Shipyard Bid Shows Need For Pentagon Merger Policy

Issue Brief

Last Friday deputy defense secretary Bill Lynn met with Wall Street analysts to deliver a message: defense spending is not headed into a big downturn. Lynn told the analysts that presidential guidance calls for increasing the regular military budget by one-percent above inflation in fiscal 2012, and the defense department plans to free up additional money for modernization by becoming more efficient. The meeting was scheduled because policymakers are concerned that negative investor sentiment will impede the ability of military contractors to raise capital.

However, investors are skeptical about whether they can count on Pentagon promises. First, the federal government is running a budget deficit of a billion dollars every six hours. Second, U.S. combat forces have largely departed Iraq and will soon start leaving Afghanistan. Third, the Obama Administration has cut $330 billion from weapons plans. Fourth, policymakers are reducing outlays for contracted services and converting thousands of contractor jobs to civil service positions. Fifth, defense secretary Robert Gates will exit the administration next year, and his replacement is likely to be less committed to robust military outlays.

I could go on, but you get the point: the Bush defense build-up is over, and the Obama defense build-down is beginning. That’s why the number of senior executives accepting buyout offers at the biggest military contractor was three times higher than management expected, and it’s why merger activity among second-tier contractors has reached a fever pitch. Apparently, defense industry employees and investors see something that deputy secretary Lynn does not: a looming contraction in military demand that will force some players to exit the sector and others to merge into more resilient combinations.

Because Pentagon policymakers will not face up to the reality of an ongoing federal fiscal crisis, they are failing to put in place policies required to manage the coming defense downturn and losing credibility with the public. In particular, they lack rigorous, realistic rules for determining what sorts of corporate combinations the government should accept or reject in the sector consolidation that will inevitably accompany the downturn. If nothing else, this week’s implausible story that a Cleveland-based start-up is bidding to buy Northrop Grumman’s naval shipbuilding unit — the biggest such business in the Western Hemisphere — should be a wake-up call for policymakers to get their act together before market forces transform the defense industrial base.

Here are the kinds of questions they should be asking themselves. If Boeing can’t find its way into the F-35 joint strike fighter program by acquiring the relevant pieces of subcontractor Northrop Grumman, won’t it eventually have to exit the tactical aircraft business? With competition a thing of the past in nuclear shipbuilding, wouldn’t it make sense to let the nation’s two nuclear shipyards combine so engineering and production processes can be rationalized? Doesn’t the cancellation of major civil and military space programs leave the rocket motor business in such a weakened state that some reduction in the number of players will be needed to assure a viable industrial base? The fact that policymakers don’t have answers to these questions today tells you they aren’t ready to cope with the coming downturn.