Filed by Northrop Grumman Corporation
Pursuant to Rule 425 under the
Securities Act of 1933 and deemed filed
pursuant to Rule 14d-2
of the Securities Exchange Act of 1934
Subject Company: Newport News Shipbuilding Inc.
Commission File No.: 1-12385
Northrop Grumman made the following report to the U.S. Department of Defense and
the U.S. Department of Justice publicly available.
The U.S. Government's Decision on the Fate
of Newport News: Unprecedented Merger to Monopoly,
Cost Savings Without Reduced Competition,
or the Status Quo
Discussion Materials Regarding Alternative Outcomes
in the Proposed Acquisitions of Newport News Shipbuilding
for the Consideration of the
U.S. Department of Defense
and
U.S. Department of Justice
August 3, 2001
Prepared and Submitted on Behalf of
Northrop Grumman Corporation
TABLE OF CONTENTS
Al Myers Presentation, "Alternative Outcomes of the Government's
Consideration of the Possible Acquisition of Newport News Shipbuilding"............................................TAB A
White Paper, The U.S. Government's Decision on the Fate of Newport News: Unprecedented
Merger to Monopoly (GD), Cost Savings Without Reduced Competition (NOC),
or the Status Quo..................................................................................................TAB B
Background Papers..................................................................................................TAB C
1. Proposed Acquisition of Newport News by General Dynamics Will Reduce
Competition in Research and Development for Surface Ships and Submarines
2. The Engine Wars: Implications for Naval Shipbuilding
3. Implications of Alternative Forces on the Naval Shipbuilding Industry
4. Economic Incentives in the Naval Shipbuilding Industry
5. Limitations of Regulatory Control in Naval Shipbuilding
TAB A
Alternative Outcomes of the Government's Consideration of the
Possible Acquisition of Newport News Shipbuilding
The government deliberations regarding the possible acquisition of Newport
News (NNS) by either General Dynamics (GD) or Northrop Grumman (NOC) could
result in following the broad outcomes:
1. Deny Both The acquisition of NNS denied to both GD or NOC;
2. Allow GD Allow GD but not NOC to pursue the acquisition;
3. Allow Both Both GD and NOC are allowed to pursue the acquisition;
4. Allow NOC Allow NOC but not GD to pursue the acquisition.
Each of these outcomes has a set of consequences.
Outcome 1. (Deny Both)
This outcome, which maintains the status quo in the Navy shipbuilding
industrial base, would support competition for future nuclear and non-nuclear
ship programs by accommodating multiple teaming alignment possibilities.
This outcome would forego, at least in the short term, the expected cost
savings that would arise from the acquisition of NNS by either GD or NOC.
Moreover, if the government denies the acquisition to either company it is
probable that the issue of the sale of NNS will be raised again at some future
date. Capital markets-driven financial considerations are likely to continue to
make NNS a candidate for acquisition. Additionally, there are continuing
affordability pressures which are likely to make a combination with another
shipbuilding contractor attractive to NNS's customer, the U.S. Navy. It is not
only possible, but even probable, that these factors would, at some future time,
outweigh the considerations that led to a decision by deny the acquisition to
either company at this juncture.
There would also exist a distinct possibility that a third party would
arise as an acquirer of NNS. If NNS were to be acquired by such a non-strategic
(i.e. a firm not in the shipbuilding business) buyer there would be a far
smaller cost savings potential. There would also exist the potential that a
buyer without a strategic interest in defense (i.e. one not in the ship building
or defense business) may seek to acquire NNS again with minimal cost savings
potential. Furthermore, a non strategic buyer would be looking for an exit
strategy which would at some future time result in NNS being, once again, on the
market. Finally, it is unlikely that future consolidation options for NNS,
whether it remains as a standalone company or is acquired (temporarily) by a non
strategic buyer, would be materially different than those currently under
consideration.
Outcome 2. (Allow only GD)
This outcome seems difficult to rationalize. Its basis could only result
from the perception on the part of the government that the cost savings which
would accrue to the customer from a GD acquisition would be sufficiently larger
than those derived from a NOC acquisition and that this cost-driven
consideration would overcome the substantial benefits arising from continued
competition between the businesses of NNS and GD because the monopoly created in
this circumstance would in all likelihood be permanent and irreversible. The
barriers to entry or reentry in terms of costs, regulatory hurdles, engineering
and technical expertise, infrastructure and time are such that it is remote that
a new competitor could ever emerge in domestic nuclear ship building.
It has been argued that the existing teaming agreement between NNS and GD
for the Virginia Class submarine demonstrates that there would be no competitive
consequence arising from allowing a monopolistic combination of GD and NNS.
There are several reasons why this is not at all the case:
GD and NNS, under or despite the teaming agreement, remain potential
competitors on future procurements of Virginia Class submarines;
GD and NNS would be competitors on future Navy ship classes;
Even with the teaming relationship in place, the customer has the ability
to continue to establish and manage the performance incentives for each the
contractor by shifting work share between the parties;
GD and NNS are competitors for ongoing contract awards pursuant to the
Technology Insertion Program for modernization of the Virginia Class
submarines.
In summary, it is clear that allowing a merger between GD and NNS would
effectively eliminate the benefits arising from the current competition between
the parties.
If such a monopolistic combination is allowed, however, some of the
consequences are easy to predict. Under this circumstance, GD would have a
dominant advantage in all of the competitive dimensions of Navy shipbuilding:
Mass - GD would command a substantial majority of future Navy shipbuilding
revenues, a large fraction of which will be either sole-source or directed
procurement;
Capability - GD would have a potentially overwhelming advantage in terms of
organic engineering, technical and manufacturing capability;
R&D - Again, GD would enjoy an enormous advantage both in terms of
knowledge and capability arising out of very substantial past R&D efforts
and in terms of continuing Government-funded R&D activities. The resulting
disparity between GD and other shipbuilders in engineering capability and
in-house
knowledge of past and ongoing R&D activities will have an immediate and
increasing effect of eliminating future competition for nuclear (de facto)
and, importantly now, non-nuclear Navy ship design and development.
It is very likely that a number of technologies, largely the result of past
and current R&D activities performed by NNS and GD, will be critical in future
Navy ships. Of particular significance in the design of future Navy surface
ships will be technologies related to integrated power systems (including
electric drive), advanced propulsors, advanced hydrodynamics, computational
fluid dynamic analysis in the areas of induced cavitation, detectable wake
effects and turbulent flow phenomena, acoustic phenomenology and thermal
signature analysis. As future surface combatants are able to realize a
substantial reduction in radar detectability, the application of these
technologies to surface ships will become increasingly important to providing
the requisite degree of stealth since all signatures will need to be balanced.
Clearly if GD were to acquire NNS it would have an overwhelming advantage
in these and other technologies critical to future surface ship designs. It is
important to note that simple access to developed R&D data will not be
sufficient to offset this advantage - it is the know how which is acquired in
the development of technologies that creates the ability to effectively
incorporate the R&D results in new designs. Access without the underlying
experience and know how is not a substitute for direct participation.
While this situation is clearly a significant competitive concern to NOC,
the more serious result would be the adverse effect the combination of GD and
NNS would have on the competition for new ideas. Competition has been the engine
for innovation and it has provided the U.S. with its technological edge in
weapon systems. If the competitive environment is eliminated, GD will have a
subtle but significant motivation to maintain existing technologies in favor of
assuming the financial risks and uncertainties associated with the development
and incorporation of new technologies. Quite apart from the increased costs and
developmental risks, one needs to acknowledge that the largest margins are
typically obtained during mature production.
Finally, but equally importantly from an overall policy perspective, the
industrial policy ramifications of a government decision to allow Outcome 2 (and
its equivalent Outcome 3 below) are enormous and reach far beyond the customer
considerations of anti-competitive behavior. Allowing Outcome 2 may also signal
a shift in policy insofar as the government will have explicitly approved a
merger to monopoly in an industry important to national defense. This could have
significant and immediate implications in light of the fact that the
consolidation of the U.S. defense industry will continue through ongoing mergers
and acquisitions. The Government's ability to distinguish this precedent from
other proposed transactions (which will also argue efficiencies as a substitute
for the benefits of competition) will be severely questioned.
Outcome 3. (Allow Both)
This result would have the same net result as Outcome 2 (Allow only GD).
This is a simple consequence of the likely response of the capital markets to
the transaction. The capital markets will clearly support the GD transaction in
favor of a NOC transaction. GD would be perceived as able, at some future time,
to command monopoly rents and, as a result, be able to generate extraordinary
financial returns that would not correspondingly accrue to NOC. Therefore,
participating in an auction with GD for the acquisition of NNS is not a remedy
that would be in NOC's interest.
Outcome 4. (Allow only NOC)
This outcome would produce a consolidated and robust industrial base for
Navy shipbuilding characterized by overall balance and the establishment of a
strong basis for continuing competition in all segments, excluding, of course,
the already existing single source for nuclear powered aircraft carriers. The
availability of NNS's engineering talent and applicable R&D derived technology
to augment NOC's existing and future non-nuclear ship business will benefit NOC
by strengthening a key segment of its defense business. The result will be an
environment in which both competitors will have a strong ongoing business base
and the Navy customer will benefit from the substantial cost savings to be
derived from the combination of NNS and NOC. The Navy customer would continue to
be the beneficiary of the ongoing competition both in terms of ship system costs
and the substantial positive effect competition will have on technological
innovation.
It has been suggested that a NOC acquisition of NNS would create new single
source for "large deck" Navy ships. This concern arises out of an attempt to
combine two segments, nuclear powered aircraft carriers and aviation capable
assault ships, which have hitherto not been considered as a single market. While
it is clear that NNS has the manufacturing assets capable of building assault
ships, GD's NASSCO yard also has the requisite capabilities to be a competitor
in this class. Clearly without the acquisition of NNS, NOC would have no ability
to compete for nuclear powered aircraft carrier contracts. On the other hand, GD
already has the ability to compete as a supplier of assault ships both in terms
of shipyard assets (NASSCO) and the technical capacity implicit in the
augmentation of its NASSCO capability with the considerable engineering
expertise resident at Bath Iron Works.
A concurrent and integrated design approach, incorporating all aspects of
the hull, combat systems, propulsion and power system design, auxiliary systems
design, electronic systems and weapon system design is required since all of
these elements interact and affect the over all platform signature and hence its
survivability and mission effectiveness. NOC understands this process and is
excited by the potential of applying its considerable expertise to meet the U.S.
Navy's future requirements.
This innovative application of a wide range of technologies to the design
of future surface combatants and amphibious ships holds the promise of providing
significant enhancement to survivability and weapon system effectiveness. The
full realization of this potential will require significantly increased levels
of integration and concurrency in
all aspects of the ship/weapon system design and development. NOC has
considerable and significant experience in weapon system design requiring this
kind of highly integrated approach - often performed in geographically dispersed
locations.
The opportunity to deploy this expertise in a new arena is a critical
element of NOC's strategic interest in its recent acquisition of Litton and is
fundamental to its interest in the acquisition of NNS.
NOC cannot, however, begin to realize this objective if it is denied the
R&D base and engineering talent to address the full breath of applicable
technologies. If GD is allowed to acquire NNS, it would command an over whelming
position in several critical technologies and would attract a dominant share of
the R&D funding required for this kind of integrated systems design approach.
This disparity would practically render the smaller player (in this case NOC)
ineffective in the short run and marginal in the medium run. If, however, NOC
acquires NNS, a healthy and robust shipbuilding environment would be established
in which competition between GD and NOC would assure that the best and most
innovative design approaches might be available to meet present and future Navy
requirements.
TAB B
THE U.S. GOVERNMENT'S DECISION ON THE FATE OF NEWPORT NEWS:
UNPRECEDENTED MERGER TO MONOPOLY (GD), COST SAVINGS WITHOUT
REDUCED COMPETITION (NOC), OR THE STATUS QUO
____________________________________________
In considering the competing offers of Northrop Grumman ("NOC") and General
Dynamics ("GD") for Newport News Shipbuilding ("NNS"), the United States
Government (the Department of Defense and the Department of Justice) has
essentially three options.
. First, the Government can move to block both acquisitions and preserve
the status quo. While this option has the laudable result of preserving
competition in nuclear submarine R&D and construction, it would do
nothing to reduce the high cost and inefficiency that currently
characterizes NNS. Moreover, it would leave in place the existing
imbalance in the Navy's shipbuilding and engineering base. Currently,
there is only one shipbuilder, GD, with the design and construction
capability necessary for the full range of ships (except nuclear-powered
carriers) that the Navy requires now and in the foreseeable future.
. Second, the Government can block GD's offer and approve that of NOC. That
option will also preserve competition in nuclear submarine design and
construction. But, unlike merely preserving the status quo, this second
option will enable NOC to realize savings that NOC estimates (though it
has been unable to validate the estimate because NNS continues to deny
NOC the ability to conduct due diligence) to be in the range of $1.9
billion to $2.6 billion over ten years. (That range is equivalent to the
cost-savings GD claims that its acquisition of NNS will achieve.)
Moreover, unlike the other options, an acquisition by NOC of NNS will
create competitive balance in shipbuilding because the combined NOC/NNS
will achieve the scale and scope currently enjoyed by GD alone.
. Third, the Government can allow GD to acquire NNS./1/ This option is
clearly the worst. Not only does this option eliminate current and future
competition for the design and construction of nuclear submarines, but it
also further exacerbates the current competitive imbalance in the Navy's
shipbuilding and engineering base. After such a merger, a combined GD/NNS
would have a stranglehold on subsurface technology and engineering that
is becoming increasingly critical in the design and construction of
surface ships. In
_____________________
/1/ This would be the likely result if the Government approves the GD
deal, regardless of whether the Government also approves a NOC acquisition.
Because NNS has cooperated with GD and provided the company with the opportunity
to perform due diligence, GD can close its offer quickly. Moreover, because of
the anticompetitive profits that GD can anticipate from the elimination of
competition in submarine design and construction as well as from the weakening
of NOC in surface ship design and construction, GD will always be able to outbid
NOC, which must rely exclusively on cost-savings from an acquisition of NNS to
generate value.
addition, in the absence of shutting down the submarine shipyard at
either GD's Electric Boat or NNS (which GD has consistently stated that
it will not do and which it probably cannot do for political and
strategic reasons), there are virtually no unique cost-savings GD can
achieve by acquiring NNS that NOC cannot achieve if it acquires NNS.
(Moreover, NOC believes that, applying its experience in the aerospace
industry, it can work with GD after a NOC/NNS merger to achieve
significant nuclear shipyard consolidation through specialization if that
is requested by the Navy.) In short, a GD/NNS combination will achieve
few if any unique, merger-specific cost-savings, and those paltry savings
would be swamped by the economic and strategic costs of allowing a merger
to monopoly in submarine design and construction.
The remainder of this white paper examines the cost of this third
option. It explains how, particularly in light of the NOC option that carries
none of the anticompetitive costs and achieves virtually all of the cost-savings
benefits of a GD/NNS merger, approval of a GD/NNS merger would contravene well-
established legal precedent and stand in stark contrast to this Administration's
commitment to free-market capitalism. It is highly unlikely that efficiencies of
any magnitude would be sufficient to defend a merger to monopoly. Given that
there are virtually no "merger specific" efficiencies (i.e., cost-savings that
can be achieved uniquely) likely to be realized by a GD/NNS combination, the
legal precedents indicate that the proposed cost-savings from a GD/NNS merger
would not be sufficient to justify even a merger that fell far short of
monopoly. Moreover, if the government were to allow a GD/NNS merger, it would be
the first time a merger to monopoly was approved in the defense industry and
would set an ominous precedent for relying on bureaucratic oversight, as opposed
to competition, to constrain procurement costs.
Mergers to Monopoly Have Long Been Illegal
The Sherman Act, enacted in 1890, is this country's original and core
antitrust law and is a bulwark of this nation's commitment to free-market
competition. Section 2 of the statute prohibits monopolization and attempts to
monopolize. Central to the law is the notion that monopolies are bad. As the
Supreme Court stated in its landmark decision in Standard Oil Co. v. United
States "[t]he evils which led to the outcry against monopolies . . . may be thus
summarily stated: (1) The power which the monopoly gave to the one who enjoyed
it, to fix the price and thereby injure the public; (2) The power which it
engendered of enabling a limitation of production; and (3) The danger of
deterioration in quality of the monopolized article which it was deemed was the
inevitable result of monopolistic control over its production and sale."/2/ In
its decision, the Supreme Court condemned, among other things, Standard Oil's
creation of a monopoly through acquisitions.
____________________________________
/2/ 221 U.S. 1, 52 (1911).
2
Mergers to monopoly have been virtually per se unlawful for the past
century. Indeed, shortly after the Supreme Court's decision in Standard Oil,
Congress showed that its concern with mergers to monopoly was so strong that it
supplemented the antitrust laws to prevent mergers before they reached monopoly
proportions. That law, section 7 of the Clayton Act (passed in 1914 and amended
in 1950), prohibits mergers which "may tend to create a monopoly" and today
serves as the principal statute governing mergers and acquisitions.
The aversion of the courts and the antitrust enforcement agencies to
mergers to monopoly extends to the defense industry. In the only reported
defense industry case involving a proposed merger to monopoly, the court granted
the FTC an injunction blocking the transaction./3/ As the court stated, "the
resulting entity would have a complete monopoly over the relevant domestic
market. . . . This showing, in itself, is adequate for the [Government] to
demonstrate a substantial likelihood that the merger will `substantially . . .
lessen competition or . . . tend to create a monopoly,' as prohibited by (S) 7
of the Clayton Act."/4/ Indeed, despite the significant consolidation of the
defense industry over the last decade, the Government has never approved a
merger to monopoly among defense contractors. It would truly be unprecedented -
- and odd, given the likely increased demands on the defense industry in the
near future -- for the Government to begin approving mergers to monopoly now./5/
The law's hostility toward mergers to monopoly is so clear that for over a
century this country's courts have rarely been confronted with such mergers, and
this country's economy has even more rarely been forced to contend with their
debilitating costs. The rare exceptions prove the rule. In the 1920s and
1930s, when this country's experience with the antitrust laws was limited and
its understanding and commitment to free-market competition was not as strong as
today, a few mergers to monopoly did avoid condemnation. Perhaps the most
famous was the merger that created the US Steel monopoly in the early part of
the century. Although the courts dismissed the DoJ's attempt to break up that
monopoly, analysis by economists has shown that
______________________________
/3/ FTC v. Alliant Techsystems, Inc., 808 F. Supp. 9 (D.D.C.
