The Globalization of the Defense Industry

Sean O’Keefe,
Board Director,
Atlantic Council

Steven Grundman,
M.A. and George Lund Fellow,
Atlantic Council

William J. Lynn III,
Finmeccanica North America and DRS Technologies Inc.

1030 15th Street, N.W., 12th Floor (West Tower),
Washington, D.C.

Time: 11:30 a.m. EDT
Date: Tuesday, July 8, 2014

Transcript by
Federal News Service
Washington, D.C.

STEVEN GRUNDMAN: Good morning and welcome to the Atlantic Council. I’m Steve Grundman, the Lund Fellow for Emerging Defense Challenges here at the council, and I’m the producer of this Captains of Industries series.

Our purpose this morning – just barely made it into the end of the morning – is to hear from Bill Lynn, the CEO of Finmeccanica North America and DRS Technologies, who will make an address entitled “The Globalization of the Defense Industry.” Bill’s address will be the ninth event in this series, the purpose of which is to make available a pre-eminent platform from which senior executives whose businesses contribute to national security can address the public interests their companies serve and the public policies that shape these markets.

Bill exemplifies the kind of public-minded business leader this series is designed to feature. In a moment I will yield the podium to one of the council’s directors, Sean O’Keefe, who will make a proper introduction of Bill that substantiates my claim to Bill’s qualifications as a captain of industry. At the same time, Bill is also the ideal person to continue the conversation we’ve cultivated in this series about the future direction of the defense industry. I will briefly summarize where we’ve come from in this series.

We launched it in October with an address by Dave Melcher, the CEO of Exelis. That address was followed in the fall by one from Linda Hudson, who was then still head of the BAE Systems, Inc.; Ellen Lord, CEO of Textron Systems; Dave Zolet, who runs the Public Sector Business of Computer Science’s corporation; John Jumper, the CEO until Monday of Leidos; Tom Enders, not least, the CEO of Airbus Group; DynCorp’s Steve Gaffney; and then most recently last month the president and COO of Space Exploration Technologies, Gwynne Shotwell. So you have a daunting list of predecessors, Bill, behind you in this series.

So I want to take a minute to summarize the particular impetus for the Captains of Industry series and the logic of its home here in the Scowcroft Center for International Security, not least because General Brent Scowcroft is here today. Thanks for coming, General Scowcroft.

First, we recognize that the marketplace of the defense business is a vital thread in the overall fabric of U.S. national security and the national security of its allies and in the Atlantic alliance and partners around the globe.

Second, that vital business thread in national security has reached an inflection formed by the confluence of several contemporary changes and landscape of the industry: fiscal crisis; the fact that while rapidly receding for more than a decade of counterinsurgency wars, allied militaries now face new and even novel challenges securing peace and prosperity throughout the rest of the century. Not least, of course, there are the astounding advances in technology that are part of this sort of confluence of events forming this inflection.

And then finally, of course, it must be said that investors in the defense industry are sounding a new impetus for how companies tethered solely to defense budgets will create value against the headwinds of growth.

The Captains of Industry Series is an initiative of the council’s Scowcroft Center and a further expression of what its namesake, General Brent Scowcroft, had in mind for the center. The Scowcroft Center, whose director, Barry Pavel, is also here, right there on the front row – thanks for coming, Barry – it’s home to the council’s long-standing attention to NATO but now also to the regional and functional security challenges facing the U.S., its allies and partners around the globe.

As I said at the outset of this introduction, companies that design and build innovative products and services are an important part of the U.S. and allied response to the national security challenges our societies face. It is only fitting, therefore, that the Scowcroft Center should want to host a speaker series that features the voices of business leaders to address these very concerns from their perspectives.

Underscoring this rationale, I now want to invite to the stage Sean O’Keefe to introduce our featured speaker. A brief introduction of Sean I do think is warranted. He is a director of the council and indeed one of the council’s very best friends and advisors. His own business career includes service as the chief executive officer of the former EADS North America, today’s Airbus Group, Inc. He was a chancellor of Louisiana State University, administrator of NASA, deputy director of OMB, secretary of the Navy, comptroller of the DOD, and once upon a time staff director of the Senate Defense Appropriations Committee, where I’ll bet he and Bill first met once upon a time when Bill served in the Senate.

