have not been fully implemented because of the need
to review several recent and complex mergers and acquisitions. 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :5

We asked DOD to review and comment on a draft of this report.  In
oral comments, DOD concurred with this report's findings and
contents.  DOD provided separate technical comments, which we have
incorporated into the report, as appropriate. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :6

To identify major market areas affected by business combinations of
defense contractors, we interviewed DOD and antitrust agency
officials and reviewed pertinent agency and corporate documents.  To
understand the broad antitrust review process and the various
agencies' perspectives, we interviewed officials from the Federal
Trade Commission, the Department of Justice, and DOD, including the
Offices of Industrial Affairs and Installations and General Counsel. 
We also interviewed various acquisition and weapon system program
officials and reviewed documents from the Departments of the Army,
the Navy, and the Air Force, as well as from legal counsels for firms
involved in the several mergers and acquisitions. 

In addition, to understand DOD's role in the antitrust review
process, we examined documents provided to DOD by companies involved
in several mergers and acquisitions and DOD's support for advice it
provided to the antitrust agencies.  We also examined consent decrees
related to defense industry mergers and acquisitions. 

We conducted our work between August 1997 and March 1998 in
accordance with generally accepted government auditing standards.  We
had limited access to the information related to the mergers and
acquisitions selected for this review.  We excluded from our review
ongoing transactions. 


---------------------------------------------------------- Letter :6.1

We are sending copies of this report to the Director, Office of
Management and Budget; the Attorney General; the Secretaries of
Defense, the Army, the Navy, and the Air Force; the Chairman of the
Federal Trade Commission; and to others upon request. 

If you or your staff have any questions, please contact me at (202)
512-4841.  Major contributors to this report are listed in appendix
II. 

David E.  Cooper
Associate Director, Defense Acquisitions Issues


List of Congressional Committees

The Honorable Strom Thurmond
Chairman
The Honorable Carl Levin
Ranking Minority Member
Committee on Armed Services
United States Senate

The Honorable Ted Stevens
Chairman
The Honorable Daniel K.  Inouye
Ranking Minority Member
Subcommittee on Defense
Committee on Appropriations
United States Senate

The Honorable Floyd D.  Spence
Chairman
The Honorable Ike Skelton
Ranking Minority Member
Committee on National Security
House of Representatives

The Honorable C.W.  Bill Young
Chairman
The Honorable John P.  Murtha
Ranking Minority Member
Subcommittee on National Security
Committee on Appropriations
House of Representatives


DEFENSE MARKET SECTORS
=========================================================== Appendix I

As part of its effort to ensure that certain capabilities to produce
defense unique products continue to exist, the Department of Defense
(DOD) has identified industrial market sectors comprised of types of
products or weapon systems important to U.S.  national security
interests.  These products or weapon systems range from tactical
missiles to tracked combat vehicles.  Table I.1 lists the defense
sectors that have experienced reductions in the number of companies
competing or under contract between 1990 and 1998.  Submarines and
ammunition are not included since these sectors did not experience
any changes. 



                               Table I.1
                
                  Prime Contractors in Defense Market
                           Sectors (1990-98)

               Reductio
               n in
               contract
Sector         ors       1990 contractors       1998 contractors
-------------  --------  ---------------------  ----------------------
Tactical       13 to 4   Boeing                 Boeing
missiles                 Ford Aerospace         Lockheed Martin
                         General Dynamics       Northrop Grumman
                         Hughes                 Raytheon
                         Lockheed
                         Loral
                         LTV
                         Martin Marietta
                         McDonnell Douglas
                         Northrop
                         Raytheon
                         Rockwell
                         Texas Instruments

Fixed-wing     8 to 3    Boeing                 Boeing
aircraft                 General Dynamics       Lockheed Martin
                         Grumman                Northrop Grumman
                         Lockheed
                         LTV-Aircraft
                         McDonnell Douglas
                         Northrop
                         Rockwell

Expendable     6 to 2    Boeing                 Boeing
launch                   General Dynamics       Lockheed Martin
vehicles                 Lockheed
                         Martin Marietta
                         McDonnell Douglas
                         Rockwell

Satellites     8 to 5    Boeing                 Boeing
                         General Electric       Lockheed Martin
                         Hughes                 Hughes
                         Lockheed               Loral Space Systems
                         Loral                  TRW
                         Martin Marietta
                         TRW
                         Rockwell

Surface        8 to 5    Avondale Industries    Avondale Industries
ships                    Bath Iron Works        General Dynamics
                         Bethlehem Steel        (Bath Iron Works)
                         Ingalls Shipbuilding   Ingalls Shipbuilding
                         NASSCO                 NASSCO
                         Newport News           Newport News
                         Shipbuilding           Shipbuilding
                         Tacoma
                         Tampa

Tactical       6 to 4    AM General             AM General
wheeled                  Harsco (BMY)           GM Canada
vehicles                 GM Canada              Oskosh
                         Oskosh                 Stewart & Stevenson
                         Stewart & Stevenson
                         Teledyne Cont. Motors

Tracked        3 to 2    FMC                    General Dynamics
combat                   General Dynamics       United Defense LP
vehicles                 Harsco (BMY)


Strategic      3 to 2    Boeing                 Boeing
missiles                 Lockheed               Lockheed Martin
                         Martin Marietta


Torpedoes      3 to 2    Alliant Tech Systems   Northrop Grumman
                         Hughes                 Raytheon
                         Westinghouse

Rotary wing    4 to 3    Bell Helicopters       Bell Helicopters
aircraft                 Boeing                 Boeing
                         McDonnell Douglas      Sikorsky
                         Sikorsky
----------------------------------------------------------------------
Notes:  In July 1997, Lockheed Martin announced that it planned to
combine with Northrop Grumman.  On March 23, 1998, the Department of
Justice filed suit to block the acquisition of Northrop Grumman by
Lockheed Martin.

Defense electronics is not included as a market sector. 

Source:  Our analysis of DOD data. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

NATIONAL SECURITY AND
INTERNATIONAL AFFAIRS DIVISION,
WASHINGTON, D.C. 

John K.  Harper
Rosa M.  Johnson
Jose A.  Ramos, Jr.
John P.  Swain

OFFICE OF THE GENERAL COUNSEL

William T.  Woods
Raymond J.  Wyrsch

*** End of document. ***