1992)(enjoining the proposed merger of the ordinance businesses of Olin and
Alliant, which involved the special circumstance of an imminent "winner-take-
all" competition that would have resulted in a single supplier to the military).
/4/ Id. at 12.
/5/ Under various force structure alternatives currently under
consideration, the optimal attack submarine fleet ranges between 50 and 62
vessels. See, e.g., Defense Budget Presentation for Fiscal Year 2002, presented
in part by Dr. Dov Zakheim, Under Secretary of Defense (Comptroller) (June 27,
2001), available at www.defenselink.com (calling for a force objective of 53
___________________
attack submarines). To meet this demand build rates would have to increase, in
some cases dramatically, over the current procurement level of one per year,
which will allow the introduction of competitive bidding once the four ships
covered by the teaming agreement are completed. See Implications of Alternatives
on the Naval Shipbuilding Industry, at Tab __. For example, build rates would
have to increase immediately to 2/year and by 2010 to 3/year -- a level that
would easily accommodate two shipyards -- if the force structure required the
addition of merely 3 more subs in the fleet (over the currently-budgeted fleet
of 53).
3
the cost to the country was substantial. According to one recent economic
analysis, the US Steel merger resulted in the price of steel being 20 to 40
percent higher than it would have been had the courts broken up the monopoly./6/
Today, the only mergers to monopoly that have any chance of approval are
those subject to review by a regulatory agency that has the power to ignore the
antitrust laws. The most prominent recent example is the merger of the Union
Pacific and Southern Pacific railroads. That merger, which was approved in the
mid-1990s by the Service Transportation Board over the vigorous opposition of
the DoJ, reduced from two to one the number of rail alternatives for certain
shippers. The merger was an unmitigated disaster for shippers, resulting in
service disruptions and numerous lawsuits that continue to this day./7/
Moreover, shippers that lost the benefit of competing rail service were forced
to pay rates that were 15% to 40% higher than those with an alternative
supplier./8/ The economic impact of the merger was so devastating that the
Surface Transportation Board was forced to declare a moratorium on further rail
mergers./9/
Both economic theory as well as experience underlies this country's long-
standing aversion to mergers to monopoly, and, not surprisingly, there is strong
bipartisan support for the rule against mergers to monopoly. As the
conservative antitrust scholar, former Judge Robert Bork has written, "[w]hen
companies . . . merge to create a complete monopoly . . . [t]he law is justified
in striking down such a merger on the theory that restriction of output is
certain and an offsetting increase in efficiency . . . is not."/10/ And as
recently as the end of July, the current Administration reaffirmed the DoJ's
opposition to mergers to monopoly by announcing its intention to block United
Airlines' proposed acquisition of US Airways. Though the two airlines fly
thousands of non-stop routes, the Department based its opposition in large part
on the fact that, according to DoJ's press release, the merged airline would
have "a monopoly or duopoly on nonstop service on over 30 routes."/11/ Attorney
General Ashcroft stated, "While mergers can further competition, this one does
not. If this acquisition were allowed to proceed, millions of
________________________________
/6/ George L. Mullin et al., "The Competitive Effects of Mergers: Stock
Market Evidence from the U.S. Steel Dissolution Suit," 26 RAND Journal of
Economics 314 (1995).
/7/ Brian O'Reilly, "The Wreck of the Union Pacific," FORTUNE (March 30,
1998) ("A pair of University of Northern Texas economists estimate that UP-SP
snafus have already cost U.S. companies $2 billion.").
/8/ Id. ("Several plastics executives said captive shippers can expect to
pay 15% to 40% more for rail freight than those with alternatives.")
/9/ See Public Views on Major Rail Consolidations, STB Ex Parte No. 582
(March 16, 2000).
/10/ Robert H. Bork, The Antitrust Paradox, at 219 (1978).
/11/ Department of Justice and Several States Will Sue to Stop United
Airlines from Acquiring US Airways, DOJ Press Release (July 29, 2001), available
at http://www.usdoj.gov/atr/public/press.releases/2001/8701.htm.
4
consumers --business, government and families -- would have little choice but to
pay higher fares and accept lower quality air service."/12/
Even the Most Extraordinary Efficiencies May Not Save a Merger to Monopoly
Though efficiencies today are relevant to merger analysis, in the modern
history of antitrust, efficiencies have never saved a merger to monopoly.
Indeed, the law requires merging parties to establish substantial, concrete, and
merger-specific efficiencies to justify anticompetitive mergers that fall far
short of a merger to monopoly./13/
In 1997, the DoJ and the FTC formally amended their Merger Guidelines to
set out a framework for analyzing efficiencies. According to the Guidelines,
the agencies will consider only "merger-specific" efficiencies -- that is, the
agencies will only credit those efficiencies that can be accomplished uniquely
by the proposed merger and that likely cannot be achieved by some less
anticompetitive means. The Guidelines also require the merging companies to
substantiate the efficiencies and the likelihood that they will be achieved.
The Guidelines also indicate that the level of merger-specific efficiencies that
the merging parties must substantiate increases with the potential
anticompetitive costs of the merger. Notably, the Guidelines state that
"[e]fficiencies almost never justify a merger to monopoly or near-monopoly."/14/
Earlier this year, in FTC v. H.J. Heinz, the Court of Appeals for the D.C.
Circuit, probably the most distinguished of the federal circuits, indicated just
how difficult it is for parties to a merger that substantially increases market
concentration to prove that efficiencies offset the merger's likely
anticompetitive effects. In Heinz, the two smaller manufacturers of processed
baby food proposed to merge and argued that the resulting efficiencies would
enable the combined firm to realize substantial cost savings (including, among
other things, closing an older plant and consolidating production in the more
efficient facility) and thereby compete more effectively with the market leader
Gerber. The district court agreed, but the Court of Appeals reversed, holding
that the lower court had erred in several respects, including its application of
the efficiencies defense. The appellate court held the trial court had failed
adequately to explain
____________________________
/12/ Id.
/13/ The courts have only recently recognized any efficiencies defense. In
the 1960s for example, the Supreme Court in FTC v. Procter & Gamble
Co., stated that "possible economies cannot be used as a defense to
illegality in section 7 merger cases." 386 U.S. 568, 579 (1967).
Although the Supreme Court has never expressly held to the contrary,
over the last ten to fifteen years the federal antitrust agencies and
the lower courts have begun to consider the prospect of merger-
specific efficiencies in adjudicating merger cases. See, e.g., FTC v.
H.J. Heinz Co., 246 F.3d 708 (D.C. Cir. 2001); FTC v.University
Health, 938 F.2d 1206 (11th Cir. 1991); FTC v. Staples, Inc., 970 F.
Supp. 1066 (1997); FTC v. Cardinal Health, Inc., 12 F. Supp.2d 34
(D.D.C. 1998).
/14/ Merger Guidelines (S) 4 (emphasis added).
5
why the proffered efficiencies could not be achieved in the absence of the
proposed merger. Moreover, because the combination would create a virtual
duopoly (far short of a monopoly), the court stated that "the high market
concentration levels present in this case require, in rebuttal, proof of
extraordinary efficiencies."/15/ Despite very substantial cost-savings, the
court found that the defendants had failed to meet this requirement.
_______________________________________
/15/ 246 F.3d at 720 (emphasis added).
6
A Merger of GD and NNS Would Create a Nuclear Submarine Monopoly
As antitrust merger analyses go, determining that a merger of GD and NNS
would create a monopoly is simple and straightforward. GD and NNS are the only
two shipbuilders currently engaged in (or capable of being engaged in) the
production of nuclear submarines./16/
Perhaps even more disconcerting than the potential submarine construction
monopoly, the proposed GD/NNS merger would create a monopoly in research and
design relating to nuclear submarines. In light of the prohibitive cost of new
entry (discussed below), the notion that any shipyard that does not currently
have the capability of building nuclear submarines would or even could
successfully perform state-of-the-art R&D or design work for subsurface ships is
ludicrous. Without the expertise that comes from employing a workforce
experienced in the construction of nuclear submarines and without the prospect
of being able to implement the fruits of successful efforts, a non-nuclear
shipyard has no incentive or ability to perform nuclear submarine R&D and design
work.
By creating such a monopoly in the construction and design of nuclear
submarines, a merger of GD and NNS would also over the long run reduce, if not
destroy, competition for the design and construction of conventionally powered
surface ships./17/ Future generations of surface ships will increasingly rely on
the technologies developed for subsurface ships. Currently, as reflected in the
competition for the DD21, NOC, which does not participate in the design or build
of nuclear submarines, is at a real competitive disadvantage to GD, which does.
In the absence of a GD/NNS merger, it is at least theoretically possible for NOC
to team with NNS, which does not compete to supply surface ships, in order to
obtain access to critical subsurface technologies./18/ Of course, a merger of
NOC and NNS would convert this theoretical possibility into an actual reality by
bringing NNS's subsurface capabilities within NOC, making a transfer of those
technologies to NOC's surface platforms much easier and more efficient. Teaming
is not an efficient substitute for vertical integration. Foreclosed from access
to these critical technologies if a GD/NNS merger is allowed to proceed, NOC
will see its competitive prowess in the area of surface ships wither and NOC
will fall farther and farther behind the GD/NNS juggernaut./19/
_______________________________________
/16/ While NOC's Ingalls shipyard produced twelve nuclear attack submarines
between 1958 and 1974, its capacity for producing nuclear submarines has long
since disappeared.
/17/ NNS, of course, already has a monopoly in the design and construction
of nuclear aircraft carriers.
/18/ Because of the higher cost structure of its nuclear shipyard, NNS is
not a realistic potential competitor with respect to conventionally powered
surface ships.
/19/ According to a recent CRS report, a combined GD/NNS would employ over
80% of all in-house designers and engineers working on Navy vessels and over 95%
of Navy research and development funds. Ronald
Footnote continued
7
The prospect of new entry into submarine design and construction would pose
no constraint on the monopoly that would be created by merging GD and NNS. The
Merger Guidelines consider the threat of new entry to be relevant when entry by
new firms will be timely, likely and sufficient to constrain a "small but
significant and nontransitory increase in price" after the merger. Because the
possibility of entry into submarine construction is so remote, it is hard to
estimate how much time and investment would be required to enter the business,
though it would surely take at least five years and cost many hundreds of
millions, if not billions, of dollars to obtain the capacity to design and build
nuclear submarines./20/ A 1994 RAND analysis, for example, estimated the cost of
restarting a "smartly" shut down nuclear submarine shipyard to be as much as $2
billion, certainly far less than the cost of creating such shipyard capability
from scratch./21/ Interestingly, according to the analysis, the most time-
consuming and expensive part of restarting such a shipyard would be assembling
the requisite skilled workforce. The RAND study confirms the recent observation
of a high ranking antitrust official at DoJ: "weapon programs can span decades,
and once capability is lost it is incredibly difficult and slow to recreate
it."/22/
The Cost of a GD/NNS Monopoly Would Be Dramatic
A merger to monopoly in the area of submarines would impose a high cost in
an area that is critical to this nation's national security. As a distinguished
panel analyzing general consolidation of this nation's defense industry noted,
"[a] merger that reduces the number of firms capable of developing a suitable
design for a new weapons system may lead to higher prices, lower quality
products, reduced advances in technology, and a reduction in the number,
variety, or quality of the proposals submitted to DOD."/23/ The notion that the
Navy can manage the costs of monopoly is flatly inconsistent with the myriad of
studies of the military's procurement experience with and without competition.
"DOD's experience, Congressional findings, the opinion of industry, and a large
body of literature lead to the conclusion that DOD's
______________________
Footnote continued from previous page
O'Rourke, Navy Shipbuilding: Proposed Mergers Involving Newport News
Shipbuilding -- Issues for Congress, CRS Report for Congress (May 22, 2001).
/20/ In addition to the difficulty of assembling a capable skilled workforce and
constructing the necessary infrastructure, the need to obtain the necessary
permits to develop nuclear capability is a significant barrier to entry.
/21/ See Birkler et al., The U.S. Submarine Production Base, at xix (RAND 1994).
/22/ Constance K. Robinson, Leap-Frog and Other Forms of Innovation, Address
before the American Bar Association (June 10, 1999).
/23/ Report of the Defense Science Board Task Force on Antitrust Aspects of
Defense Industry Consolidation (April 1994) ("DSB Report"), at 27.
8
regulatory and auditing procedures are not a substitute for competition in
assuring the best mix of price and quality."/24/ One would have thought that the
dismal experience of the Navy in trying to control the costs of nuclear aircraft
carriers -- a NNS monopoly that arose naturally as opposed to being created by a
merger -- would be proof enough of the intolerable costs of monopoly.
The case of F-15 engines provides an illustrative proxy for the costs of
merger to monopoly./25/ In the late 1960s, Pratt-Whitney and GE competed to
develop the next generation engine to be used on the F-15 fighter. After the
initial competition, the Air Force selected Pratt-Whitney as the sole source.
After a series of cost overruns, reliability problems and other performance
issues with Pratt-Whitney, the Air Force was willing to listen when GE
approached with an alternative engine design (which it had developed at its own
expense). The Air Force held another competition, ultimately selected the GE
product and claims to have saved upwards of $2.5 billion over the 20-year life
of the procurement, all the while receiving "vastly improved engines,
significantly enhanced warranties, and an enlarged industrial base." Without
the presence of a second viable competitor, the Air Force would have had no
option but to overpay for an unreliable and under-performing product.
In the case of nuclear submarines, the costs that will result from the
elimination of competing shipyards are also not wholly speculative. In fact, the
presence of competing nuclear submarine shipyards has in the past directly saved
the Navy money, specifically in connection with the Trident submarine program.
Without even having to solicit competitive bids for the program to develop the
Trident submarine, the Navy was able to extract substantial cost reductions from
GD by threatening to shift work to NNS./26/ The threat was taken seriously
because the Navy had previously shifted work on the Los Angeles class from GD to
NNS because of performance issues at GD./27/
Though the costs of a submarine monopoly will be substantial, they are hard
to project with any precision. The various studies of the absence of
competition in various military procurements place the cost of monopoly from as
low as 10 percent to as high as 50 percent or
______________________
/24/ DSB Report at 27. See also FTC v. Alliant Techsystems Inc., 808 F.
Supp. 9, 16(D.D.C. 1992) ("There is persuasive opinion in the record that Army
oversight, while effective, is an imperfect substitute for the action of the
competitive marketplace.").
/25/ See The Engine Wars: Implications for Naval Shipbuilding, at Tab __.
The F-15 example was the subject of The Great Engine Wars, a book written by
David M. Kennedy and commissioned by Robert Murray of the John F. Kennedy School
of Government at Harvard University.
/26/ See Appeal of General Dynamics, Electric Boat Division, 83-2 B.C.A.
(CCH) (P) 16,907 (findings of fact discussing contract negotiations on the
Trident development program).
/27/ Id.
9
more./28/ As former Under Secretary of Defense for Acquisition and Technology,
Jacques Gansler, stated recently, "all the empirical data there shows that the
competition tends to improve the performance at an average cost reduction of
around 30 percent, sometimes up to 50 percent."/29/ Even ignoring GD's
obligation to establish that the efficiencies it will gain from its acquisition
of NNS are "merger-specific" as discussed below, the cost savings that GD
projects from its merger with NNS come nowhere close to covering the additional
cost to the Government from the loss of competition.
As substantial as the direct cost increases to DOD are likely to be,
the loss of competition for R&D and design may represent the greatest threat of
a GD/NNS merger. It is obviously hard to value the loss of the "idea" that would
lead to superior military capability. As Defense Science Board's report noted,
"Competition in the defense industry generally has quality and technology
components that may be as important or more important than competition on
price."/30/ There is strong support in the literature for the notion that
monopolies invest in less research and development than is socially desirable,
and that rivalry stimulates the innovative process./31/ As two knowledgeable
observers of the defense industry have written:
Cost and price effects strike us as secondary to design innovation as the
most important reason for preserving contractor rivalries. Competition's
greatest benefit in weapons acquisition arguably is its power to spur firms
to devise ingenious approaches for fulfilling DoD's mission requirements.
The main potential hazard of mergers is the danger that technological
competition will diminish, and that specific technologies may become
entrenched as the one or two remaining suppliers freeze out innovative
design approaches that threaten their vested interests or defy conventional
wisdom. Preserving rival design centers can counteract lethargy, myopia,
or error -- an important safeguard where national defense policy rests
heavily on exploiting superior technology. Weapons
_____________________
/28/ See generally Washington, A Review of the Literature: Competition
Versus Sole-Source Procurements, ACQUISITION REVIEW QUARTERLY, Spring 1997.
/29/ Remarks of J. Gansler on panel discussion, "Are We Buying the Right
Weapons in the Best Way? The Pentagon's Weapons Buying Systems: Lessons Learned"
(Washington, D.C. April 3, 2001).
/30/ DSB Report, at 27. See also Robert Kramer, Antitrust Considerations in
International Defense Mergers, Address before the American Institute of
Aeronautics and Astronautics (May 4, 1999) ("As important as price competition
is to [DoJ], a second major and possibly even greater concern is maintaining
competition for innovation.").
/31/ See, e.g., Yao and DeSanti, Antitrust Analysis of Defense Industry
Mergers, Public Contract Law Journal, vol. 23, no. 3 (1994).
10
acquisition experience suggests that rivalry for new design and development
awards can be acute even when a market segment contains only two firms./32/
A GD/NNS combination would combine the only two technologically capable firms
with incentives to perform submarine R&D.
The Current Teaming Agreement Between NNS and GD Provides No Excuse
GD apparently believes that the Government should simply blink at
these daunting monopoly costs because GD's teaming agreement with NNS on
Virginia-class submarines has already eliminated competition between the
shipyards. For GD now to cite its teaming agreement with NNS -- which was sold
to DoD and Congress on the ground that the teaming agreement would preserve two
independently owned shipyards capable of producing nuclear submarines -- as a
reason for permanently extinguishing any possibility of competition on
submarines is cynical to say the least. Moreover, an attempt to equate a
temporary teaming agreement between two independent shipyards with a permanent
merger to monopoly defies logic. Under a teaming agreement, the parties or the
Government always have the option to restore actual competition by ending the
agreement; once a merger occurs, competition can only be restored by the forced
divestiture of a nuclear-capable shipyard (a result that could conceivably be
achieved only after years of costly litigation) or by the de novo entry of a new
shipyard (a prospect that, as explained above, is not realistic).