Among a long list of advisers and supporters who we here at the council have to thank for its growth and prosperity, Sean O’Keefe’s contributions surely stand out. Thank you, Sean. Thank you for coming here today and introducing Bill. (Applause.)

SEAN O’KEEFE: Thank you, Steve, for that very gracious introduction of the person who is going to introduce the speaker. I mean, I feel like I’m, you know, standing here between you all and the main event. But I want to commend you again, Steve, for the production of the series. This is a really remarkable opportunity, I think, to hear from a wide range of different backgrounds and interests but all common within our industrial sector, and the challenges that are faced across the board with different perspectives but at the same time all very informative, and I think today will be no exception to that particular case.

Bill, I’ve got to tell you that the Atlantic Council wanted you to attend this and participate in this effort and deliver this talk today so very much that Steve went to herculean lengths to navigate through your impossible schedule to make this work. (Laughter.) And I commend you as well, Steve, for that perseverance because you’ve been successful. So we’ll work that through, but it’s one that really is quite a remarkable feat.

It is a real pleasure to introduce a gent that I’ve had the great privilege of working with over the better end of three decades. He’s a great friend and a guy that I’ve really enjoyed the opportunity to engage on a wide variety of different issues in our respective checkered past but one that always has been successful in that. Bill is one of those tremendous guys that, while you may disagree on issues, he is never disagreeable. And as a result it always made those challenges seem that much more conquerable. And I thank you, Bill, for that great privilege of being able to do so.

He now, as you’ve just heard, is the chairman and CEO of Finmeccanica in North America and DRS Technologies, a post he’s handled now for the last couple of years, and in typical Bill Lynn style did not come in while no one noticed. He arrived and immediately took the challenges of an extensive reorganization of the company and has really turned it into a very, very strong competitor within the market space.

His background, as you heard very briefly, is a combination of both public sector as well as private sector leadership experiences. Most recently, before arriving at DRS Finmeccanica, he was President Obama’s deputy secretary of defense from the point of inauguration of the first term until late 2011. He served under Secretaries Bob Gates and Leon Panetta, and managed in the course of that challenge the better end of 3 million folks and oversaw a budget of better than $700 billion a year.

During his tenure, most, I think, remarkably, he personally led the department’s efforts and initiatives in dealing with and wrestling with the challenges we now see much more fulsome described of cybersecurity, of space strategy and of energy policy, all three of which were real cornerstones of Bill’s tenure there in this administration during that time.

During the Clinton years he served as the undersecretary of defense/comptroller towards the latter end of the second term, as well as – and from the first term forward, he was the director of program analysis and evaluation in OSD, which is now part of the comptroller’s office. So he managed to pull all the jobs together and make them one, of course.

Prior to his service in the Department of Defense, he served for six years on the staff of Senator Ted Kennedy, as a liaison to the Senate Armed Services Committee, and yes, Steve, that’s precisely where Bill and I met, in my capacity at the time as the staff director on the Defense Appropriations Subcommittee. I now look back on that and wish I had been nicer to him during the course of that time – (laughter) – and had granted some of the requests he came in with that, at the time, seemed a little bit off but by all means they certainly look a lot better now.

Before joining Senator Kennedy’s staff, he was on the professional staff of the Institute for Defense Analysis (sic; Analyses) at CSIS. From the early part of the last decade he served in industry as the senior vice president for the Raytheon Company, after having spent time as the vice president of DFI International.

He is a graduate of Dartmouth College. He has a law degree from Cornell. He has a master of public affairs from the Woodrow Wilson School at Princeton University. And his publications – in addition to his leadership credentials here of both public and private sectors, he’s an accomplished author of “Toward a More Effective Defense,” numerous articles in various newspapers and professional journals. He’s been recognized for numerous professional and service contributions, including the Distinguished Public Service Medal for the Defense Department on four occasions, the Joint Distinguished Service Award from the chairman of the Joint Chiefs of Staff.

