When the EADS and BAE announced merger plans earlier this year, it spurred a flurry of speculation about how the rest of the aerospace and defense industry would respond. Now in the aftermath of the merger being called off, speculation continues about the outlook of defense merger and acquisition (M&A) activity – and specifically what impact that will have on government and suppliers.

While the Department of Defense has indicated its reluctance to sanction M&As among the US primes (particularly when mergers lead to monopoly situations), at sub-tier levels, M&A activity has been occurring at a robust pace and promises to continue-at least in the near future.

From a government buyer perspective, however, the question of whether benefits accrue from M&As is very much an open one.

On the plus side, improved economies of scale and scope, typically associated with M&As, may enable better affordability opportunities in the face of declining budgets.

On the minus side, M&As contribute to supplier concentration which may foreclose competitive options, reduce innovation incentives and result in scale and scope economies simply being retained within the industrial base as profit contribution improvement rather than being passed through to the customer.

On the “to-be-determined” side, sometimes the principal driver behind M&A activity is to gain entry to new markets or to achieve diversification.

A question that isn’t being asked, however, is what impact M&As may have on agility and the ability to adapt on the supplier side?”

While such moves may potentially benefit shareholders, government customers are likely to benefit only indirectly, if at all, via a more financially stable supplier with stronger balance sheets that can better weather business downturns. (Certainly, balance sheet strength isn’t a current concern for most US defense companies.)

Regardless of the underlying M&A motivation, the combined enterprise’s ability to create value versus bureaucracy is a common challenge. A question that isn’t being asked, however, is what impact M&As may have on agility and the ability to adapt on the supplier side?

Today’s defense environment is being impacted by several forces, including:

  • Declining defense budgets
  • Overall higher levels of uncertainty in defense direction
  • Rapidly evolving cyber-security threats
  • Non-nation state threats from adversaries playing outside traditional rules (e.g. terrorists)
  • Shift from traditional hardware platforms to emphasis on information-based defense systems and services competencies

Combined, this environment suggests substantial changes are expected in defense systems and product value chains. Long term development and production cycles of expensive, complex defense systems and products are quickly becoming out of vogue.

Instead, demand today is shifting toward single-purpose, fast-to-develop (or commercial off-the-shelf), distributed and networked defense systems and products – or products that make existing platforms more capable rather than building new platforms. This changing demand is shifting focus from large weapons systems to a variety of “black boxes” and networking processes.

These new systems and products can make their way to the fight faster and more affordably. Today’s budget and demand dynamics imply that defense value chains will need to be more agile and adaptive than in the past.

But this raises the question: Will larger-scaled enterprises be an impediment or can they be enabler to greater value chain flexibility?

Since the early 1990s, the private-sector trend in value chain configuration has been away from large vertically-scaled enterprises towards horizontal, extended value chain models. The consumer high-tech industry is probably the best example of this trend where integrating “best of breed” supplier participants and partners enabled innovation, speed-to-market, scalability and lower cost to the consumer in a rapidly changing competitive global environment.

Of course, such value chain configurations face challenges in integration, coordination, visibility and dependency across an extended network of suppliers. Supplier issues with Boeing’s 787 development and production and the disruption of automotive and high-tech supply chains as a result of the natural disasters of 2011 in Japan are reminders of the risks of horizontal, extended supply chains.

The horizontal, extended value chain trend also has its exceptions. In contrast, some newer companies have adopted vertically integrated value chains to improve control and ensure development and production speed by minimizing hand-offs and dependency on outside suppliers.

Perhaps the best aerospace and defense example of vertical integration is SpaceX with its Falcon 9 rocket and Dragon capsule serving the international space station. Largely developed and produced “in house”, SpaceX has gone from start-up to a second NASA-sponsored delivery in the space of 10 years while building an impressive backlog of commercial launch business. Given the relatively low volume, high complexity nature of the space industry, however, economies of scale may be far less important in the space industry than in most defense sectors.

Another circumstance that may drive increasing vertical integration is declining defense demand. As large program demand declines and previously stretched in-house capacity becomes available, primes will evaluate whether to bring out-sourced capabilities back in house.

Here again is the question: Will increased scale and scope resulting from M&As enable agility and adaptivity via improved control and fewer hand-offs (such as the SpaceX model), or will they result in larger, slower moving bureaucracies that succeed only by gobbling up or crowding out competition?

In a budget-constrained environment begging for improved flexibility, the more successful M&As will be those that demonstrate characteristics of the former-not the latter.

Of course, the paradox underlying this discussion is the inherent inflexibility of the government acquisition process.

While constrained budgets and changing defense demands may mean the government customer is demanding better flexibility, the government acquisition process is far from being agile and adaptive. Rather, with few exceptions, the government acquisition process tends to be a “one size fits all” approach that is stuck in the old long development, long production, slow approval cycle of the past, which is a remnant of the Cold War when the principal adversary was a slow-moving centrally-planned economy.

In today’s world, cyber and non-traditional adversaries use low-cost and rapidly developing COTS-derived weapons to operate against us. Regardless of whether defense markets evolve towards the horizontal or vertical value chain model, the ability of the government customer to meets its needs by capturing benefits of greater value chain flexibility capabilities depends on the government buyers’ ability to adopt agile and adaptive acquisition processes and behavior-and accomplishing that feat makes M&As look easy by comparison.

Randall Garber is a partner at A.T. Kearney Public Sector & Defense Services.