Even assuming the teaming agreement remains in force, the proposed
merger to monopoly between GD and NNS still imposes significant costs.
. First, under the terms of the teaming agreement, GD and NNS remain
potential competitors for future procurements of Virginia-class submarines
because the teaming agreement covers only the first four subs. Moreover,
GD and NNS continue as competitors to design and build future generations
of nuclear submarines.
. Second, the teaming agreement still allows for R&D competition. DoD can
reward an innovative shipyard with additional funding to develop a
promising concept into an actual piece of equipment that can be
incorporated into future submarines.
. Third, even with the teaming agreement, the option remains for DoD to
reallocate the division of work between the shipyards in order to provide
incentives and rewards for GD and NNS to remain efficient and innovative.
__________________________
/32/ Kovacic and Smallwood, Competition Policy, Rivalries, and Defense
Industry Consolidation, JOURNAL OF ECONOMIC PERSPECTIVES, vol. 8, no. 4, Fall
1994 (citations omitted).
11
. Fourth, the existence of two independent shipyards allows DoD to benchmark
costs and provides some measure of the relative cost-effectiveness of the
two shipyards. Such benchmarking by DoD would become much more difficult
(if not impossible) if the yards were under common ownership.
GD's Projected Cost-Savings Do Not Justify a Merger to Monopoly
GD has publicly stated that it expects its acquisition of NNS to
generate about $2 billion in cost savings to the Government over ten years. Even
assuming that those cost-savings are credible and that sound antitrust policy
would give GD full credit for all those projected savings, savings of that
magnitude would not outweigh the substantial costs entailed by extinguishing all
prospects for competition on submarines now and forever more. The claimed
efficiencies of $2 billion over ten years equates to a mere 3.7% of the annual
revenues of a combined GD/NNS. Even this generous assumption on efficiencies
amounts to a small fraction of the costs to be expected from a monopoly. As
mentioned earlier, monopoly can result in price increases of thirty percent and
more, and an even greater loss from a reduction in the generation of new ideas.
However, as the earlier discussion of the relevance of efficiencies to
merger analysis indicated, the antitrust laws do not call for a balancing of all
the savings GD projects against the costs of monopoly. Rather, only those cost-
savings that are "merger-specific" -- that is, that cannot be achieved through
some less anticompetitive means -- should be considered as an offset against the
costs of monopoly. In other words, if the Government can realize most, if not
all, of those cost savings without a merger to monopoly, then those savings
cannot justify the merger. And, since NOC believes that, by acquiring NNS, it
should be able to achieve cost savings in the range of $1.9 billion to $2.6
billion over ten years without any loss of competition, there appear to be
virtually no merger-specific cost-savings that a GD acquisition of NNS will
achieve.
In Contrast to GD/NNS, NOC's Acquisition of NNS Would Not Reduce
Competition
Because NOC and NNS compete for no military procurement and have
complementary capabilities, NOC's acquisition of NNS poses no threat of a loss
of competition. NOC's shipyards, Ingalls and Avondale, produce conventionally
powered surface ships, while NNS produces nuclear submarines and nuclear
aircraft carriers. Similarly, to the extent each possesses shipbuilding or
design expertise, those capabilities do not overlap. Most importantly, as
explained above, NOC is not a potential competitor in the design or production
of nuclear submarines (or, for that matter, nuclear aircraft carriers)./33/
________________________________
/33/ While NOC does provide certain subsystems that are incorporated in
submarines and does possess certain technologies that have application with
respect to submarines, those vertical relationships between NNS and NOC pose no
threat to competition. First, in connection with its acquisition of Litton, NOC
made commitments to the Navy to ensure that the Navy will have the benefit of
open competition on procurement of subsystems and
Footnote continued
12
NNS is also not a significant potential competitor on any of the
platforms on which NOC currently competes. Because of the high costs inherent in
NNS's shipyard because of its nuclear capability, NNS cannot compete effectively
for the conventionally powered surface ships that are NOC's current focus. This
is equally true for conventionally powered, large-deck aviation-capable ships,
like LHD craft./34/ While NNS's experience designing and building nuclear
carriers certainly gives it most (though not all) of the know-how to build large
deck amphibious assault ships, its cost-structure is prohibitive. The real
potential competitive threat to NOC comes from GD. GD's NASSCO shipyard in San
Diego is physically capable of producing large deck ships, while GD's experience
in making LPD-17 ships at Bath Iron Works gives it the design and integration
capability to produce such large deck aircraft-capable ships./35/ In addition,
by using NASSCO, GD can avoid the high overhead inherent in a nuclear-capable
shipyard (like that of NNS).
In fact, not only does a NOC/NNS merger not pose any risk of reducing
competition, such a merger actually holds the promise of increasing competition.
Currently, NOC and NNS represent two different halfs of the total shipbuilding
equation (respectively, conventionally-powered surface ships, on the one hand,
and nuclear powered sub-surface and surface ships on the other). GD represents
the only complete shipbuilder capable of making all types of ships (with the
exception of nuclear carriers, which have long been a monopoly). Unlike a GD/NNS
merger, which would give the merged company a tremendously disproportionate
share of engineering talent and technological capability, a NOC/NNS merger would
achieve a roughly equivalent distribution of talent and capabilities between the
surviving two shipbuilders./36/ That rough equivalency should increase the vigor
of future competitions between GD and a merged NOC/NNS.
_________________________
Footnote continued from previous page
systems integration. See Letter from Albert F. Myers to David R. Oliver dated
March 13, 2001. Second, after a merger of NNS and NOC, GD will still be able to
turn to Lockheed and Raytheon, among others, to obtain the systems and
technologies that NOC possesses.
/34/ It has been suggested that NOC and NNS would be competitors should the
Navy ever decide to procure smaller, conventionally powered aircraft carriers.
Though the possibility of procuring such ships has been much discussed over a
number of years, no such procurements seem likely in the foreseeable future.
Moreover, if there were such a program in the future, GD through its NASSCO
shipyard (complemented by the engineering and manufacturing expertise developed
at Bath Iron Works) would likely be a more serious competitor than NNS because
of NNS's cost disadvantage.
/35/ NASSCO, which is now owned by GD, has competed for this type of vessel
in the past, as it submitted bids for LHD 2 through 4.
/36/ See note 19 above. If NOC acquired NNS, NOC/NNS would employ
approximately 56% of in-house engineers, while GD would maintain its 44% of
engineers.
13
A NOC/NNS Merger Should Achieve Virtually All of the Projected GD/NNS Cost-
Savings
Because NNS has thus far refused to allow NOC to perform due
diligence, NOC has not yet been able directly to calculate and verify the cost
savings that it could achieve through an acquisition of NNS. However, at least
conceptually, it should be able to achieve most of the savings projected by GD.
For example, a substantial portion of GD's projected savings come in the area of
procurement and overhead savings. NOC should be able to match most of those
savings. In fact, there are some efficiencies that a NOC/NNS can achieve that a
GD/NNS could not realize. For example, the efficiencies associated with
combining NNS's subsurface technologies and capabilities with NOC's surface
capabilities and technologies would not be matched by a GD/NNS combination -- GD
already has access to all the capabilities and technologies that NNS has. In
addition, GD does not have the experience or capability to match NOC's proven
ability to achieve cost-savings through the LEAN initiative that it has
developed on the aerospace side of the house and is beginning to realize on the
shipbuilding side. The $1.9 billion to $2.6 billion over ten years that NOC
parametrically projects to achieve by acquiring NNS is at least equal to the
savings that GD projects to achieve from its proposed acquisition of NNS.
The only arguable unique cost-savings that a GD/NNS merger could
achieve is the closing of either NNS's or Electric Boat's shipyard and
consolidating all submarine production in a single yard. However, GD has
publicly stated that it does not intend to close either one of the yards after
the acquisition, and GD has pledged to maintain the respective skilled
workforces for a period of time. Closing one of the two shipyards is probably
neither politically nor strategically feasible. Moreover, should the Navy's rate
of procurement of submarines increase (as seems likely), more than one yard will
likely be required./37/ Finally, although a NOC acquisition of NNS would ensure
that NNS's shipyard remains open, NOC's experience in limiting infrastructure
costs through specialization in the aerospace sector holds the promise of
generating some consolidation savings even as the two shipyards remain open and
competition between them remains viable.
Only a NOC/NNS Merger Achieves Cost-Savings and Preserves Competition
Under established principles of antitrust law, the Government can
legitimately consider only the merger-specific cost-savings from a GD/NNS
merger. Those savings pale in comparison to the overwhelming costs that a
GD/NNS merger to monopoly would impose on its customer, the U.S. Government. By
contrast, the option of a NOC/NNS merger is a classic case of allowing the
Government "to have its cake [substantial cost savings] and eat it too [by
preserving submarine competition]," while under the status quo there will simply
be no cake.
___________________________
/37/ See note 5 above.
14
The choice is clear and simple. It would be ironic if this
Administration, which came to office in part by professing its intention to rely
on the marketplace rather than bureaucracy in economic affairs, became the first
to approve a naked merger to monopoly on the ground that the bureaucracy can
effectively manage a newly created monopoly.
15
TAB C1
Proposed Acquisition of Newport News by General Dynamics Will Reduce Competition
in Research and Development for Surface Ships and Submarines
This white paper explains why the acquisition of Newport News Shipbuilding
("NNS") by General Dynamics Corporation ("GD") would reduce competition in
research and development in the surface ship and submarine industries. This
issue is of particular concern to Northrop Grumman Corporation ("NOC") because
research and development is critical to the design of advanced combat and ship
systems.
As discussed in more detail below, surface ships and submarines are
becoming more reliant on advanced technology. Much of this technology, including
that which is used on surface ships, is being developed in conjunction with the
submarine program. If GD acquires NNS, NOC's ability to obtain the necessary
engineering data and engineering expertise, as well as to utilize it in ship
design, would be greatly reduced. At the very least, the likelihood of NOC
teaming with NNS would be much lower. NOC believes that over time its ability to
compete for engineering, design and construction of surface ships will be
seriously harmed if it cannot access submarine-developed advanced technology.
NOC believes any "horizontal" firewall between the research and development
divisions of GD and NNS would not be effective or efficient.
Advanced ship systems technology is becoming an increasingly important part of
______________________________________________________________________________
ship development
________________
Over the last fifty years, advanced technology has become an
increasingly important part of ship development, both for the combat systems
(e.g., fire control, radar, missiles) and ship systems (e.g., hull design,
propulsion). Missiles with computer and radar tracking have replaced optical-
sighted guns as the principal anti-air weapon on surface ships. Ship systems are
also more complex. Propulsion systems for US Navy surface combatants, for
example, have evolved from large, labor intensive steam and diesel engines to
compact, low maintenance gas turbines that burn jet fuel.
The move towards greater technological complexity has continued with
the Navy's next planned surface combatant, the DD 21, which is expected to be
deployed in littoral (i.e., coastal) operations in support of Marine
Expeditionary Forces. This ship's Operational Requirement Document calls for
unparalleled technological advances in both the combat systems and ship systems.
One new system, electric drive, was described in a CRS report to Congress in the
following terms:
The Navy's decision to use electric-drive propulsion technology
represents a technological shift for the Navy arguably comparable in
significance to the Navy's shift from
Page 2
sail to steam power in the latter 1800s or the Navy's development of
nuclear propulsion in the 1950s./1/
The change in administration does not appear to have affected the
continuing trend towards greater technological sophistication. The Bush
Administration has called for a "leap ahead" in weapons systems./2/ Testimony by
Secretary of Defense Donald Rumsfeld before the Congressional Armed Services
Committee has echoed the need for the United States to prepare itself
technologically./3/
The ongoing emphasis on technology in ship systems and weaponry means
that future ship building will continue to require access to innovative
technology and engineering to remain competitive.
Advanced ship systems technology is often developed through the submarine
_________________________________________________________________________
program. The trend is towards greater use of submarine-developed advanced
_________________________________________________________________________
technology on surface ships.
____________________________
The type of technology being developed depends, at least in part, on
the nature of the perceived threat to the country. In the last decade there has
been a renewed emphasis in the littoral battleground./4/ Because littoral
operations often take place in
____________________________
/1/ Congressional Research Service, "Electric-Drive Propulsion for U.S.
Navy Ships: Background and Issues for Congress", July 31, 2000, at 1.
/2/ Merle D. Kellerhals, Jr., "Bush Seeks $310,500 million for FY 2002
Defense Spending", www.eucom.mil, 28 February 2001 ("The research
_____________
and development spending will focus on leap-ahead technologies for new
weapons and intelligence systems; improvements to the laboratory and
test range infrastructure; technologies aimed at reducing the costs of
weapons and intelligence systems; efforts that are focused on
countering unconventional threats to national security; and funding to
continue development of a missile defense program.") (emphasis added).
/3/ Donald Rumsfeld, Secretary of Defense, testifying before the Senate
Armed Services Committee, June 21, 2001, at 7 ("Nations are arming
themselves with a variety of advanced technology systems, from quiet
submarines armed with high-speed torpedoes, and cruise missiles to air
defense radars to satellite jamming capabilities.").
/4/ Aerospace Daily, "Navy, Marines push new technologies for littoral
operations," February 22, 2000; Bryan Bender, "A sea change in ship
size," Jane's Defense Weekly, April 19, 2000 ("The US Navy's
transformation from a `blue water' force to one increasingly operating
in the littorals has put the focus primarily on equipping the surface
fleet with new information technologies, air- and sea-launched weapons
and other next generation components."); Rear Admiral Jay Cohen,
Before Senate Armed Services Committee, Subcommittee on Emerging
Threats and Capabilities, June 5, 2001 at 2 (referring to littoral
antisubmarine warfare). See also, Office of
Footnote continued
Page 3
shallow waters with restricted maneuvering room, a maximum amount of stealth is
required. Since submarines, by their very nature, are weapons of stealth,
companies with submarine expertise have a distinct advantage in the development
of this technology.
In the 1990s, the USS Arleigh Burke was designed to meet this greater
need for stealth in a littoral environment. Not only was the radar cross
section/5/ slashed to resemble a tuna boat but the ship's hull design included
sound isolation devices as well as hardened and ground reduction gears to reduce
the acoustic signature./6/
More recently, the Navy decided that its next planned surface
combatant, DD 21, would also use several critical submarine-derived
technologies:
. Hydro-acoustic analysis for propellers and hydrodynamic flow (i.e.,
the study of objects in water to minimize flow separation and noise);
. propulsor design including flow into and out of the propulsor (i.e.,
to control flow and noise);
. machinery quieting and isolation including analysis methods and
rafting (i.e., the ability to isolate and reduce structural noise);
and
. electric drive propulsion (i.e., the transmission of power from the
engines to propulsion and non-propulsion systems, which can increase
the stealthiness of ships)./7/
___________________________________
Footnote continued from previous page
Naval Research website listing littoral anti-submarine warfare as an
important future naval capability.
/5/ Radar cross section refers to the reflectivity of an object expressed in
square meters or decibels.
/6/ See DDG 51 Top Level Requirements, OPNAV Inst. S9010, Ser.N865G/6615,
dated March 22, 1993.
/7/ CRS Electric Drive Report, supra note 1, at 58 (the potential for electric
drive to increase "submarine quieting" has led the Navy to consider
installing it on Virginia Class Submarines. By developing a common system
for both submarine and surface vessels, the Navy hopes to reduce the
engineering and research and development costs) (citing testimony of Rear
Admiral
Footnote continued
Page 4
Most of the technologies being developed for the DD 21 directly or
indirectly affect acoustic signature. The emphasis on controlling or reducing
the DD 21's acoustic signature, which is to be similar to the Los Angeles Class
submarines, is a clear advantage for submarine manufacturers. Companies whose
experience is with surface ships lack that expertise and, for reasons discussed
more fully below, are not able to easily acquire it.
Merger of GD and NNS would lead to a single source for much advanced ship
_________________________________________________________________________
systems technology
__________________
As described above, many of the advanced ship systems are being
developed either in, or in conjunction with, the submarine program. The result
is that GD and NNS, as the only two submarine new construction shipyards, hold a
vast amount of the Navy's high tech expertise./8/
Each company has a large engineering staff devoted exclusively to
submarine and ship systems. Combined, they would have about 80% of in-house
engineering talent working on ship systems./9/ The concentration of high tech
expertise in GD and NNS is reflected in the percentage, perhaps over 95%, of the
Navy research and development budget going to these companies./10/ This figure
might even increase if the Navy were to implement submarine-designed proposals
derived from the Navy/Defense Advanced Projects Research Agency submarine
payloads project./11/ As pointed out in a CRS Report on the proposed merger of
GD and NNS, this concentration of engineers is important because:
___________________________________
Footnote continued from previous page
J. P. Davis and Rear Admiral Malcom I. Fages to the Military Procurement
Subcommittee of the House Armed Services Committee, June 27, 2000).
/8/ Congressional Research Service, "Navy Shipbuilding: Proposed Mergers
Involving Newport News Shipbuilding - Issues for Congress," at 17, May 22,
2001 ("staffs at [Electric Boat] and [Newport News] are the only two among
the six yards that have extensive experience and resources in the design
and engineering of submarines and nuclear-powered ships.").
/9/ Id. at 24.
/10/ Id. at 18 (quoting former Secretary of Defense Cohen expressing his
opposition to the 1999 attempt by General Dynamics to acquire Newport
News). The 95% figure may actually be an overstatement but it is, in any
case, a substantial percentage.
/11/ Id. at 27. The DARPA project was designed to increase the number and
variety of weapons and sensors on Navy attack submarines.