And in the two short years, I believe, that Bill has returned now to the private sector, he’s established himself as a real industry leader. The challenges that he’s taken on now as a director on the board of directors of the National Defense Industrial Association is to continue to work through the issues that this administration introduced for export control reform and working that now as – on the side of the occasion dealing with industry concerns – that affects all of the industry players and participants here in the United States, regardless of where the companies are chartered. As a proxy company, DRS/Finmeccanica North America, of a foreign parent, he deals with all the regulatory challenges that frankly don’t affect most of the other competitors in the market space. And this is a challenge that I’m acutely familiar with myself by virtue of past experience, and I think we’ve spent an awful lot of time working through some of those challenges and, I would say, always very successfully.

Today Bill is going to focus, though, dominantly on – well, very nicely puts up a chart – to describe the globalization of the defense industry. And it really turns on the question of how dramatically the commercial market space has introduced new technology and technology development efforts that are now becoming more dominant as requirements within any defense industrial capacity. And as a result, today better than a third of all of the contracts the Defense Department lends are towards commercial or international companies. So it is a changing industrial environment and a changing market space that the U.S. government has been posed with.

It poses great opportunities, but it also has great challenges, as well as a – important implications for the U.S. industrial base and its ability to transform and adapt to respond to those kind of circumstances and become as competitive as we need to be to maintain that industrial capacity.

So I think we’re going to hear uniquely from a gent who has seen this every corner and direction of those challenges that we could possibly have invited. So again, Steve, I think it – commend the Atlantic Council for the invitation, and I hope that you will all please join me in welcoming my friend the honorable Bill Lynn. (Applause.)

WILLIAM LYNN: Thanks very much, Sean, for that – for that very gracious introduction. As Sean said, we’ve for the past 25 years worked together and probably more often in kind of alternate administrations, as I’m leaving or as – probably Sean’s leaving, he’s handing me the baton, I’m giving it back to him, on usually Inauguration Day. (Chuckles.) It – but through all that, Sean’s been a terrific friend and a great, great counselor, and I very much enjoyed working with you.

I’ve had almost as long a relationship with Steve. Steve first joined the team at PA&E back in 1993. We were in something of a similar state back then, as the defense budget was uncertain and moving down. It was an unstable world. We had the benefit then, though, of both – it goes back to Sean and I as – we were able to look back and blame Sean for what he’d left. Sean in his speeches was able to blame us for wrecking this great product that he had built. It was kind of mutually serving, in that sense.

But I am particularly honored to be here at the Scowcroft Center, and it’s an especial honor, General Scowcroft, for the named individual for the center to be here, someone of your stature. It’s an honor.

I did a couple of months between the Defense Department and moving to DRS/Finmeccanica – I did some public speeches, talked to some of the speaking agencies. They said you’re supposed to start with a joke. I’m not quite sure they meant for defense nerds to do that, but nevertheless, I want to start kind of a setup there of – it’s a – it’s a joke about baseball, and it really goes back to my youth, growing up in Connecticut.

There were a couple of older gentlemen who I knew and who were great baseball fans, and that was really the centerpiece of their life, and their relationship had always been – they’d grown up playing Little League and then college ball. They’d gone to the University of Connecticut. Both had been pitchers. As they fell out of playing, they watched games and really pretty much every evening during the summer they’d sit down and watch their favorite team, the Yankees, hopefully win, but not always.

And they – that was – as they got well on in years they realized that this at some point was going to end, and they started – they made a little pact. The pact was that whoever went first would go to heaven and answer the most important question they had, which was could they continue playing baseball in heaven.

Well, sure enough, one of them passes. That evening, after the funeral, the surviving one is lying in bed, and an apparition appears, and it’s his friend.

He goes, great, you’ve held to the pact. You’ve held to the deal. What’s the answer? Baseball? No baseball?

He goes, well, good news/bad news. Good news is that indeed there is baseball in heaven, and it’s fabulous. They’re – you know, great weather, all-natural turf, none of this astro crap, and you get to play with the greats. You get to play with DiMaggio, Mantle, Whitey Ford. They’re – it’s just great.

