WASHINGTON — In an unanticipated move last week, Pentagon acquisitions chief Frank Kendall announced he would seek to deter future consolidation involving top tier defense contractors, a stance defense analysts said injects uncertainty into the defense market.

Lockheed Martin's pending $9 billion acquisition of Sikorsky Aircraft, which US anti-trust regulators recently approved, does not violate the Pentagon's proscription against primes merging with each other, Kendall noted in remarks to reporters. But it does move a high percentage of the market share for an entire line of products — military helicopters — into the largest defense prime contractor, which already holds a dominant position in high performance aircraft through the F-35 program, he said.

"Mergers such as this, combined with significant financial resources of the largest defense companies, strategically position the acquiring companies to dominate large parts of the defense industry," Kendall said.

"With size comes power, and the department's experience with large defense contractors is that they are not hesitant to use this power for corporate advantage. The trend toward fewer and larger prime contractors has the potential to affect innovation, limit the supply base, pose entry barriers to small, medium and large businesses, and ultimately reduce competition, resulting in higher prices to be paid by the American taxpayer in order to support our war fighters."

In addition to working with anti-trust regulators at the Justice Department and Securities and Exchange Commission, the DoD "is convinced that we should work with the Congress to explore additional legal tools and policy to preserve the diversity and spirit of innovation," Kendall said.

While Kendall was clear about his misgivings, his remarks may have created more confusion than clarity.

Loren Thompson, a defense-industry consultant and analyst with the Lexington Institute, said Kendall’s remarks would likely have a chilling effect on merger and acquisition M&A activity in the defense sector, particularly among primes. If the Pentagon is departing from current anti-trust standards, it needs to spell out what the new standards are, he said.

"Traditionally, antitrust officials have looked at issues like horizontal or vertical market integration in reviewing a proposed deal. But now, simple size seems to have become a sticking point for the Pentagon," he said. "It appears as though every prime that considers a significant transaction will have to think twice given these sort of nebulous concerns that the department has raised."

The Department of Justice did not respond to a request for comment.

Another potential negative consequence of Kendall's remarks, which seem to punish companies that perform, is that they might discourage large primes from fully participating in upcoming competitions, he said.

"He specifically cites the problem that was caused by Lockheed Martin prevailing in a winner-take-all competition for the F-35. He's blaming them for winning on a program that the government itself set up," Thompson said. "If I were Lockheed Martin, the message I'd be getting is I need to diversify away from defense to keep growing. And, since I'm being punished for winning the F-35 and getting too big, maybe I shouldn't compete on anything else for a while."

Steve Grundman, a former Pentagon industrial policy chief who is now a consultant and a member of the Atlantic Council, said if the Pentagon wants to stop private companies from conducting a transaction, they want to do, it either needs a legal basis or enough power to push back. Legislative relief from Congress may be the more difficult option, he said.

"I think he's going to have a much harder time getting new law to address the kinds of concerns that he described. However, if you want to be a defense contractor, the DoD is the biggest, baddest customer there is," he said. "He may have better luck working it through policy choices, and acquisition choices and acquisition strategies."

But there is a certain amount of risk attached to Kendall's efforts, he said.

"One risk is that he actually, perhaps inadvertently, has imposed less rather than more clarity about the government's merger policy toward defense firms," Grundman said. Alternatively, "he could have his bluff called, and that's not good for his stature and authority."

Thompson also questioned whether congressional action would be an effective solution.

"Congress is not some finely tuned instrument that weighs all the issues analytically and concludes on an optimal outcome," he said. "When you ask Congress to get involved, it's open season; every little constituent interest and other narrow gauge concerns manifest itself in the process."

Byron Callan, an analyst with Capital Alpha Partners, suggested the Pentagon could best reshape the competitive balance in the defense industry by tweaking its spending priorities to include non-traditional companies with potentially disruptive technologies.

"Congress can really only do so much in this. What you really have to do is start carving money out of programs, and creating lanes for new starts," he said. "You have to change incentives to change behaviors, and the incentives are in the budget."

With major contract awards becoming fewer and farther between, large defense companies have turned to stock dividends and share buybacks to appease shareholders, he said. For this business strategy to continue, management teams at primes may prefer the stability that comes with consolidation to the inherent disruption and instability that comes with innovation, he said.

"To me, they are loudly signaling, they are quite content with how things are," he said of the large primes. "When you talk about lowering the barriers to entry and changing the competitive landscape, that's highly disruptive."

Congress has already given the Pentagon quite a bit of leeway by including various provisions in the National Defense Authorization Act giving the DoD authority to engage with outside companies, he said. Congress advanced the NDAA via conference committee last week, but President Obama threatened to veto the bill over its use of overseas contingency operations funds to work around sequestrations budget caps.

The question for the Pentagon's leadership then becomes: Are you making cuts to major programs of record to fund these new initiatives that could change the balance of power in the defense sector, Callan said.

"If you want to keep Lockheed Martin on its toes with the F-35, then dramatically increase the pace on the 6th generation fighter," he said.

Lockheed Martin immediately took issue with Kendall's statement, and quickly issued a rebuttal.

"There is no evidence to support the view that larger defense companies reduce competition or inhibit innovation," a company spokesman said in a prepared statement. "In fact, we have consistently delivered the best and most sophisticated defense capabilities in the world."

More than 60 percent of Lockheed's work is performed by small and mid-sized companies acting as subcontractors, according to the statement.

"We believe that defense contractors should continue to be assessed based on the performance and effectiveness of the products and solutions offered, not on the size of their company," the statement concluded.

The Aerospace Industries Association (AIA) also weighed in, noting that consolidation is market driven and follows downturns in defense spending, as in the 1990s.

"We're seeing fewer and fewer new programs which start farther and farther apart," the AIA said in a prepared statement. "With fewer programs for which to compete, the stakes for individual companies grow ever higher – loss of a contract competition could mean the end of a company's ability to compete for defense work.  In this environment, it's no surprise that industry is looking to become leaner and more efficient."

Jeff Bialos, a partner at Sutherland Asbill & Brennan who specializes in aerospace and defense M&A and previously served as the Pentagon's deputy undersecretary of defense for industrial policy, said Kendall's concerns include that current law doesn't give the Pentagon ample discretion to address certain implications of mergers for competition in defense markets. The question is not one of vertical or horizontal integration, he said, but rather of the influence that comes with an oversized position in the market.

Size alone is not anti-competitive under anti-trust laws, Bialos said. But it's not hard to envision a scenario in which a company becomes so big, and involved in so many sectors of the defense business, that smaller firms are afraid to team with one of the large firm's rivals for fear of angering the giant and being frozen out of future business.

"That's the issue that I think that one might argue that current law doesn't sufficiently address," he said.

Email: aclevenger@defensenews.com

Twitter: @andclev

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