Page 5
designers and engineers can create new designs and develop new
technologies that can be sources of competitive advantage to a ship
building organization when the organization incorporates the new designs
and technologies into bids for future Navy ship acquisitions./12/
The expertise of GD and NNS is particularly apparent in relation to
two important systems referred to above: acoustics and electric drive. Both
companies have unique acoustic engineering expertise as a result of the Navy's
research and development funding and their engineering, design and construction
of Los Angeles (SSN 688) and later submarine classes. GD and NNS were also "the
only two firms of any kind that mounted efforts to propose designs for fully
integrated electric-drive/integrated power systems (as opposed to specific
components of such a system) ..." for the DD-21, a non-nuclear surface ship./13/
NOC cannot obtain this technology from GD, NNS, or the Navy
___________________________________________________________
Information concerning advanced ship and weapons systems is rightly
treated as very sensitive. Much of the data is classified and, even where it is
not, often contains proprietary information./14/ Companies have little incentive
to provide such data to competitors. Even the Navy, as a neutral repository of
such information, has been unwilling to release it. In the context of the DD 21
project, NOC (and previously Litton Ship Systems) has spent over a year trying
to gain access to certain submarine related information held by the Navy. Even
though several Navy officials have acknowledged NOC's need for the data, nothing
has been provided to NOC as yet./15/
The proposed acquisition of NNS by GD will only exacerbate the
situation by eliminating the potential for teaming arrangements between NOC and
NNS. The NOC DD 21 Gold Team (led by subsidiary Ingalls Shipbuilding) hired NNS
as its subcontractor for electric drive because it was the only way to gain
access to required
_____________________________
/12/ Id. at 16.
/13/ Id. at 26.
/14/ The Chief of Naval Operations security instructions limit the transfer of
classified or sensitive data.
/15/ NOC is willing to make available a list of its ongoing efforts to obtain
this information over the past year. The list includes only those
contacts for which NOC has written corroboration. It does not include the
many telephone calls that were made during this time frame.
Page 6
technology and engineering expertise. If the proposed merger between GD and NNS
had already been approved, it is unlikely that NOC could have competed for the
project. It would also have crippled the Navy's efforts to have competing teams
on the DD 21 project.
Although advanced ship systems technology is usually developed through funding
______________________________________________________________________________
by the Navy, mere access to these funds would not allow NOC or anyone else,
__________________________________________________________________________
other than GD and NNS, to compete in research and development
_____________________________________________________________
Access to Navy funding is critical for firms undertaking advanced
technology research and development because of the enormous costs and risks
involved./16/ However, merely providing Navy funds would not allow NOC to
undertake the development of such technology. In order to develop the relevant
engineering expertise, NOC needs not only engineers but also engineers with
substantial experience. Understanding the theoretical parameters of propulsion,
______________________
for example, is not a substitute for first-hand experience with the actual
systems.
It would not be practical for NOC to hire, assuming it could do so, a
sufficient number of experienced engineers from NNS or GD. It would require a
very large upfront investment in personnel before there was any actual work for
them to do. NOC would have to continue to pay these engineers in the hope that,
some day, the company might win a Navy contract in which the research and
development would have a practical application./17/ Since it takes several years
between an Operational Requirements Document and an actual contract award, the
investment, when compounded by the risk of not being successful, is
staggering./18/
As a practical matter, it would also be difficult to lure engineers
away from GD/NNS without any actual ongoing Navy research and development
contracts. The
__________________
/16/ Defense Science Board Task Force (Department of Defense), "Vertical
Integration and Supplier Decisions," May 1997, at 38 ("Whether a prime or
supplier is likely to become competitive in a new technology is, in part,
based on receiving DoD science and technology (S&T) funding."). The risk
is exacerbated by the lack of certainty concerning the actual application
of the research. The Navy might not ultimately use the research or
Congress might withdraw funding for a particular project.
/17/ Even if the Navy were willing to guarantee an allocation of research and
development funds the risk would be reduced but not eliminated.
/18/ In the case of the DD 21, the ORD was approved in November of 1997. The
contract award is expected in December of 2001.
Page 7
best engineers would want a stimulating work environment as well as the job
security that comes from a company that successfully bids on important projects.
NOC, at least in the short term, would have difficulty satisfying either
requirement. It would also be difficult for NOC to compete using outside
designers and engineers. In-house designers and engineers at GD/NNS are more
effective because they work across a range of projects, allowing them greater
access to their company's sensitive information and technology.
Even if NOC were to obtain the necessary engineering expertise, it
would be at a cost disadvantage relative to GD/NNS because the latter entity
could spread its research and development expenses over the production of both
surface ships and submarines. The huge costs involved in entering into the
production of nuclear submarines would, of course, prevent NOC from doing the
same.
Absent the ability to develop this expertise, NOC must either team
with NNS, as it has done in the past, or merge with NNS. A merger between GD and
NNS would eliminate the former option because of the platform competition
between GD and NOC for surface ships.
Without two sources for this advanced technology, innovation competition will be
________________________________________________________________________________
stifled
_______
It is well understood that firms compete not only on price but also in
terms of innovation. Innovation has become a particularly important source of
competition over the last 20 years in several industries, including defense. In
fact, innovation competition may be of greater significance in the long term
than price competition./19/ For example, innovation competition is responsible
for the explosive growth and change in the telecommunications industry, leading
to the creation or enhancement of such products as cellular phones and Internet
services. The stifling of innovation was also a central issue in the Justice
Department's case against Microsoft Corporation./20/
_____________________________
/19/ Constance K. Robinson, "Leap-Frog and other Forms of Innovation," June
10, 1999, at 1 ("Curtailing innovation through mergers may have serious
anticompetitive consequences to consumers over the long run, and may be
even more damaging to them than a price increase or quality decrease.");
Robert Kramer, "Antitrust Considerations in International Defense
Mergers," at 3, May 4, 1999.
/20/ US v. Microsoft, 65 F. Supp 2d 1, 103 (1999) ("Microsoft's past success
in hurting such companies and stifling innovation deters investment in
technologies and businesses that exhibit the potential to threaten
Microsoft. The ultimate result is that some innovations that would truly
benefit consumers never occur for the sole reason that they do not
coincide with Microsoft's self-interest.").
Page 8
Innovation competition is particularly important in the defense
industry given the security provided by maintaining a technological lead over
other nations./21/ Indeed, it was the critical importance of innovation
competition that led the former Secretary of Defense to reject the previous
proposal of GD to buy NNS. The Department of Defense announcement specifically
noted a concern that "[i]f the two companies were to merge, there would be a
concentration of ... engineering talent and of the technology advances from
Navy-funded research and development."/22/
Consequently, combining the research and development of GD and NNS,
the primary developers of advanced ship technology, will not encourage the level
of innovation that the Navy and the Defense Department expect and require for
their projects.
Firewalls between the research and development teams of GD and NNS would not be
_______________________________________________________________________________
effective
_________
Firewalls are designed to prevent the transfer of sensitive
information, such as proprietary or non-public technical and price data, between
divisions or subsidiaries of the same company. Firewalls are often an effective
remedy in vertical mergers where a company is acquiring a supplier or
distributor. For example, a company that merges with one of its suppliers might
obtain competitively sensitive information about unaffiliated suppliers by
virtue of its relationship. Firewalls can prevent the disclosure of that
information to the company's affiliate.
However, firewalls are apt to be less effective in a horizontal
context, where two divisions are competing with one another and reporting to the
same executive./23/ First, an executive has a fiduciary duty to maximize overall
revenue. Having two
_____________
/21/ Kramer, supra note 19 at 3 ("when our defense strategy depends on
maintaining a technological lead over possible adversaries ... reduction
in the pace of innovation can have life-and-death implications.").
/22/ News Release, Department of Defense, "Secretary Cohen Announces Decision
on General Dynamics and Newport News Shipbuilding Merger Proposal," at 2,
April 14, 1999.
/23/ Firewalls have been used to deal with horizontal issues in only very
limited circumstances. In the defense industry, such firewalls have been
used where the merging companies already have competing teams in place
and the contract is near to being awarded.
Page 9
divisions competing against one another as well as duplicating certain costs
would not allow the executive to satisfactorily discharge that duty. Second, one
of the benefits of mergers is the potential for efficiencies. By maintaining
such an artificial separation, the transaction would lose some of those direct
benefits.
Conclusion
__________
GD and NNS, because of their unique Navy submarine engineering and
construction contracts, have a significant advantage in key submarine derived
technologies and engineering. Future Navy ship programs will, of necessity,
rely on this technology and innovation. Should the proposed acquisition be
approved all submarine derived technology and engineering will be resident in a
single corporation. NOC will not have access to this information, which would
have a deleterious effect on its ability to compete in the production of surface
ships. Conversely, the NOC/NNS transaction would provide two capable sources of
submarine related technology for the Navy and the private sector, resulting in a
healthier industrial base.
TAB C2
The Engine Wars: Implications for Naval Shipbuilding
The purpose of this paper is to describe the effects of creating a sole
supplier in the defense industry by drawing on the U.S. Air Force's experience
in creating a sole supplier -- Pratt Whitney -- for F-15 engines. The thesis of
the paper is that if nuclear shipbuilding were to become a monopoly business,
the Navy (like the U.S. Air Force) would be unable to ameliorate monopoly-
induced inefficiencies. More importantly, unlike the jet engines example, the
DOD would be severely constrained in its ability to induce viable competition
due to the significant entry barriers present in the nuclear shipbuilding
industry. One-time, short-run gains from creating a sole supplier in this
industry are likely to be overwhelmed by the long-run costs of implanting a
monopoly-induced, sub-optimal incentive structure in nuclear shipbuilding.
The paper's approach to proving this thesis is as follows. The first
section provides a brief overview of the dynamics in the market for jet engines
during the early 1980s. The goal of this section is to provide a historical
perspective on how the incentives provided by a particular market structure can
affect every customary measure of performance--cost, quality (including schedule
adherence), and R&D or innovation--undertaken by a defense contractor. The
paper's second section evaluates how key insights from such an experiment are
applicable to the nuclear shipbuilding industry.
Section I. Sole-Sourcing Jet Engines: A Case Study/1/
In the late 1960s the Air Force conceived of the F-15, a premier
performance plane to be powered by engines with a thrust-to-weight ratios of
10:1. This engineering requirement would prove a daunting challenge for the two
viable engine producers, Pratt and Whitney and General Electric, whose previous
offerings had clustered around thrust-to-weight ratios of 5:1. The Air Force
decided to sole-source these engines (designated F100s) from Pratt and Whitney
(PW) on the basis of a 50-hour qualification test in which the PW engine seemed
more promising than the General Electric (GE) prototype. However, turning PW's
test model into a full-scale development project proved more difficult than had
been expected. So much redesigning, readjusting, and fine-tuning were required
for the model to pass concurrent tests that the final engine deviated
substantially from the prototype. Additionally, the thrust-to-weight ratio
slipped to 8:1. Yet, in one key sense the Air Force got what it wanted--a plane
promising unprecedented performance.
However, the Air Force soon realized that performance per se was not
enough; the full potential of F-15s could only be realized if they proved
durable. Yet durability was not what the Air Force had originally contracted for
in making a sole-source contract with PW for an engine
_____________________
/1/ The Great Engine Wars, written by David M. Kennedy and commissioned by
Robert Murray, John F. Kennedy School of Government, Harvard University, Report
No. C16-85-629, 1985.
optimized for unprecedented performance. The F100s demanded extraordinary
upkeep. Likened to a stable of racehorses, these engines required continuous
tuning, parts replacement, maintenance, and troubleshooting. Eventually,
necessary (and unanticipated) modifications overwhelmed the Air Force's repair
and maintenance facilities. The life-cycle price tag on the F100 engines
increased substantially.
PW met each new problem with the assurance that the crisis at hand would be
the last one the engine would experience, but this proved an elusive goal. For
example, the engine's power allowed pilots to fly at less than full throttle,
which caused the engine's turbines to break more frequently than expected. The
absence of extensive performance data on this new engine also made it more
difficult to predict how often the turbines would break or whether the problem
would get worse with age. More alarming still, as more pilots flew more
missions, it became clear that the engine could lose power without warning under
certain circumstances, and sometimes even destroy itself under others. To
complicate matters, two of PW's vendors that were critical to the F100
experienced workforce strikes simultaneously, leaving PW without replacement
parts, and forcing it to cease production temporarily in 1979. The Air Force was
constantly a step behind in repairs, spare parts, and qualified personnel for
the F100. By the end of 1979, for instance, the Air Force had over 40 F-15s
standing inoperable for lack of operating engines.
While the Air Force was wrestling with PW's F100, GE had assembled a test
engine at its own expense. Combining characteristics of the engine GE had
developed for the B-1 bomber and a new commercial engine, CFM-56, the so-called
F101X impressed the Air Force enough that it decided to fund the prototype's
initial production. Air Force officials contend that they decided to fund a
transition of the F-101X from its test phase into initial production as a tactic
to shock PW into improving its own cost-effectiveness and customer service,
which had markedly deteriorated since the F100's inception.
In the event, GE further impressed the Air Force by preparing an upgraded
model of the F101X that boasted more power than PW's F100 and substantially less
wear. The Air Force decided to see what it could gain from competition, and in
mid-1981 issued a Request For Information (RFI) to both PW and GE, soliciting
detailed data on each firm's product pricing, reliability, performance, delivery
rate, spare parts, and warranties. Because GE's response to the RFI had
promised good prices on a reliable engine with spare parts and buyer-friendly
warranties, the Air Force stepped up its interest in the F-101X, and approved
the engine for full-scale engineering development (an acquisition milestone
today called engineering and manufacturing development).
Nonetheless, the prospects of ever using this alternative engine seemed at
best marginal, and the Air Force, in the beginning, remained skeptical about
committing resources to GE's F-101X demonstrator program. Officials concluded
that it would be virtually impossible to insert
2
an F-101X into an F-15 or F-16. The costs and difficulties of establishing
another contractor and another full support service network for the F-101X
seemed insurmountable. Further, fresh in the Air Force's memory was the testing
and repair cycle it had undergone to get the F100 serviceworthy. Compounding all
such skepticism was PW's strong desire to remain a sole supplier and the
influence it wielded in Congress and the Pentagon attempting to secure that
privileged position. PW saw the competition as a bluff, and maintained that the
deciding factor in engine selection would continue to be thrust-to-weight ratio.
As a result, PW played down the Air Force's new demands for durability. However,
the prospects for the F101X improved significantly when the Navy, in the market
at the same time to procure an alternative for its disappointing F-14 engine,
indicated a willingness to bear some of the costs of turning GE's demonstrator
prototype into a full-fledged fighter engine.
The transition from fostering viable competition to actually procuring a
competitive product was not easy. PW realized that the competition it had so
confidently dismissed was beginning to threaten its comfortable F100 niche.
Consequently, PW attempted to forestall the competition, offered significant
price reductions on its new engines, as well as a host of fringe benefits that
would extend to models already in the field. PW also encouraged congressional
intervention to stop the Air Force from introducing competition for the engines
on its two high-performance aircraft. The Air Force viewed these concessions as
PW's attempts to remain a sole-provider for the F100 engines. They declined PW's
proposal, and congressional pressure on the Secretary of the Air Force only
emboldened his commitment to pursue a competitive procurement. The GE effort to
move the F101X into production was showing dramatic results. The F-101X had
begun to deliver everything the Air Force wanted: a stall-free engine, immune to
throttle-provoked misbehavior and packing more power than the existing F100s.
The Air Force now was in a position to test the ultimate gains from inducing
competition, and asked both companies for complete details about engine price,
reliability, performance, delivery rate, and, most importantly, price schedules
on spare parts and warranties.
PW and GE submitted their "best and final" offers to the Air Force in
November 1982. The competition had been more effective than anticipated: both
contractors offered engines promising twice the life span of previous models and
a higher degree of durability, all priced substantially lower than the Air Force
expected. Moreoever, GE offered more attractive agreements on both spare parts
provisions and warranty offers, a key feature of the acquisition in the light of
how logistical costs began to overwhelm the Air Force's introduction of the
first F100s. The company also agreed to provide dual sourcing for any part the
Air Force specified and to help locate alternate vendors if necessary. GE's
warranty was a flat 5% of the engines' price, regardless of the proportion of
the contract GE eventually won. PW's offer, on the other hand, gamed the
warranty provision by adjusting its cost in proportion to the share of the total
quantity of engines it would receive. PW's warranty started at 5% of the
engines' price for a contract granting PW 100% of engines. It then increased the
price of the warranty up to 33 percent of the engines' price for a contract
granting PW only 25% of the total.
3
The Air Force was unwilling to commit to a long-term procurement contract
on the basis of the GE bid and decided instead on a one-year award, intending
to buy 120 F-110s (the redesignated F101X) and 40 PW F100s. Additionally, the
F-110s were chosen for the F-16 aircraft, of which the Air Force planned to
purchase over 1,000, while PW's award was for the F-15, with only hundreds more
slated for production.
The "Great Engine War," as it has been dubbed represents how competition,
or its absence, affects the relationship between the government-customer and its
contractors. The Air Force claims the engine war saved it more than $2.5
billion over 20 years. More importantly, the Air Force believes that it received
"vastly improved engines, significantly enhanced warranties, and an enlarged
industrial base." The New York Times, in commentary on the engine's acquisition
strategy, praised the Pentagon, saying that if other services followed its dual-
competition standard, it "would vastly improve the quality of every weapon on
the Pentagon's long shopping list. Besides that, it would cut defense costs
dramatically."/2/
Section II. The Lessons of Sole-Sourcing: Jet Engines to Nuclear Shipbuilding
The "Great Engine War" of the 1980s, described above, has important
implications for the current proposal to create a monopolist in the nuclear
shipbuilding industry. Restoring efficiency in such a market structure requires
that procurement practices be designed to induce a monopolist to act in ways
that run counter to its self-interest. The jet engine experience highlights the
fact that it is very difficult to ameliorate the customary market distortions
associated with the operation of a monopolist. These monopoly-induced
distortions are summarized below:
Sole-sourcing is inefficient in a dynamic market environment. High initial
costs, technical riskiness, and long developmental times are hallmarks of any
major military procurement. Any procurement, especially the product offered by a
nuclear shipbuilder, will entail a "technological evolution." The jet engine
experience highlights the fact that it is very expensive to buy flexibility
(design changes, customer service, etc.) from a monopolist in a constantly
evolving environment.
The Air Force's relation with PW suffered markedly when it needed technical
support in getting the F100 engines serviceworthy. Lt. Col. William Eddy,
working for the Air Force Command System at the time noted, "They didn't want to
do what we wanted them to do."/3/ Gen. Alton Slay (who was responsible for all
aspects of the F-15 program), publicly airing his views on contracting problems
with PW, told Dun's Business Monthly that when he went to
_______________________
/2/ Ibid, p.26.