OK. Well, what could possibly be the bad news?

Well, you’re pitching tomorrow. (Laughter.)

So the – this – and that went OK. (Laughter.)

So this is a little bit of a good news/bad news talk as well. The good news is we still clearly have the strongest industrial base, the best technology, the best-equipped force in the world. The bad news is, given the external environment, given the budget situation, given the way that technology’s developing, we won’t be able to retain that edge, retain that lead, I think, unless we take steps, and the steps I want to talk about is, in particular, within the industrial base what – what’s going on, how does the Pentagon adapt to the changes. I think it’s not going to be able to stay with the industrial structure it’s had today. I’ll try and describe where I think that structure’s going and then talk a bit, leading into the questions – I’m very interested in your views – on how does the department and industry adapt to these changes to maintain that edge that has been so critical for decades, going back into the last century.

Let me start – if you’d go to the next slide, let me start with setting the budget landscape here. This is a traditional chart Steve and I used going back to PA&E. It shows in real dollars the ups and downs of the – of the defense budget. Many of you understand this. Well, let me make a couple of points.

One, we’re essentially at fifth inflection point of defense spending since World War II. The first three occurred after conflicts, after World War II, after Korea, after Vietnam. The budget rode up during the conflict, rode down afterwards.

The fourth one occurred in the – in the Reagan years, and it was not the result of a change in conflict. Initially was a result in a resource change. As the – as the budgets tightened in the mid-1980s, the legislation led by Senators Gramm, Rudman and Hollings was introduced, focused on budgets, and that started to bring the defense budget down. And then in the late 1980s, of course, we had the end of – the fall of the Berlin Wall, the breakup of the Warsaw Pact, the end of the Cold War. That accelerated that decline, which we didn’t come out of until the middle end of the Clinton years and then of course the ramp-up now for the war on terror and the conflicts in Iraq and Afghanistan. And we’re now starting – we’re more than starting; we’re back down off that.

What you – one thing you should notice: Despite all the – you know, the attention to, you know, how low the defense budget’s going and sequestration, if you look at where we are now, relative to where we were in just before 9/11, we’re actually about $100 billion higher. We were around 400 billion (dollars) in constant dollars in 2000, 2001. We’re now around 500 billion (dollars).

So – now we’re not assured of staying there, although I think you’re starting to see – it’s not – a flattening out; I think the Murray-Ryan agreement helped, although obviously we’d like to see, you know, more of a multiyear agreement. I think that it’s also a different time. The political character is different in a – in a couple ways than it was in the early ’90s. In the early ’90s, if you remember, there was a – the whole debate was dominated by the phrase “peace dividend.” And what that meant is people, particularly Democrats, were looking to spend defense resources on other national priorities, whether it’s education, health or whatever, and there was the thinking that you could shift resources – I got involved in the ’92 presidential campaign – every presidential candidate had his peace dividend. That was – that was the – that was the motif back then.

You don’t see that as much right now. You don’t see a lot of talk about diverting defense resources to other national priorities. There’s a lot of talk about sequester, but that’s a little bit different. That’s more budget-driven. It’s more deficit-driven. It’s not – so it’s not a priority shift. Countering – so I think there’s less gravitational pull on the defense budget in that sense, particularly from the left side of the political spectrum. The countering shift, though, is on the right-hand side – mostly on the Republican side – support for defense, I think, is not as strong as it once was. I think in the – in the tea party and some of the other newer groups, deficit reduction has started to trump maintaining defense. So there’s a tension there.

So there’s not as much pull-down from the left, there isn’t as much support from the right, but right now there’s, I think, an uneasy stability.

But I don’t think we’ve seen quite the full impact of the reductions that were – that are already in place and that they – because of the instability in the budget, the Pentagon has been slow to program the reductions in the out-year, and you see it most recently in the manifestation where the Pentagon kind of has two budgets. They have a BCA budget and then they have a budget that’s about 25 billion a year higher, hoping that the sequester will be partially repealed.

