May 20, 2015    Volume 22, No. 7

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U.S. Military Enters A New Era Defined By Globalization Of Its Technology Supply Chain

By Richard A. McCormack

The U.S. defense industrial complex has entered a new phase of its centuries-long development, the latest characterized by globalization of supply chains and the inability of U.S. defense contractors and laboratories to drive technological change. Gone are the days when the Department of Defense could depend on American industry to provide it with high-tech components used in advanced weapons systems. Gone too are the well-funded defense R&D enterprises responsible for the creation of entire industries such as the Internet, high-performance computing and the global position system.

The Department of Defense and its major contractors are now dependent on foreign manufacturers for many of the military's most advanced weapons systems.

DOD is slowly catching up to the structural change caused by globalization of technology and supply chains. It is wrestling with the regulatory and procurement systems it has in place to monitor and conduct business with foreign suppliers, but it has little time to waste, says Bill Lynn, CEO of Finmeccanica North America and former Deputy Secretary of Defense from 2009 until 2011.

The defense industry is a shadow of its former self, representing less than 3.5 percent of the U.S. economy, a position that continues to decline as defense budgets reach new lows with no chance of them growing faster than the economy.

"Facebook is worth more than Lockheed Martin, Raytheon, Northrop Grumman and General Dynamics, combined," notes Lynn. Apple "could buy half the industry with the cash it has on hand."

When their R&D budgets are combined to total a scant $3 billion (or only 1.6 percent of revenue), the five biggest defense contractors -- Boeing, Lockheed, Raytheon, L3 and Northrop -- would not even make the list of the top 20 global companies that invest in R&D, notes Lynn.

The defense sector and the U.S. military have "moved from being a net exporter of technology to a net importer," he notes. The defense industry has had little impact on the latest technology developments such as 3D printing, autonomous vehicles and information technology in general.

"Those are things where the commercial industrial base is stronger than the defense industrial base and in many ways the key to maintaining our future [defense] technology edge is to be able to import those technologies into our defense industrial base," Lynn told a recent meeting of the Center for Strategic and International Studies in Washington, D.C. Since many of the underlying technologies now reside outside of the United States, DOD has to figure out how to deal with foreign corporations and state-owned enterprises that hold the keys to its success.

The defense industry has almost stopped investing in research and development and capital equipment, which does not bode well for its future health, says Lynn. Most of the cash the industry is generating is going to stock buybacks and dividends. In 2013, 80 percent of cash generated was going to dividends and buy-backs. By 2014, that number surged to 102 percent, which means the big defense contractors were taking cash off the balance sheet in order to give it back to shareholders.

The desire of executives in the defense industry to drive stock prices to record highs has worked, "but over the long run, you have to wonder how this strategy is going to play out over a half a decade and a decade in terms of [whether there will be] the technology to keep refreshing the military," says Lynn.

The changes described by Lynn are well understood by Stan Sims, Director of the Pentagon's Defense Security Service, which approves foreign company involvement in U.S. military programs. "We have been seeing foreign investment for a while," says Sims. "We have been dealing with this for quite some time. So welcome to the discussion."

The process by which foreign companies are approved as contractors, or are allowed to purchase U.S. companies, has been changing, says Sims. "We are not adapting as fast as most of us would like, but we are adapting. The bureaucracy is slow, but we have to be patient with it because we see ourselves as a risk management organization."

Sims' office has hired lawyers from the private sector, bankers, business school graduates and accountants to help assess foreign takeovers, foreign investment and the contractual means by which U.S. contractors purchase goods from overseas suppliers. Managing the global industrial base for security purposes goes beyond just the challenge of compliance and oversight by the office that approves mergers and investment, says Sims. The bias in favor of "Buy American" and against foreign companies runs deep within the military's procurement community. "It's a mindset and culture," says Sims. "We have to change the culture and mindset of the people dealing with this. We have to change our acquisition professionals."

But there is only so much the DOD can do. "We took a look at the supply chain. We have done studies at DSS -- looked at the acquisition managers and looked at how much they knew about their own supply chain, and it was ugly. It was not pretty. We can give you examples and examples about how our industrial base is not managing the supply chain in a risk-managed approach."

So if the private sector wants to criticize the Pentagon for not being responsive to the business changes caused by globalization, it has only itself to blame. "The government does not own the industry supply chain," says Sims. "You do. You own it. You hire it. You pay for it. You own it. The government doesn't own it. You have to take responsibility. Soon will be gone those days where we have the big integrators and primes who get the government contract and then they immediately farm out -- sub out. They may have some visibility at the first or second layers [of the supply chain] and beyond that no visibility at all. But if you own the supply chain, you pay it, then you manage it, you control it. The government cannot do it. The companies that are going to get the business are going to be the ones that are aggressive in knowing what their supply chain is and they will be able to deliver products that are uncompromised. They are going to know who is doing the work -- not every widget, but someone has to take a look at what are the important widgets -- the critical aspects of the supply chain -- and you have to take an interest in that. It means you have to have a more aggressive risk-management approach. If you are looking for the U.S. government to do that, you are looking in the wrong place. Industry owns the supply chain."

Lynn says that changing perceptions about foreign involvement in the defense industry are similar to what happened in the U.S. auto sector. Thirty years ago, the American automobile industry was dominated by the Big Three and it was considered unpatriotic to drive a German or Japanese automobile. Americans and their representatives in Congress were skeptical about foreign nameplates.

But as foreign auto companies started building factories in the United States and hiring American workers, the tide turned. Companies like BMW, Toyota, Subaru and Honda built solid political support in the United States because they built their cars state-side and hired American workers.

"The politicians care about the jobs; they care less about the nameplate," says Lynn. "BMW will get political support if they build their cars here."

The defense industry "is a couple of decades behind, but the [foreign] nameplate will become less important if defense firms build their products in the United States," says Lynn. "Every country does this. [Congress] will look for the jobs and will care less about who owns it."

The Pentagon cannot get stuck in a protectionist view of technology, says Lynn. It cannot restrict access to commercial technology since so much of it originates from foreign suppliers. "The key point is we need to manage the transition to this [new] industrial base era," says Lynn. "We need to have pretty strong attention and active management of this transition."

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