/3/ Ibid, p.4.
4
meet PW, he met "with their lawyers, not their managers."/4/ PW's lawyers were
quick to point out that such interactions are hallmarks of contracting any
complex defense procurement with the government. In their view, "Once you
qualify an engine through testing, (and it's accepted by the government), it
becomes frozen in design. You cannot change anything - you can't change a washer
without formal processing and approval of funding if necessary, or price
adjustment, if necessary."/5/
Loss of competitive alternative due to sole-sourcing can be very expensive.
Since it is not possible to write a contract covering all future contingencies,
efficient contracting requires that the government maintain some satisfactory
alternative over the procurement process. The Air Force gained from dual
sourcing in jet engine procurement because GE (despite loosing to the F100) had
remained a viable manufacturer of jet engines. It was possible for GE to build a
demonstration engine at its own expense because it could appropriate major
subsystems from the engines it was already building for the B-1 bomber and the
F-18. Monopolization of nuclear shipbuilding will foreclose all such
opportunities for competitive procurements. Investments and technical know-how
required to credibly threaten an incumbent in this industry are simply too large
to impose any cost discipline.
Gary Hansmen (Aeronautical Systems Divisions (ASD) contract officer, who
negotiated several F100 buys), commenting on the lack of satisfactory
competitive alternative to sole-sourcing from PW, noted that, "In any sole-
source negotiating situation, all they have to do is wait you out. You can't
wait for ever; you need that product."/6/ While pointing to PW's proclivity for
taking maximum possible advantage of its sole- sourcing situation, Hansmen
noted, "They were willing to give us anything we wanted. It was just a question
of whether there was enough money in the budget."/7/ Under these condition the
impact of credible dual sourcing was dramatic. As the GE engine became a viable
competitor, PW offered the Air Force a package deal on its engines that could
eventually save the Air Force $3 billion. PW's offer was not accepted. While the
dramatic cost reduction was impressive, PW's package had work provisions the Air
Force did not ask for or want. More importantly PW's offer raised expectations
that even the current deal could be bettered as dual sourcing took roots in this
industry. Gary Hansmen, who was on the source selection team felt the contract
would "effectively wipe out the competition and sew up the business for five
years."/8/
Competitive remedies to sole-sourcing may be difficult. Encouraging
competition to remedy monopoly-induced market distortions usually requires
funding a competing product in its developmental stages. In light of high costs
of funding development efforts, the benefits of
__________________________
/4/ Ibid, p.4.
/5/ Ibid, p.4.
/6/ Ibid, p.16.
/7/ Ibid, p16.
/8/ Ibid, p.13.
5
competition are often too uncertain to validate the significant investments
required to support two plausible suppliers. Further, current procurement
practices, at least in theory, are supposed to result in the best possible value
from the defense contractor. As such, supporting competition often requires
arguing for unknown benefitsa position that is often very difficult to quantify
and defend. This problem is particularly acute in nuclear shipbuilding because
the investments and technical know-how required to enter this industry is quite
large and complex. Adding to such budgetary and technological hurdles, the
prospect of introducing a competing product is often met with skepticism from
within the armed forces because of the logistical complications (repair,
maintenance, stocking new parts, etc.) and the associated pains of learning to
make the new product service-worthy. The systemic inertia induced by using a
known complicated system (albeit a cost-inefficient one) in nuclear propulsion
could make the introduction of a new, competing system unattractive even if it
promised superior value. This situation is further complicated by the
incumbent's desire to remain a monopolist and the political influence an
incumbent may exercise over the whole process of initiating competition.
Fortunately in the nuclear shipbuilding industry, under current procurement
system (for example, teaming arrangements between General Dynamics and Newport
News to build nuclear submarines), the cost of maintaining a dual source is
quite low. Monopolization of the nuclear shipbuilding industry will
significantly increase the cost of any remedy i.e. ushering dual sourcing when
needed. Any measure of gains from monopolization must take into account the
forgone opportunity cost of abandoning the current dual source system.
The Air Force's experience in getting GE's F-101X service-ready illustrates
each of the above hurdles. While the Air Force was clearly impressed with GE's
demonstrator engine, the difficulties involved with establishing a new full
support and service network around another engine seemed insurmountable. Major
Tack Nix, who initially reviewed the demonstrator engine said, "I consider it
strictly a textbook exercise; I said this was going to be a great
demonstrator."/9/ Then there was the issue of funding a demonstrator program. It
was fortuitous that the Navy at that time was willing to fund such a program,
and that the Air force could influence Congress to shift some of the Navy's
funds to that project. The PW lobby did not hesitate to point out the potential
logistical, support, and maintenance problems that would attend introducing a
new engine. Fortunately for GE, and in the long run for the government,
embarrassing the Air Force officials backfired.
Regulating a sole supplier is often quite ineffective. Key to effective
regulation is accurate information about cost of production. It is often
impossible to collect the information required to incentivize a monopolist to be
cost-effective and innovative in an environment where the product is constantly
evolving. In the absence of any benchmark for what "value" is --cost, quality
(including schedule adherence), and innovation--, it is very difficult for a
regulator to ensure the best possible "deal" from a defense contractor. Creating
a sole supplier in nuclear
___________________________
/9/ Ibid, p.8.
6
shipbuilding will leave to the Navy the unenviable task of guessing the best
value for any procurement. Estimating best value is often difficult even if the
contractor reports true operational logistics and cost of production.
Ultimately, from society's perspective, the real question is not how good a
current contract is but how good it can be. The life cycle costs (including
parts and warranties) of jet engines, after competitive bids were submitted by
PW and GE, were substantially lower than any Air Force estimate. This is not
surprising, because without a competitive process the Air Force was in no
position to determine what true costs would be. Fixed-price (or price-cap)
contracts designed to acquire a product at the lowest price are usually
ineffective (especially when it comes to the quality and technical
innovativeness of a product) when the exact specification of the product is
unknown at the time of contracting. The Navy will have no credible benchmarks
for accessing value if it chooses to contract with a sole supplier for its
nuclear shipbuilding program.
The Air Force's initial experience in contracting with PW for jet engines
and its eventual savings from encouraging competitive bids provide a good
example of the drawbacks involved with sole-source contracting. The keys to
cost-cutting on engine procurement were provisions dealing with spare parts and
warranties. Procuring spare parts at best prices required data on dimensions,
tolerances, material performance characteristics, and the manufacturing process
involved. As a sole supplier, PW could extract not only top dollar for this
information but was able to retain significant control over the supply of these
parts. According to The Wall Street Journal, although PW produced only 20% of
its own spare parts, the Air Force acquired almost 80% of these parts from PW,
which benefited handsomely from handling and management fees./10/ As a sole
supplier, PW also exercised considerable leverage on warranty contracts. Since
problems with the engines and the associated damages could not be anticipated,
it was almost impossible for the Air Force to share the costs of major engine
problems. The severity of this problem can be seen by the cost of warranty
coverage. PW had charged the Air Force $53 million for warranty coverage on
roughly $130 million worth of engines. Competition in engine production
dramatically reduced the informational bottlenecks regarding pricing for both
spare parts and warranties. As a part of its RFP, the Air Force required both
manufacturers to divulge "Level II" procurement data, i.e., everything necessary
to enable another manufacturer to reproduce the part in question. Both
manufacturers eventually also settled for a flat warranty price of 5% of the
engine prices.
Summary
It has been the purpose of this paper to highlight the distorted economics
of a sole supplier in the jet engines industry and draw inferences for
monopolistic control of nuclear shipbuilding industry. The results of this
analysis suggest three concluding observations.
_________________________
/10/ Ibid, p.17.
7
First, if the nuclear shipbuilding industry is monopolized, all direct
benchmarks for evaluating cost-effectiveness and innovativeness in this industry
will be lost. Economic theory clearly points to loss in dynamic efficiency if an
industry is monopolized. In fact the Air Forces' experience with PW in the late
70's provides a good example of how distorted incentives, over time, can reduce
the will to innovate and discipline costs. The static, one-time gains that may
be realized by a monopolist are always more visible, but the Air Force's
experience indicates that the eventual losses from long-term inefficiency may be
quite large and significant.
Second, once monopolized, an industry will require regulation to ameliorate
some of the monopoly-induced distortion, and this regulatory process tends to
prove very burdensome. This industry will produce the most technologically
advanced products whose exact specification cannot be predetermined.
Informational requirements for efficient contracting under such a continually
changing environment is quite imposing. However flexibility in product design is
key to keeping pace with the current transformation of military forces. Economic
theory strongly suggests the government ability to design effective procurement
contracts that foster innovation and cost-effective production is quite limited.
Finally, The Air Forces experience highlights the difficulties associated
with fostering competition, once an industry is monopolized. Competition for
nuclear-powered ships after General Dynamics were to acquire Newport News
Shipbuilding is almost certainly not viable. While low levels of procurement
today for nuclear submarines may not present opportunities for vigorous
competition, maintaining the independence of the two shipbuilders at least
allows for some way of benchmarking costs, quality, and innovativeness. More
importantly, maintaining two independent sources allows the possibility that
credible competitive forces can be unleashed if procurement needs change.
Maintaining an industrial base where some form of competition is possible is the
only way to ensure long-term value for the government's investment in nuclear
shipbuilding and undersea warfare.
8
TAB C3
Implications of Alternative Forces on the Naval Shipbuilding Industry
The purpose of this paper is to elaborate the implications of alternative
future force structures on shipbuilding revenue shares and submarine procurement
rates. At its most basic, the paper describes a forward-looking perspective on
the shares of revenue that would result from the acquisition of Newport News
Shipbuilding by General Dynamics or Northrop Grumman, figures that have been
widely discussed as a part of even the public commentary about these two
competing merger proposals./1/ The significance of these revenue-concentration
calculations is that they form one of the more straightforward indicators of the
very different market structures for shipbuilding that would result from the two
proposals. The paper's deeper insight, however, concerns the sensitivity of
submarine procurement rates to alternative force structures. The key point of
this analysis is that even for an objective as low as 50 SSNs, 3 new ships per
year would have to be authorized, beginning in the relatively near future. As
demonstrated in the acquisition strategies associated with the procurement of
surface combatants and logistics ships, a procurement requirement calling for
two or three ships per year of the same class has tended to warrant a
competitive allocation of awards among at least two different firms.
The thesis of the paper is that the outcomes of the Department of Defense's
(DoD's) ongoing review of strategy and force structure are critical to a proper
evaluation of the antitrust considerations relevant to the two proposals to
acquire Newport News. Moreover, two implications of those outcomes would be to
skew toward 80 percent the share of revenue that might accrue to a General
Dynamics-Newport News combination and to increase the build-rate of attack
submarines to at least three per year.
The paper approaches its proof of this thesis on the following course.
First, it describes the nominal force structure of planned Navy ships and two
alternative future forces drawn from the emerging results of the DoD's strategy
review. Next it calculates the annual, steady-state acquisition funding required
to sustain these three ship-forces and makes an illustrative allocation of that
funding among the six shipyards owned by Newport News, General Dynamics, and
Northrop Grumman. From that allocation, the analysis describes how future
revenues might be shared between General Dynamics and Northrop Grumman under
each company's merger proposal. Finally, the paper explores the implications of
the alternative force levels for the required procurement of attack submarines.
The results of this exploration depict how the build-rate for these submarines
would have to increase to support the levels of attack submarines postulated in
the three force structure alternatives used to calculate revenue shares.
______________________
/1/ Most notably in CRS Report RL 3096, Navy Shipbuilding: Proposed Mergers
Involving Newport News Shipbuilding - Issues for Congress, by Ronald O'Rourke,
May 2001, which indicates a 70:30 ratio of revenue between the General Dynamics-
Newport News combination and Northrop Grumman, based on shipbuilding programs
experienced in the 1990s.
1
Section I: Alternative Navy force structure objectives
The baseline force structure objective considered in this analysis is
displayed in the table below. It can be thought of as the nominal "300-ship"
fleet that emerged from the DoD's 1997 Quadrennial Defense Review. That force
consists of 12 aircraft carriers, 36 amphibious ships, 14 ballistic missile
submarines, 50 attack submarines,/2/ and 116 surface combatants, rounded out by
70-odd logistics, mine warfare, command, and support ships./3/ Based on the
indicated replacement costs and life of these ships, the total annual funding
required to sustain this force is about $10 billion./4/
Baseline Fleet/5/
Ship type Number Replacement Exp. Life Annual
of ships cost (B)/6/ (Years)/7/ cost (B)
----------------------------------------------------------------------------------------------------------------------
A/C carriers 12 5.2 50 1.25
Big-deck amphibs 12 1.4 40 0.42
Other amphibs 24 0.6 40 0.36
SSBNs 14 2.4 40 0.84
SSNs 50 1.8 30 3.00
Destroyers 89 1.0 35 2.54
Cruisers 27 1.2 35 0.93
CLF ships 30 0.3 35 0.26
Mine warfare 16 0.2 30 0.11
Command 4 0.7 35 0.08
Support 22 0.2 35 0.13
----------------------------------------------------------------------------------------------------------------------
TOTAL 300 9.91
_____________________
/2/ It should be noted that the DoD's amended budget submission for fiscal year
2002 already has increased the force objective for attack submarines from 50 to
53. See June 27, 2001 Defense Budget Presentation for fiscal year 2002,
presented in part by Dr. Dov Zakheim, Under Secretary of Defense (Comptroller).
Transcript available at www.defenselink.com.
/3/ Note that "today's" fleet consists of slightly more than 300 ships. For
example it includes 18 SSBNs, four of which are scheduled to be retired because
of treaty agreements, plus several older attack submarines and surface ships
that are rapidly approaching the end of their service lives.
/4/ The approach adopted here is a steady-state-type analysis, which begins with
a target force structure of naval ships, described in numbers and types of
ships. It estimates unit replacement (i.e., construction) costs from current and
historical budget data (expressed in billions of budget year 2000 dollars). It
estimates the expected useful lives of the different types of ships from
publicly available data on commissioning and retirement dates. The calculation
of steady-state funding is the annual cost, by ship-type, necessary to sustain
the targeted force structure. For example, 15 ships of a given type in the
fleet, whose unit replacement cost and useful lives are $0.6 billion and 30
years, respectively, require annual, steady-state funding of $0.3 billion ((15 x
$0.6)/30 = $0.3).
/5/ This fleet composition is based on information published by the American
Shipbuilding Association and is located at www.americanshipbuilders.com.
/6/ Replacement cost estimates are in billions of budget year 2000 dollars. They
are based on extrapolations from current and historical budget data, located at
the Navy budget link available through www.defenselink.mil.
/7/ The expected useful lives are in years, estimated from publicly available
commissioning and retirement dates in Jane's Fighting Ships 2000-2001 Yearbook.
2
The second and third force-objective alternatives were motivated by a
recent presentation about the results of Secretary of Defense Rumsfeld's study
of how conventional forces relate to the emerging strategy of military
transformation./8/ The one new shipbuilding investment program that the study
found attractive was the Virginia-class SSN. Mine warfare, fast sealift
concepts, and conversions of strategic ballistic missile submarines (SSBNs) to a
configuration suited to the launch of guided, conventional missiles (SSGNs) also
were seen as attractive research and development initiatives. The presentation
also favored the Burke-class guided missile destroyer (DDG-51), but noted that
that program is nearing the end of its planned procurements. Conversely, the
study appears to give less support to the emerging DD-21 surface combatant
program, new aircraft carriers, and amphibious ships. Accordingly, the force
alternatives posited here simply put more emphasis on ship-types endorsed in the
study and less on other types of ships.
The first alternative, characterized in the table below as the
Transformation fleet, maintains the overall force at 300 ships but changes the
composition of ships in the fleet in accordance with the indications emerging
from the DoD's strategy review. It increases the total number of submarines
(raising to 62 the number of attack submarines and adding 4 SSGN's), mine
warfare and support ships, while modestly reducing the numbers of aircraft
carriers, amphibious ships, and combat logistics ships in the fleet.
Transformation Fleet
Ship type Number Replacement Exp. Life Annual
of ships cost (B) (Years) cost (B)
------------------------------------------------------------------------------------------------------------------------
A/C carriers 9 5.2 50 0.94
Big-deck amphibs 10 1.4 40 0.35
Other amphibs 20 0.6 40 0.30
SSBNs 14 2.4 40 0.84
SSGNs 4 1.5 30 0.20
SSNs 62 1.8 30 3.72
Destroyers 79 1 35 2.26
Cruisers 27 1.2 35 0.93
CLF ships 27 0.3 35 0.23
Mine warfare 18 0.2 30 0.12
Command 4 0.7 35 0.08
Support 26 0.2 35 0.15
------------------------------------------------------------------------------------------------------------------------
TOTAL 300 10.11
The second alternative force objective, shown in the table below, scales
back the total number of ships to a level more consistent with a constrained
funding environment. It then also adjusts the composition of that force in
directions consistent with the emerging review of strategy. The resulting force,
totaling about 249 ships, would increase to 56 the absolute number of attack
submarines in the force, add four SSGNs, and make one-third reductions to the
numbers of surface combatants and combat logistics ships,
_____________________
/8/ Briefing of the Rumsfeld study of conventional forces was given by the study
group's leader, David C. Gompert, on June 22, 2001. A transcript is available at
http://www.defenselink.mil.
3
while reducing the remaining force elements in rough proportion to the overall
reduction in the fleet.
Constrained Fleet
Ship type Number Replacement Exp. Life Annual
of ships cost (B) (Years) cost (B)
------------------------------------------------------------------------------------------------------------------------
A/C carriers 9 5.2 50 0.94
Big-deck amphibs 9 1.4 40 0.32
Other amphibs 18 0.6 40 0.27
SSBNs 14 2.4 40 0.84
SSGNs 4 1.5 30 0.20
SSNs 56 1.8 30 3.36
Destroyers 60 1.0 35 1.71
Cruisers 20 1.2 35 0.69
CLF ships 20 0.3 35 0.17
Mine warfare 14 0.2 30 0.09
Command 3 0.7 35 0.06
Support 22 0.2 35 0.13
------------------------------------------------------------------------------------------------------------------------
TOTAL 249 8.77
Section II: Future revenue shares
Based on these three alternative force structures and the estimates of
annual funding associated with each class of ships, the analysis next makes an
allocation of funding to different shipyards, as indicated in the three tables
at Attachment 1. In an effort to minimize the amount of judgment necessary to
determine this allocation, the approach adhered to current policies and
practices as closely as possible. Newport News remains the sole builder of
nuclear aircraft carriers, and Northrop Grumman's Ingalls Shipbuilding continues
as the only builder of build large-deck amphibious assault ships./9/ Funding for
the other types of ships was allocated to competing yards in essentially the
same proportions as experienced in the 1990s. In addition, the funding necessary
to refuel nuclear-powered ships that remain in the force structure is included,
allocated between Newport News and General Dynamics as it has been distributed
to them in the past.
The two tables below show the effects of these allocations on how total
shipbuilding revenue would be shared between General Dynamics and Northrop
Grumman under the two merger proposals now under consideration. The first table
depicts, for each merger proposal and alternative force structure, the revenue
shares in absolute dollars, as well as the revenue at the individual shipyards
constituting each firm's total. The figures indicate that if General Dynamics
were to acquire Newport News Shipbuilding, its total shipbuilding revenues would
range from a low of $7.48 billion per year under the Constrained fleet
alternative to a high of $8.37 billion per year under the
______________________
/9/ This is not to say that Ingalls is the only yard capable of building these
ships. For example, the National Steel and Shipbuilding Co. (NASSCO), which is
owned by General Dynamics, submitted bids to build the second, third, and fourth
ships of the LHD-1 class (large deck) amphibious ship.
4
Transformation fleet alternative. If Northrop Grumman were to acquire Newport
News, its total shipbuilding revenue would range from a low of $5.01 billion per
year under the Constrained fleet alternative to a high of $5.99 billion under
the Baseline fleet scenario.
Baseline Fleet Transformation Fleet Constrained Fleet
Funding(B) Funding(B) Funding(B)
---------------------- ------------------------ ----------------------
Avondale 0.48 0.45 0.38
Ingalls 2.15 1.94 1.52
NNS 3.35 3.32 3.12
BIW 1.85 1.69 1.29
EB 2.44 3.03 2.82
NASSCO 0.32 0.33 0.26
---------------------- ------------------------ ----------------------
Total 10.61 10.76 9.37
GD acquires NNS
GD & NNS 7.97 8.37 7.48
NOC 2.64 2.39 1.89
NOC acquires NNS
GD 4.62 5.05 4.37
NOC & NNS 5.99 5.71 5.01
The second table translates these absolute figures into a series of ratios
expressed as General Dynamics' share: Northrop Grumman's share.
Ratios of GD:NOC revenues
Baseline Fleet Transformation Fleet Constrained Fleet
GD acquires NNS 75:25 78:22 80:20
NOC acquires NNS 44:56 47:53 47:53
The ratios suggest the following observations. First, relative to current
revenue shares resulting from General Dynamics' acquisition of Newport News
(i.e., 70:30),/10/ each alternative force structure would increase General
Dynamics' revenue dominance resulting from combining the two nuclear-capable
shipbuilders. Under the Constrained fleet alternative, the spread of the ratio
grows to 80:20. It would appear that the growth in submarine construction under
all three alternatives, concentrated at two General Dynamics yards, overtakes
any offsetting reductions in other classes of ships (e.g., aircraft carriers),
to the increasing advantage of the combined General Dynamics-Newport News firm.
Second, relative to the current revenue shares resulting from
_______________________
/10/ CRS Report RL 3096, Navy Shipbuilding: Proposed Mergers Involving Newport
News Shipbuilding - Issues for Congress, by Ronald O'Rourke, May 2001, p. 24
5
Northrop Grumman's acquisition Newport News (i.e. 42:58),/11/ the spread of the
ratio narrows under all three force alternatives toward 50:50. Moreover, the
calculations suggest that the kinds of variations to the Baseline fleet
indicated by the emerging results of the DoD's strategy review would actually
narrow the spread of the ratio in General Dynamics' favor. This result appears
to arise from the fact that reductions to the procurement of aircraft carriers
and amphibious ships adversely affect the Northrop Grumman-Newport News revenue
totals more than the increases to submarine construction shared with General
Dynamics/Electric Boat help it. Finally, it is worth observing that the ratios
associated with Northrop Grumman's acquisition of Newport News are not sensitive
to even broad changes to acquisition plans. While the robustness of this point
may extend only to variations of the force centered mostly on changes to the
levels of attack submarines, it also follows logically from an industrial
structure characterized by two matched firms, each with shipbuilding
capabilities spanning the full breadth of platforms and propulsion types.
Section III: Attack submarine procurement rates
The first purpose of this paper has been to describe the implications on
revenue shares of alternative ship-force levels in the future. But these same
alternative force levels have equally important implications for acquisition
planning. The Navy's existing acquisition program envisions acquiring one
submarine each year into the future, a rate that may be too small to motivate a
robust competition between General Dynamics and Newport News Shipbuilding for
the award of each ship. However, one-per-year is also a rate insufficient to
sustain even a 50-ship fleet, let alone still larger force levels that are both
the express/12/ and implied results of the DoD's ongoing strategy review. In
fact, the procurement rate turns out to be very sensitive to even modest
increases to the size of the submarine force structure objective.
For example, and as illustrated in the table below, sustaining the force of
53 submarines now planned in the fiscal year 2002 defense budget request would
require ramping up production of attack submarines to three per year at the
point around 2009 when large numbers of Los Angeles-class ships in the legacy
force begin reaching the end of their service lives. Reaching and sustaining a
force objective of 56 attack submarines, as posited in the Constrained force
alternative would require ramping up to 2 per year immediately and then 3 per
year beginning in 2010. The still larger force objective of 62 posited in the
Transformation force alternative would require ramping up to 3 per year
immediately.
________________________
/11/ O'Rourke, p. 29
/12/ See June 27, 2001 Defense Budget Presentation for fiscal year 2002,
presented in part by Dr. Dov Zakheim, Under Secretary of Defense (Comptroller).
Transcript available at www.defenselink.com.
6
SSN Force Levels Under Alternative Acquisition Profiles/13/
Fiscal year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
SSN-21 and earlier 50 50 50 49 49 48 48 45 45 45 43 41 38 35 33 30 27 24
classes
VA-class, '98 thru 1 2 2 3 4 4 4 4 4 4 4 4 4 4 4 4 4
'02
------------------------------------------------------------------------------------------------------------
Legacy Force 50 51 52 51 52 52 52 49 49 49 47 45 42 39 37 34 31 28
FY 2002 Budget Force
Ships authorized 1 1 1 1 1 1 3 3 3 3 3 3 3 3 3 3 3 3
Cumulative additions 1 2 3 4 5 6 9 12 15 18 21 24
to force
------------------------------------------------------------------------
Total SSN's in fleet 53 51 52 53 52 51 51 51 52 52 52 52
Transformation Force
Ships authorized 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
Cumulative additions 3 6 9 12 15 18 21 24 27 30 33 36
to force
------------------------------------------------------------------------
Total SSN's in fleet 55 55 58 61 62 63 63 63 64 64 64 64
Constrained Force
Ships authorized 2 2 2 2 2 2 3 3 3 3 3 3 3 3 3 3 3 3
Cumulative additions 2 4 6 8 10 12 14 17 20 23 26 29
to force
------------------------------------------------------------------------
Total SSN's in fleet 54 53 55 57 57 57 56 56 57 57 57 57
Summary
Much of the public commentary about the two competing proposals to acquire
Newport News Shipbuilding has centered on calculations of static, historical
revenue shares and acquisition plans. For example, based on shipbuilding
revenues over several of the past years, it is said that General Dynamics'
acquisition of Newport News would concentrate 70 percent of shipbuilding monies
in that combined firm. It is also widely observed that the acquisition program
for attack submarines over the past several years has called for the
construction of one or fewer submarines each year, a level at which the putative
economies of concentration might well exceed the expected value to the Navy of
having two, independent shipyards to compete for these awards. However, more
important to an assessment of the antitrust considerations about the two
proposals is a dynamic perspective of how revenues and acquisition plans may
change in response to the fundamental reconsideration of military strategy and
force structure that began at the advent of the new Administration in January.
It has been the purpose of this paper to develop this more dynamic perspective
on the naval shipbuilding industry. The paper has constructed three plausible
(if not probable) ship-force structures and then worked out the implications of
those alternative forces on, first, the revenues likely to accrue to each
shipyard and, second, the acquisition plans for attack submarines.
___________________
/13/ These calculations assume a six-year construction lead time. They also
assume that the SSN build program is fixed until FY 2003.
7
The analysis turns up two important conclusions. First, with respect to
revenues, it shows that under a broad range of the likely future ship-forces,
Northrop Grumman's acquisition of Newport News would result in an allocation of
revenues between the two remaining shipbuilding firms that is roughly even and
stable. While revenue is only one of many attributes that might speak to the
viability of a healthy, competitive industrial base for ships into the future,
it is nevertheless a prime indicator. By contrast, General Dynamics' acquisition
of Newport News would tend to skew the distribution of revenues toward an 80
percent concentration in the nuclear-capable firms that might undermine the
competitive health of the overall sector. The second key conclusion of the
analysis is that the procurement rate is extremely sensitive to increases in the
objective force levels of submarines. No force of submarines that is likely to
emerge from the DoD's strategy and force structure could be achieved and
sustained without a procurement rate of three ships per year after 2009. Any
submarine force level above the 53 now planned will require at least 2 per year
beginning in 2003. And force levels above 60 cannot be achieved before 2012
without increasing the procurement rate above 3 per year immediately. Whereas
the viability of competition for awards of one submarine per year or fewer may
be questioned, the Navy's current acquisition strategies for surface combatants
and logistics ships would suggest that programs requiring 2 or 3 ships per year
warrant a competitive award between at least two, independent firms.
8
ATTACHMENT 1
Estimated Steady-State Funding Distribution
(Billions of BY 2000 Dollars)
Baseline Fleet
Ship type Annual cost (B) Avondale Ingalls NNS BIW EB NASSCO
-----------------------------------------------------------------------------------------------------
A/C carriers 1.25 1.25
Big-deck amphibs 0.42 0.42
Other amphibs 0.36 0.24 0.12
SSBN 0.84 0.84
SSN 3.00 1.50 1.50
Destroyers 2.54 1.27 1.27
Cruisers 0.93 0.46 0.46
CLF ships 0.26 0.13 0.13
Mine warfare 0.11 0.05 0.05
Command 0.08 0.08
Support 0.13 0.06 0.06
Carrier refueling 0.50 0.50
SSBN/SSN refueling 0.20 0.10 0.10
-----------------------------------------------------------------------------------------------------
TOTAL 10.61 0.48 2.15 3.35 1.85 2.44 0.32
Transformation Fleet
Ship type Annual cost (B) Avondale Ingalls NNS BIW EB NASSCO
-----------------------------------------------------------------------------------------------------
A/C carriers 0.94 0.94
Big-deck amphibs 0.35 0.35
Other amphibs 0.30 0.20 0.10
SSBN 0.84 0.84
SSGN 0.20 0.20
SSN 3.72 1.86 1.86
Destroyers 2.26 1.13 1.13
Cruisers 0.93 0.46 0.46
CLF ships 0.23 0.12 0.12
Mine warfare 0.12 0.06 0.06
Command 0.08 0.08
Support 0.15 0.07 0.07
Carrier refueling 0.40 0.40
SSBN/SSGN/SSN refueling 0.25 0.13 0.13
-----------------------------------------------------------------------------------------------------
TOTAL 10.76 0.45 1.94 3.32 1.69 3.03 0.33
Constrained Fleet
Ship type Annual cost (B) Avondale Ingalls NNS BIW EB NASSCO
-----------------------------------------------------------------------------------------------------
A/C carriers 0.94 0.94
Big-deck amphibs 0.32 0.32
Other amphibs 0.27 0.18 0.09
SSBN 0.84 0.84
SSGN 0.20 0.20
SSN 3.36 1.68 1.68
Destroyers 1.71 0.86 0.86
Cruisers 0.69 0.34 0.34
CLF ships 0.17 0.09 0.09
Mine warfare 0.09 0.05 0.05
Command 0.06 0.06
Support 0.13 0.06 0.06
Carrier refueling 0.40 0.40
SSBN/SSGN/SSN refueling 0.20 0.10 0.10
-----------------------------------------------------------------------------------------------------
TOTAL 9.37 0.38 1.52 3.12 1.29 2.82 0.26
TAB C4
Economic Incentives in the Naval Shipbuilding Industry
The purpose of this paper is to explain the economic incentives of
shipbuilding firms under different market structures and the consequences of
those incentives for the Department of Defense's (DoD's) interest in having
access to efficient industrial resources for this crucial defense industry.
Efficiency, as used in the context of this paper, is intended to relate all the
attributes of "value" that are the customary measures of a defense contractor's
performance--cost, quality (including schedule adherence), and innovation. The
paper proceeds on the premise that a proper understanding of the economic
incentives operating in these alternative market structures provides the
strongest basis for predicting how well and how likely the DoD is to realize
value from the shipbuilding assets available to it in the future. That is to
say, underlying economic incentives are assumed to be a powerful, if not
decisive, determinant of future market outcomes.
The thesis of the paper is that, among the three alternative market
structures presently under consideration, that structure which joins Newport
News Shipbuilding with the shipbuilding assets of the Northrop Grumman
Corporation will generate economic incentives across the industry that are most
consonant with the DoD's interest in achieving the greatest value from its
acquisition of ships. The key insight of this analysis is not that General
Dynamics' acquisition of Newport News will distort the performance of the market
to accommodate a monopolist's customary incentives--which is manifest. Instead,
the key insight of the analysis is that only Northrop Grumman's acquisition of
Newport News holds the promise of correcting existing distortions that arise
from the inefficiencies inherent in both the industrial structures associated
with the status quo and with General Dynamics' acquisition of Newport News.
The paper's approach to proving this thesis proceeds as follows. In its
first section, the paper briefly recounts the economic theory of a monopolist's
incentives relative to those of a firm facing competition (or at least the
threat of entry) in a given market. The simple point of this section is to
delineate the customary market distortions associated with monopoly and
introduce the concepts of efficiency typically used by economists and public
policy analysts to assess alternative market structures. The second section of
the paper evaluates the economic incentives of shipbuilding firms in three
different market structures:
1. The status quo, in which the shipbuilding assets of Newport News,
General Dynamics, and Northrop Grumman remain independent of one
another.
2. A dominant-firm market structure resulting from the acquisition of
Newport News by General Dynamics.
3. A market structure of equally-matched shipbuilding rivals that would
result from the acquisition of Newport News by Northrop Grumman.
1
Section I. Market distortions of monopoly
The economic theory of how monopoly power may distort economic incentives
of a firm is well established. Under competition, suppliers have strong
incentives to offer their customers the goods and services they want at prices
that just cover the costs of providing the features and quality the customers
are willing to pay for--the economic recipe for efficiency. Monopoly, on the
other hand, diminishes and distorts these incentives to efficient production.
The best known of these distortions concerns a monopolist's incentive to charge
prices above marginal costs. However, this is only the most obvious distortion
and the one with the least immediate application to a naval shipbuilding
industry subject to a monopsonist's detailed oversight of costs. More
importantly, over time the dynamic effects of a monopolist's incentive structure
also distort conduct away from an efficient allocation of resources in ways less
directly amenable to regulatory controls. The classic formulations of both these
static and dynamic monopolistic effects are as follows:
. Dead-weight loss to customers' welfare./1/ The key to an efficient allocation
of resources under a competitive environment is the observation that in the
long run the value to buyers of the last unit of output is exactly the same
as the market value of resources required in producing it. In contrast, a
single-product, profit-maximizing monopolist generally has the incentive to
set prices higher than the cost of producing an additional unit, and so
produces too little of the good compared to what consumers would otherwise
have demanded. Under such a pricing strategy the aggregate economic loss is
greater than the monopolist's gains, creating a "dead-weight loss" to
aggregate welfare.
. Wasteful rent-seeking activity./2/ The ability to charge higher prices not
only increases a monopolist's profit at the expense of total welfare, it also
encourages a monopolist to expend some of its extra profits derived from
having market power to maintain the status quo. This expenditure of resources
to attain and sustain monopoly is called rent-seeking behavior. Advertising,
political lobbying, and the erection of barriers to entry can be examples of
so-called rent-seeking behavior./3/
. Low "technical" efficiency./4/ Monopoly power in a dynamic context can also
have perverse effects on incentives to reduce costs ("X-inefficiency," as it
has been dubbed in economic theory). Outside a competitive environment, there
is limited ability to understand the technological environment and its
possibilities for productivity. Under
___________________________
/1/ See D.W. Carlton and J.M. Perloff, Modern Industrial Organization, 2nd
Edition (Boston: Harper Collins, 1994), chapter 5.
/2/ See J. Tirole, The Theory of Industrial Organization (Boston: The MIT Press,
1988), pp. 75-76.
/3/ Political lobbying, for example, is a particularly good example for rent
seeking. See, Mintz, J., "Utilities Secretly Lobbied Congress; Electric Firms
Gave Millions to Left and Right to Halt Deregulation," in A-section, page A01,
The Washington Post, May. 11, 2000, for an example of how certain regulated
utility companies "spent $17 million over the [last] 3 1/2 years . . . to bottle
up legislation" in Congress that would have challenged their franchise.
/4/ Tirole, pp.75-76.
2
such a circumstance, it is quite likely that a monopolist will not achieve
cost-minimizing production. Without external benchmarks of performance, it is
difficult for both customers and the monopolist itself to gauge internal
efficiency.
. Low incentives to innovate and maintain quality./5/ There is strong support
in the economics literature for the notion that monopolies have lower
incentives to innovate than firms participating in more competitive markets,
in which rivalry stimulates the innovative process. For example, monopolies
may invest less in research and development than is socially desirable. More
generally, the emergence of a sole supplier naturally dampens the incentives
to enhancing quality that arise from a firm's desire to ensure repeat
purchases and avert losing sales to rivals. Indeed, with respect to the U.S.
aerospace industry in particular, there is historical evidence indicating
that the industry became technologically more progressive as the Federal
government exposed industry members to more robust competition./6/
Section II. Economic incentives under alternative shipbuilding market structures
This section of the paper evaluates the relative efficiency of three
possible market structures in the shipbuilding industry --the status quo, a
dominant-firm structure, and an equally-matched-rivals structure. The relative
efficiency of these alternative market structures is shown to be a function of
the economic incentives of the resulting firms to allocate resources, minimize
costs, and innovate. In particular, the different structures are distinguished
by the extent to which each promotes the dissemination of key shipbuilding
resources--tools and technology, in particular; disciplines the costs of
operating nuclear shipyards; and advances the prospect for continuing
innovations in naval shipbuilding.
1. Status quo structure
Under the current industrial structure, there are two principal defects in
the economic incentives to generate value for the DoD. First, as surface ships
have become increasingly complex in response to mission requirements calling for
applications of key nuclear submarine-derived technologies, the two shipbuilding
firms which have been the recipients of the Navy's vast investment in nuclear
propulsion and undersea warfare have an incentive to withhold the dissemination
of key technological resources from other actual and potential competitors.
Second, the status quo results in weak cost discipline in the construction of
both submarines and, especially, aircraft carriers.
Structural bottlenecks in technology dissemination. The current market
structure restricts competition in surface shipbuilding because competitors in
this market do not have equal access to the tools and technologies developed
from the Navy's many years of investment in nuclear propulsion and undersea
warfare. Moreover, there are strong indications, consistent with the nuclear
shipyards' economic incentives, that the
________________________
/5/ Tirole, p. 115.
/6/ Stekler, H.O., "Technological Progress in the Aerospace Industry," Journal
of Industrial Economics 15 (3) (July 1967): 226-36.
3
prevailing allocation of these technological resources is less than efficient.
For example, the system specifications for the next-generation surface
combatant, the Zumwalt-class of destroyers (DD 21), require an acoustic
signature similar to the Los Angeles-class submarines (SSN 688)./7/ Other
complex technologies and innovations associated with submarines that now have
direct application to the design of future surface ships include those relating
to hull coating, propeller and turbulent boundary layer noise, and machinery
noise control and transmission paths./8/
The Navy's intention to develop a common electric drive propulsion and
power distribution system for submarines and surface ships underscores the
reliance of future surface ships on technologies fostered until recently only at
the nuclear shipyards./9/ In principle--and the Navy's best interest--Ingalls
should enjoy efficient access to these sorts of technologies. Northrop Grumman
should be able to secure access to these technologies either from the Navy
itself, which owns intellectual property rights to them and has an incentive to
facilitate robust competition, or from Newport News, which is the only nuclear-
shipbuilding competitor to General Dynamics, the other shipyard with ready-
access to these tools and technologies. However, in practice, Northrop Grumman's
access to these tools and technologies reflects the distorted incentives at play
in the existing market structure, placing it at a competitive disadvantage.
For example, to develop its concept for electric drive in the design of the
DD-21, Northrop Grumman's team did indeed subcontract to Newport News. But
Newport News and Northrop Grumman do not share mutual incentives for a full
transfer of technology and know-how. While collaborating with Northrop Grumman
on electric drive, Newport News is also a potential competitor of Northrop
Grumman's for other surface ships and for the overall integration of weapons
systems on complex ships./10/ Ingalls' only other alternative is to acquire this
kind of know-how from the customer, the Naval Sea Systems Command (NAVSEA). But
here too the presumptive incentives of the Navy to share technology that would
enhance competition and innovation are stunted. Advanced technologies developed
in pursuit of nuclear propulsion and undersea warfare are complex and shrouded
in extreme national security secrecy. As a result, Ingalls must access these
technologies through NAVSEA without the benefit of having a comprehensive
knowledge of the range of possibilities that may comprise a catalogue of the
relevant technologies. Moreover, Ingalls' experience in the DD-21 program
suggests that the Navy itself has not yet developed a process for brokering
these technologies to the non-nuclear shipbuilders in a way that is responsive
to the competitive demands of a fast-paced development program. For example,
Ingalls was forced to develop signature-related calculations without the benefit
of Navy-funded, submarine-derived know-how for which it has requested data./11/
At the very least, it can be said that NAVSEA's process
______________________
/7/ Northrop Grumman, DoD/DoJ Briefing, June 6, 2001, p. 7.
/8/ Northrop Grumman, DoD/DoJ Briefing, June 6, 2001, pp. 5; cf. O'Rourke,
ibid., pp. 25-26.
/9/ Northrop Grumman, DoD/DoJ Briefing, June 6, 2001, p. 7.
/10/ Newport News claims to be "the only shipyard with both the physical
capacity and the technical capability to design, integrate, build, repair,
overhaul, refuel, and deactivate every type of ship in the U.S. Navy fleet." See
Loren Thompson, "US Shipbuilders: The Tide Begins to Turn," Sea Power Magazine,
April 1999.
/11/ Northrop Grumman, DoD/DoJ Briefing, June 6, 2001, p. 6.
4
for reviewing requests for access to technology, data, and know-how is
problematic and no doubt complicated by NAVSEA's own internal barriers and
rivalries.
Weak cost discipline at Newport News. The current market structure also
provides limited incentives for the nuclear shipbuilders to develop and
implement business practices that would lower costs. The public record is
replete with indications that the cost-structure of the Newport News shipyard
exceeds the DoD's contractual expectations and needs./12/ In fact, the cost
overruns at Newport News have been so alarming that the Pentagon hired the
consultancy Bain & Co. to recommend new ways to control costs at that yard (an
initiative also indicative of the challenge DoD faces in properly regulating the
franchise it has granted Newport News)./13/ It has been estimated that the
Ronald Reagan carrier being built at the facility is running about $89 million
over budget./14/ Cost overruns on refueling the USS Nimitz aircraft carrier have
been estimated at $200 million./15/ These cost overruns may well relate to the
lower incentives to technical efficiency that result from Newport News' lack of
rivals for the production and refueling of nuclear powered aircraft carriers.
But they may equally reflect certain rent-seeking behavior on the part of
Newport News that inflates the overhead costs charged against the government's
cost of the aircraft carrier. For example, in 1998, Newport News, with great
fanfare and assistance from the Virginia state government, established the
"Virginia Advanced Shipbuilding and Carrier Integration Center," a systems
integration facility intended to help Newport News retain prime contracting
authority over future aircraft carriers against the threat to its incumbency
arising from non-shipbuilding systems integrators, like Lockheed Martin and
Raytheon./16/ Not only does this initiative reflect an intensive political
lobbying effort by Newport News, it also is likely to add excess operating costs
to the overhead charged against existing Navy contracts.
______________________
/12/ Squeo, A. M., "Newport News Draws Fire Over Cost Cutting Efforts - navy
Officials Say Company's Status as Sole Builder of Aircraft Carriers is the
Problem", in Corporate Focus, Wall Street Journal, Jan.23, 2001. Addressing his
dissatisfaction with the progress NNS had made toward reducing costs on the
aircraft carrier program, former Navy Secretary Richard Danzig said in this
article, " [Newport News] only achieved half of what they promised . . . ."
/13/ Ibid.
/14/ See David Lerman, "NNS On Target With Cost-Cutting Navy Confirms Shipyard's
Planned Saving by 2003," Daily Press, Feb. 1, 2001, p. A1.
/15/ See Michael Fabey, "Nimitz Cost One Slippery Number Carrier's Refueling
Almost Complete.", Daily Press, Jan. 10, 2001, p. A1.
/16/ See Jerri Fuller Dickseski, "Governor Gilmore Signs Bill Establishing
Carrier Integration Center During Ceremony At Newport News shipbuilding,"
Newport News, Jan. 19, 1998, Press Release.
John L. "Jack" Roper IV, executive vice president-operations at Norshipco,
commenting on the use of public money in funding the "Virginia Advanced
Shipbuilding and Carrier Integration Center" noted "But it definitely begs the
question: Is there only one shipyard in the industry that merits state money?",
See Whitt, T., and C. Dinsmore, "Should The State Give Shipbuilder A tax Break",
The Virginian-Pilot, Feb. 9, 1998, p. A1.
5
2. Dominant-firm structure: General Dynamics Acquires Newport News Shipbuilding
Under the industrial structure resulting from an acquisition of Newport
News by General Dynamics, all four of the market distortions associated with
monopoly are likely to diminish the value the DoD can achieve from the
shipbuilding resources available to it. Nuclear ships of both types will tend to
cost more, stray from planned schedules, and fail to achieve the full range of
technological advances that are technically available under a more competitive
industrial structure. But among these four distortions, diminished incentives to
achieve efficiency and pursue innovation are those most threatening to the DoD's
interests.
Loss of leverage in disciplining costs of nuclear shipbuilding. The merger
of General Dynamics and Newport News Shipbuilding would create a sole supplier
for nuclear-powered ships. Facing such monopoly power, the DoD would lose
leverage over cost-discipline that it could derive from a market structure
allowing at least some rivalry in the production of nuclear ships. Economic
theory suggests strongly that the DoD will pay more for nuclear-powered ships in
the long run. This disparity may well encourage a search for more cost-effective
weapon systems that the DoD can use as substitutes to achieve the military
missions that aircraft carriers and submarines perform. Long-range bomber
aircraft and missile-laden surface ships have been suggested, for example, as
substitutes for some of the precision-strike missions of aircraft carriers and
submarines./17/ However, in the short-run, there are only inferior substitutes
for the full range of missions aircraft carriers perform and possibly no
substitutes for the core undersea warfare missions of submarines.
The merger would eliminate any leverage the Navy has had up to this point
in contract negotiations over nuclear submarines. Notwithstanding that the two
shipyards today are teamed to produce the first four Virginia-class attack
submarines, the DoD still derives significant leverage from the possibility of
competitive awards in the future or if one or the other of the yards should fail
to adhere to its part in the teaming arrangement. In fact, rather than dampening
the economic incentives to efficiency, the teaming arrangement itself has
created a regulatory regime of discipline and scrutiny that may actually enhance
the government's insight into costs and the credibility of rivalry on future
awards that disciplines the two firms' performance. However, the incentives
embodied in the teaming agreement would dissolve with the elimination of rivalry
that would result from the merger. The point is that even in the absence of
nominal "competition" for nuclear ships, the Navy derives leverage to discipline
costs and performance from the threat of rivalry which the teaming arrangement
promotes.
It is a point well illustrated in the history of the sole-source Trident
submarine program. Struggling to motivate General Dynamics to contain costs and
meet performance objectives, the Navy undertook to facilitate Newport News'
ability to compete for award of the ships./18/ In a subsequent review of an
award of the Trident ship
_______________________________
/17/ See Dr. Paul Kaminski, et al., DOD News Briefing, May 18 1998
/18/ In 1986, Rear Adm. Stuart F. Platt, the Navy's Competitive Advocate
General, said of the Navy's decision to offer Trident inspection and repair
contract to Newport News, "It's a first step toward
Footnote continued
6
to General Dynamics, the Armed Services Board of Contract Appeals (ASBCA) found
that General Dynamics was motivated to reduce costs by a belief that the Navy
otherwise would make the award to Newport News./19/ General Dynamics found this
threat credible at least in part because it previously had lost work to Newport
News on the Los Angeles-class submarine program over the Navy's dissatisfaction
with its performance./20/ The combination of General Dynamics with Newport News
would eliminate these possibilities for motivating efficiency, since the Navy
would have no credible alternative to General Dynamics for submarine
procurement.
Reduced incentives for technology insertion and innovation. Economic
principles also indicate that the combined entity would have markedly lower
incentives to pursue and achieve innovations in naval nuclear propulsion and
undersea warfare. This is a particularly threatening prospect in consideration
of the high priority the Navy places on advancements in undersea warfare.
For example, the acquisition plans for the Virginia-class of submarines
envisions an evolving design that can accommodate the insertion of new
technologies with each new ship that is authorized./21/ Accordingly, the Navy
has maintained a very active program of research and development in these areas
for which General Dynamics/Electric Boat and Newport News compete vigorously for
contract awards and, as importantly, pride of achievement. In fact, it was a
matter of special congressional interest at the time the Navy was putting in
place the teaming arrangement for construction of the Virginia-class ships
whether the collaboration would have any adverse effects on the competitive
friction between the two yards that had produced so many astounding
technological achievements over the years. The Navy acknowledged the importance
of this friction and made assurances that it would prevent the teaming agreement
from mitigating competition for technology developments./22/
Moreover, the advance of a keystone technology in the future of naval
shipbuilding,/23/ electric drive, may well be at risk from the combination of
General Dynamics and Newport News. General Dynamics and Newport News are the
only two firms now capable in the full range of technologies necessary to
develop the application of this technology to Navy ships./24/Not only will the
combination of these two firms stall
________________________________________________________________________________
Footnote continued from previous page
competition. (This) work would provide Newport News the experience so they could
submit credible bids on construction." See C.R. Herron. and M. Wright,
"Competition for the Trident Sub?", The New York Times, January 12, 1986, p.4,
Column 2.
/19/ Northrop Grumman, DoD/DoJ Briefing, June 6, 2001, p. 33.
/20/ ibd.
/21/ See Fiscal year 2001 Budget Request (http://164.224.25.45/fy2001), Dept of
Navy, Exhibit R-2, RDT&E Budget Item Justification, and February 2000.
/22/ See, Military Procurement Subcommittee, Hearing on the New Attack Submarine
Program, March 18, 1997.
/23/ Richard Danzig, former Navy secretary, likened the change to integrated
power to that "from sail to steam or from propeller to jet engines or to nuclear
power." See, Navy Office of Information, "Navy Selects Integrated Power Systems
and Electric Drive for DD 21", January 6, 2000.
/24/ See Ronald O'Rourke. "Navy Shipbuilding: Proposed Mergers Involving Newport
News Shipbuilding: Issues for Congress," CRS Report for Congress, RL30969, May
22, 2001, p. 26.
7
the competitive engine of innovation among engineers working to advance electric
drive technology; economic theory also suggests that General Dynamics, without
fear of competition in the development of electric drive, may slow that
technology's introduction onto ships in order to extend the production of older-
generation ships on which its immediate returns are greater./25/ The successful
introduction of the DD-21, with electric drive, would hasten the end of
production on the DDG-51 class of ships, an established program on which General
Dynamics' Bath Iron Works shipyard now enjoys almost risk-free returns. Faced
with a competitor in the development of electric drive, General Dynamics could
not afford to delay its advancement of the technology for fear of losing the
lead over this keystone technology to a rival. But enjoying dominance over the
development of electric drive, General Dynamics' incentives to promote both
advancement of the new propulsion system and the new class of ships on which it
would be employed are conflicted.
3. Equally-matched: Northrop Grumman acquires Newport News Shipbuilding
The industrial structure resulting from Northrop Grumman's acquisition of
Newport News promotes a superior set of economic incentives to efficient naval
shipbuilding. It rectifies each of the distortions in the incentives at play
under the status quo and averts those that would result from monopoly ownership
of the nuclear shipbuilding yards:
. Bottlenecks impeding a more efficient application to surface ships of the
tools and technologies developed in the nuclear shipbuilding programs would
be replaced by Northrop Grumman's immediate access to the assets and know-
how of Newport News.
. Cost discipline over Newport News' performance on the aircraft carrier
program would be strengthened by the Navy's leverage over non-nuclear
shipbuilding programs for which Northrop Grumman competes/26/ and by
Northrop Grumman's familiarity with the construction of large-deck
amphibious ships.
________________________________________________________________________________
Footnote continued from previous page
Ronald O'Rourke, "Navy Zumwalt (DD-21) Class Destroyer Program: Background and
Issues for Congress", CRS Report for Congress RS20698, Updated March 13, 2001,
p. 4-5; Otto Kreisher, "Influencing Events Ashore," Navy League of the United
States.
/25/ For a discussion of economic incentives created by procurement practices,
see Rogerson, W., "Incentive Models Of The Defense Procurement Process," in
Defense Handbook of Defense Economics, edited by Hartley, K., and T. Sandler,
(1995), Elsevier, P.311-346.
/26/ A shipbuilder with market power in one market will have incentives to
reduce costs in that market, if such cost overruns are perceived as structural
inefficiencies and affect future contracts in other markets where there is
credible competition. Current Federal Acquisition Regulation (FAR) allows the
Navy to consider past performance and, more importantly, lets the Navy define
"the approach for evaluating past performance" in assessing any source selection
(see Federal Acquisition Regulation subpart 15.305). The Navy's ability to
enforce cost-cutting measures increases to the extent cost overruns in one
market can be tied to procurement standards in another market in which
shipbuilders operate.
. Cost discipline on nuclear submarines would be improved by the
reinforcement of rivalry between General Dynamics/Electric Boat and Newport
News and by Northrop Grumman's opportunities to streamline overhead at
Newport News.
. Competition for technology insertion and innovation would be enhanced by
the maintenance of rivalry between the two firms' nuclear shipbuilding
engineering teams and by Northrop Grumman's advanced technology and systems
integration capabilities.
Summary
It has been the purpose of this paper to explain the economic incentives of
shipbuilding firms under the different market structures implied by the
proposals now under consideration for the acquisition of Newport News
Shipbuilding. Much of the public commentary about the government's review of
these proposals has tended to focus on static or even historical features of the
market structure for shipbuilding, without regard to the dynamic, long-term
consequences of underlying economic incentives./27/ Yet, there are strong
indications from economic theory about the incentives likely to animate firm
performance in the different market structures that would result from an
acquisition of Newport News. The success of General Dynamics' bid to acquire
Newport News would concentrate in one firm all the private nuclear shipbuilding
assets available to the Navy, subjecting the Navy's chances for achieving cost,
quality, and innovation in shipbuilding to all the customary distortions of
monopoly power: less ship-based military effectiveness for its money; more
gaming of the acquisition and legislative processes to blunt competition; lower
technical efficiency of shipbuilding practices; and fewer innovations to drive
the advancement of nuclear propulsion and undersea warfare. By contrast,
Northrop Grumman's acquisition of Newport News not only prevents of monopoly
control over nuclear shipbuilding, it also improves the economic incentives
already distorting performance under the industrial structure associated with
the status quo.
The results of this analysis suggest two concluding observations. First,
General Dynamics' acquisition of Newport News would impose a regulatory burden
on the Navy and the DoD far greater than that which constitutes simple cost-
based contract management. To the already difficult task of identifying costs
and making an appropriate allocation of them to Navy projects, this new
regulatory regime would add the still more challenging problem of determining
what nuclear ships should cost, in the absence of direct benchmarks or
competitive prices. In addition, it would add to this regulatory burden the
problem of having to broker tools and technologies derived from the Navy's
investments in nuclear shipbuilding and undersea warfare to any team that might
compete with General Dynamics for any class of ships. The overall prospect of
this new regulatory burden would seem to run in contradiction to the trend of
deregulation (i.e., "acquisition reform") that has been a hallmark of DoD's
recent acquisition policies.
________________________
/27/ See Ronald O'Rourke. "Navy Shipbuilding: Proposed Mergers Involving Newport
News Shipbuilding: Issues for Congress," CRS Report for Congress, RL30969, May
22, 2001, p. 1-38-
9
The second observation suggested by this analysis is that the acquisition
of Newport News will play an important part in how successfully naval systems
will be able to keep pace with the transformation of military forces that has
been signaled by the new Administration. If naval platforms--aircraft carriers,
submarines, and surface combatants--cannot keep pace technologically and
economically with the emerging demands of future warfare, they will fall out of
operating, program-budget, and acquisition plans in favor of non-naval systems
that are more cost-effective. The effect of Newport News' acquisition on the
expected cost of existing systems that may be constructed over the next six
years is only the smallest part of the equation that will determine the
competitiveness of naval systems for the future. More important will be the
ongoing ingenuity of naval systems and industrial engineers and shipyard
managers to transform these platforms from workhorses of the Cold War to
centerpieces of the revolution in military affairs. Economic theory would
strongly suggest that success in that transformation is more likely to emerge
from the competitive friction of two equally-matched rivals than from a market
structure dominated by one, highly-regulated firm.
10
TAB C5
Limitations of Regulatory Control in Naval Shipbuilding
The purpose of this paper is to explain the limitations of using regulatory
control of monopoly to achieve efficiency, and to indicate how these limitations
on regulating a nuclear shipbuilding monopoly would impose an extraordinary
burden on the Department of Defense. Most of these limitations arise from
constraints on the availability of the information required by economic
regulation. "Informational constraints" refer to the inescapable reality that a
regulator, such as the DoD, cannot ever have complete information as to the
lowest possible costs of producing desired technologies, nor have complete
knowledge about the true range of technological possibilities available to its
supplier. Indeed, in the absence of competitive pressure, even the managers of
the regulated monopolist may face information constraints of their own making,
since they are not forced to evaluate and investigate innovative and cost-
reduction opportunities. A monopolist seeking to maximize its own profit has
inherent incentives to charge high prices, and to provide as low a level of
quality as it can persuade the customer to accept, for any given level of
payment./1/ The discipline of competitive forces is the most effective way to
uncover opportunities for cost reduction and quality improvements. The thesis of
this paper is that if General Dynamics were to acquire Newport News
Shipbuilding, forming a monopoly over nuclear shipbuilding, these regulatory
problems would adversely affect the dynamic efficiency of the business and the
value for money that the DoD would obtain from it.
The problems of regulation
Unregulated monopolies typically perform poorly relative to competitive
firms along several dimensions. Adverse results include losses to customers
arising from the monopolist's ability to set price above the cost of production,
as well as low technical efficiency in production, and low incentives for
innovation and quality improvement/2/ resulting from the lack of market pressure
provided by competing firms. Of course, it is all of these problems that give
rise to the orientation of U.S. antitrust law and DoD policy toward promoting
competitive market structures and policies.
Nonetheless, some products are produced in such small numbers and with such
large-scale technology that reliance on a single supplier may seem to hold the
most promise for efficient operation. When such a product is essential,
governments have in some instances granted one firm an exclusive franchise to
supply the product and then attempted to mitigate the negative economic
consequences of the resulting monopoly by regulating the prices paid for the
output of the firm./3/
________________________
/1/ "Quality" should be understood in two senses: the degree to which a product
is free of defects, as well as the level of innovation or the performance
characteristics embodied in the product.
/2/ See for example J. Tirole, The theory of industrial organization, MIT press
1988, p 75-76.
/3/ The need for regulation routinely arises in natural monopoly utility
industries such as local electric power and local water distribution, and some
transportation facilities such as railway lines and airports.
1
The core of economic regulation is this regulatory designation of the
supplier, and regulatory control of the price that will be paid for the
supplier's product. The major challenge facing a regulator seeking to set such a
price is that the regulator has no way of knowing very much about the costs of
producing various levels of quality./4/ The regulator would like to get whatever
quality it desires at the lowest possible cost, or alternatively, the regulator
would like to obtain the highest possible quality for a given level of cost.
Unfortunately, the regulated firm often has objectives that are in conflict
with those of the regulator, and it is from this conflict, together with the
opportunities given to the firm by virtue of the regulator's informational
constraints, that key problems of effective regulation arise. Provision of
quality is difficult: the incomes and comfort of the firm's management and
workers and the profits of the firm's shareholders will be enhanced to the
extent that the firm gets paid more for delivering a given level of quality, or
delivers lower quality for a given amount of money.
Conflicting objectives between the regulator and the firm means it is
unrealistic to expect the firm's managers to reveal all they might know in
answer to the question: "What is the lowest possible cost of producing this
technology, with these particular quality characteristics?" The monopolist
wishes to generate profits for itself that are as high as possible. This
requires that it do what it can to raise prices and ignore what may be cost-
effective, but unprofitable expenditures aimed at enhancing quality. These
objectives mean that the monopolist has an incentive to make use of the
difference in information available to the regulator and the firm; at a minimum,
if the managers of the firm simply have doubts about the correct answers to what
is an inevitably uncertain forecasting exercise, an informational problem will
arise as a result of the understandable tendency they will have, in the absence
of competitive pressure, to resolve those doubts in favor of an inflated budget
or reduced quality goals.
Thus, in attempting to generate efficient outcomes, the regulator of a
monopoly has to try to induce it to act in ways that are against its own self-
interest. Well-understood regulatory methods do exist that are effective in
keeping costs down, or that are effective in sponsoring high quality. However,
these methods are far from perfect. The informational constraint results in two
related problems. First, what the monopolist and regulator attain under
regulation is almost surely not going to be any of the desirable and feasible
combinations of cost and quality. Second, there will not be any way of knowing
how far off the mark the results have been. While designating a single firm as
the sole source may avoid many of the more or less quantifiable costs of
supporting an "extra" supplier, there is no assurance that the added costs and
reduced quality resulting from imperfect regulation do not far outstrip those
savings. A review of the specific tools available to regulators will illustrate
the risks involved.
_________________________
/4/ Although the "should-cost" studies carried out by the Department of Defense
do provide an extraordinary level of information, they cannot provide
information equivalent to that revealed in a competitive process between
suppliers competing to demonstrate their ability to deliver a high-quality
product at low cost. Such suppliers have strong incentives to develop and reveal
definitive information that cannot be expected from an administrative process.
2
Regulatory Methods
The large economic literature on regulation somewhat obscures the relative
simplicity of the basic regulatory options. Regulatory methods can be classified
according to the extent to which they focus on attaining highest quality or
alternatively, lowest cost. These competing objectives translate directly into a
regulatory spectrum of price control that can be described according to the
strength of cost control incentives.
"Low-powered incentives" for cost control are provided by "cost-plus"
regulation./5/ Under cost-plus regulation, the firm reports its costs to the
regulator and receives reimbursement for them, plus some level of markup. This
type of regulation does allow the regulator to specify difficult quality targets
and have some reason to hope that if they are attainable at all they will be
met. However, even if a firm is allowed to spend as much as it likes on quality
enhancement, there is still nothing to rule out the possibility that subjecting
the firm to the competition of another supplier could have delivered the same or
even better quality at significantly lower cost
At the other end of the spectrum, creation of "high-powered incentives" for
cost control is the primary objective of "fixed-price" contracting. With fixed-
price contracting, an agreement is reached between the regulator and the
supplier as to how much will be paid for the product. The supplier then produces
the product and delivers it to the regulator. Note that while costs will be
controlled under fixed-price contracting, the firm gets any money left over from
exercising control. Unless the regulator has been able to specify, in detail,
every dimension of quality in advance, as part of the original contract, the
supplier may be expected to act on its incentives to reduce costs and enhance
its own profit by cutting corners on quality. This problem is especially marked
in product sectors involving new technology with unknown characteristics. In
such a circumstance, such thorough contracting in advance of production is not
practical.
After a bad experience with pure fixed-price contracting, it is not
surprising when regulators return to procedures that retain some quality
incentive by allowing a share of cost overruns to be passed on the buyer. For
example, the Air Force experience with wing problems on the C5A--problems that
necessitated subcontract expenditures for repairs, even as the supplier,
Lockheed, was almost destroyed by the cap on its payments--certainly made clear
the risks of pure fixed-price contracting in an arena in which risky
technological advances are of paramount importance. Of course, after painful
experience with both cost-plus and fixed-price contracting with sole source
suppliers, the DoD worked to find ways such as prototype competitions, to reduce
technological uncertainty before committing to a single firm, even for one
specific program. Prototype competitions reduce the time window during which the
inevitable problems of regulated monopoly may emerge, by deferring down-
selection to the last possible minute. The existence of multiple potential
suppliers for any particular program
________________________________
/5/ See Jean-Jacques Laffont and Jean Tirole, A Theory of Incentives in
Regulation and Procurement, MIT Press, 1993, Chapter 1.
3
was crucial for implementation of this strategy./6/ Prototyping success stories,
albeit qualified ones such as the competitively prototyped F-16 fighter program,
are prominent in the history of modern defense contracting. Even if a competitor
will be placed in a long-term sole source position after winning a contract,
market discipline is provided by the knowledge that the Department of Defense
can respond to bad performance by turning to an alternative supplier on future
programs, or on similar programs in the near future.
Even the cost control aspects of more successful cases of regulated
monopoly fixed-price contracting are subject to qualification. When a regulator
gives a sole source provider a contract with a fixed-price component, the
resulting price may not be particularly low. The amount of the payment is set
via negotiation between the regulator and the firm, prior to the start of
production. There is no assurance that the discipline of the market would not
have provided a significantly lower fixed-price. Again, this is at least partly
a result of imperfect information in the hands of the regulator.
From the standpoint of the entire society, the fact that costs are
controlled to the benefit of any party at all accounts for the theoretical
appeal of fixed-price contracting. Experiments with fixed prices carried out by
the Department of Defense have more likely been driven by a desire to reduce the
political fallout of costs that grow far in excess of original budgets. To the
extent that a move toward fixed prices has reduced that fallout, the shift has
served some purpose. However, there is no assurance that use of fixed price
contracts in sole source situations has delivered any price benefits relative to
what a competitive process would have delivered, or that fixed-price contracts
secure the desired and proper level of technical performance. It may be the case
that as the DoD has moved toward tighter control of cost overruns, public
concern with the escalating costs of various technological advances has made an
entirely predictable shift toward equal concern with failures of performance.
Regulators ranging from the DoD to various public utility authorities have
sought to balance price and quality by refining their regulatory methods.
Contracting methods may specify a "sharing" percentage, which specifies that a
portion of cost-overruns will be reimbursed, or attempt to use various quality
incentive payments on top of a base fixed-price scheme. While these methods may
move outcomes closer to the regulator's objectives, the fundamental problem
posed by the informational constraint remains: one cannot know how much lower
costs could have been or how much better quality could have been, but one can be
assured that the gap between regulatory outcomes and competitive potential is
ever-present.
As Alfred Kahn, the "father of deregulation" has said:
The essence of the case for competition is that the potential performance
of an industry is unknowable; it is the rivalry of independent suppliers
that offers the greatest possible assurance that all economically feasible
___________________________
/6/ Smith, G., et al., "The use of prototypes in weapon system development,"
Project Air Force (R-2345), Santa Monica, CA: Rand Corporation, 1981.
4
avenues for cost reduction and service innovation will in fact be explored
and their results subjected to the impartial test of the marketplace./7/
The impartial test of competitive procurement for weapon systems is no less
essential, if weapons embodying the best possible combination of cost and
performance are to find their way to the to the ultimate test of battle.
Summary and implications for nuclear shipbuilding
Problems posed by information constraints would apply in force if nuclear
shipbuilding were to become a monopoly. Particularly serious would be the
potential loss of incentives for technical progress. One paramount technology
that would be at risk is the electric drive system./8/ Currently only General
Dynamics and Newport News have the capabilities on the level required by the US
Navy to develop this technology./9/ Competition between these two firms would
help to ensure that the technology would be developed at the lowest feasible
cost, and that it would be available on a timely basis. A merger of these firms
would not only make it difficult for regulators to determine the appropriate
cost of developing electric drive, or to determine the actual limits on its
performance characteristics, but could likely lead to a delay in development and
integration of electric drive into naval vessels./10/
The risks to cost efficiency when a cost-plus approach is followed are
illustrated by the Navy's own experience with the relatively high costs of NNS,
in its role as a long-term monopoly supplier of aircraft carriers. There is no
easy fix to problems such as this, as long as a monopoly position is maintained.
With respect to nuclear submarines, if the Navy moves toward a fixed-price
approach in order to reduce excessive costs, it is likely to encounter problems
of quality degradation that could not be eased by the prospect of a quick return
to a competitive situation. Once the expertise and capability possessed by a
___________________________
/7/ Alfred E. Kahn, The Economics of Regulation: Principles and Institutions,
Vol. 2: Institutional Issues, John Wiley and Sons, New York, 1971, p. 305.
/8/ Richard Danzig, former Navy secretary, likened the change to integrated
power to that "from sail to steam or from propeller to jet engines or to nuclear
power." See, Navy Office of Information, "Navy Selects Integrated Power Systems
and Electric Drive for DD 21", January 6, 2000.
/9/ See Ronald O'Rourke. "Navy Shipbuilding: Proposed Mergers Involving Newport
News Shipbuilding: Issues for Congress," CRS Report for Congress, RL30969, May
22, 2001, p. 26. Ronald O'Rourke, "Navy Zumwalt (DD-21) Class Destroyer Program:
Background and Issues for Congress", CRS Report for Congress RS20698, Updated
March 13, 2001, p. 4-5; Otto Kreisher, "Influencing Events Ashore," Navy League
of the United States.
/10/ Economic theory suggests that General Dynamics, without fear of competition
in the development of electric drive, may slow that technology's introduction
onto ships in order to extend the production of older-generation ships on which
its immediate returns are greater (For a discussion of economic incentives
created by procurement practices, see Rogerson, W., "Incentive Models Of The
Defense Procurement Process," in Defense Handbook of Defense Economics, edited
by Hartley, K., and T. Sandler, (1995), Elsevier, P.311-346). The successful
introduction of the DD-21, with electric drive, would hasten the end of
production on the DDG-51 class of ships, an established program on which General
Dynamics' Bath Iron Works shipyard now enjoys almost risk-free returns. Faced
with a competitor in the development of electric drive, General Dynamics could
not afford to delay its advancement of the technology for fear of losing the
lead over this keystone technology to a rival.
5
competitive supplier have been dispersed, re-constitution may be possible only
at extremely high cost and with long delay.
In conclusion, no approach to regulating monopoly businesses yet devised is
immune from potentially serious problems. We contend that problems similar to
those observed in every other regulatory setting would arise in any attempt on
the part of the DoD to regulate a monopoly supplier of nuclear ships. It is not
just that practical difficulties make cost auditing imperfect; the underlying
incentives of a monopoly supplier make difficulties inevitable. It would be
misleading to infer from the relatively responsive behavior of a supplier firm
under competition that the same firm would continue to be responsive if it were
a monopoly under regulation. Maintaining a competitive environment is the only
effective way to avoid or mitigate these problems.
6
THIS ANNOUNCEMENT IS NEITHER AN OFFER TO PURCHASE NOR A SOLICITATION OF AN
OFFER TO SELL SHARES OF NEWPORT NEWS SHIPBUILDING. THE EXCHANGE OFFER STATEMENT
(INCLUDING THE PROSPECTUS, THE RELATED LETTER OF ELECTION AND TRANSMITTAL AND
OTHER OFFER DOCUMENTS) FILED BY NORTHROP GRUMMAN WITH THE SEC CONTAIN IMPORTANT
INFORMATION THAT SHOULD BE READ CAREFULLY BEFORE ANY DECISION IS MADE WITH
RESPECT TO THE OFFER. THE PROSPECTUS, THE RELATED LETTER OF ELECTION AND
TRANSMITTAL AND CERTAIN OTHER DOCUMENTS WILL BE MADE AVAILABLE AT NO CHARGE TO
ALL STOCKHOLDERS OF NEWPORT NEWS. THE EXCHANGE OFFER STATEMENT (INCLUDING THE
PROSPECTUS, THE RELATED LETTER OF ELECTION AND TRANSMITTAL AND ALL OTHER
DOCUMENTS FILED WITH THE SEC) WILL ALSO BE AVAILABLE AT NO CHARGE AT THE SEC'S
WEBSITE AT WWW.SEC.GOV.
____________
Note: Certain statements and assumptions in this release contain or are based on
"forward-looking" information (that the company believes to be within the
definition in the Private Securities Litigation Reform Act of 1995) and involve
risks and uncertainties. Such "forward-looking" information includes the
statements above as to the impact of the proposed acquisition on revenues and
earnings. Such statements are subject to numerous assumptions and uncertainties,
many of which are outside the company's control. These include the company's
ability to successfully integrate the operations of Litton, assumptions with
respect to future revenues, expected program performance and cash flows, the
outcome of contingencies including litigation, environmental remediation,
divestitures of businesses, and anticipated costs of capital investments. The
company's operations are subject to various additional risks and uncertainties
resulting from its position as a supplier, either directly or as subcontractor
or team member, to the U.S. Government and its agencies as well as to foreign
governments and agencies; actual outcomes are dependent upon factors, including,
without limitation, the company's successful performance of internal plans;
government customers' budgetary restraints; customer changes in short-range and
long-range plans; domestic and international competition in both the defense and
commercial areas; product performance; continued development and acceptance of
new products; performance issues with key suppliers and subcontractors;
government import and export policies; acquisition or termination of government
contracts; the outcome of political and legal processes; legal, financial, and
governmental risks related to international transactions and global needs for
military aircraft, military and civilian electronic systems and support and
information technology; as well as other economic, political and technological
risks and uncertainties and other risk factors set out in the company's filings
from time to time with the Securities and Exchange Commission, including,
without limitation, the company's reports on Form 10-K and Form 10-Q.
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