The challenge of that in the Pentagon, as General Cartwright knows well, is that you never make a hard budget decision in the Pentagon until you have to. And so as long as there’s – you know, as long as it’s out there that it might be a little bit higher, we have, I think, tended to hold off on the hard decisions. You see it with, you know, like the aircraft carrier force structure – that decision is deferred. The Army would defer the most extreme end-strength reductions. And the – and the hope is that the money will show up in the end. And, you know, of course, we’d like to see those things; we would like to see that money show up in the end. The danger is that, though, the department needs to plan on a long-term cycle and if it doesn’t show up it actually makes things worse.

So if you go to the next (chart ?) – so the budget situation is – has some stability, although it’s not – we haven’t yet seen the full impact. The challenge is: The Pentagon’s needs are not declining.

We don’t face the same kind of challenges we faced in the Cold War, but it’s different than, I would say, the early ’90s. And the span of challenges that we face right now is much broader – both geographically, but also in type. We now face challenges across the spectrum of conflict, from the prospect of, you know, possible, you know, peer challenges over the coming decades in Asia, to the other extreme of terrorists challenging us in Asia and the Middle East and elsewhere.

At the same time you’ve seen, I think, a trend in warfare where – the tradition where lethality used to track the sophistication of the adversary is much less true. It used to be that large nation-states had the most lethal combination of equipment and technology. There’s still some tracking, but it’s not as great. We see it –you know, maybe the most dramatic manifestation was IEDs. You know – you know, fertilizer bombs can defeat our most sophisticated armor. You see it as well in – you know, a little bit more sophisticated, but counter-strategy area denial, anti-access strategies don’t require the same level of technology as – that we deploy to counter them, and so there’s an asymmetry growing there.

And then, finally, in a world – I spent a fair amount of time in the department – cyber is – it doesn’t require the same kind of resources as other major technological developments, and, I suggest there’s it’s the fifth domain of warfare, and I think indeed it is in the sense that it’s a space that we need to be able to operate in, we need to be able to defend, but the development of weapons in that era, the – is – doesn’t require either the resources in terms of personnel or in terms of dollars to develop very, very destructive capabilities. And I think that’s something we haven’t really seen come to yet full fruition, but there’s a trend that we’ve seen where the – you know, the original – you know, five, 10 years ago the focus was on exploitation. We called them attacks, but they were really thefts. It was theft of information. Now we’re seeing more disruption where you see denial-of-service attacks and – you know, on banks, on other commercial entities. But the – we haven’t seen too much of it, but the capability exists for actually true destructive attacks that you could – you could destroy equipment, you could destroy things, you can kill people with cyber. I think we should anticipate that that’s indeed where cyber will go, because the unfortunate history of warfare is, we’ve never developed a weapon we haven’t used, and so I think we – I think we have to develop a strategy that works to counter that.

And that’s – you know, that’s where industry comes. If you go to the next slide – I want to start down a little bit of a path here to set this up and talk about the history of our defense industry. And the first 150 years – really from the Revolutionary War right to the onset of World War II – we relied on an arsenal and shipyard system. It wasn’t – we didn’t have, really, a defense industry at all. We had government-run arsenals, government-run shipyards that we supplemented in wartime with commercial operations. And it was – it was parallel to the way we did the military itself. We didn’t really have a standing army, either. We mobilized to fight a conflict and then we demobilized. It was the same, essentially, with industry.

In World War II – if you go to the next chart – World War II, the sophistication of the technology that was required, the scale that was required meant that the old system just didn’t work, and in quite an amazing feat – in the space of just a few years, the government under President Roosevelt and Secretary Stimson built a industry structure largely relying on commercial, whether it was, you know, the car companies – the automobile companies or other sectors – each of them shifted. Either they shifted some of their technology, shifted some of their – some of the – most or all of their production lines to the war effort and, obviously, that won World War II, but the structure itself also stayed. We did not go back to the shipyard/arsenal system at that point. We then retained, essentially, this conglomerate structure where most of the major industrial leaders in the United States had a defense division. As I said, it started with the automobile companies, really, but then, you know, General Electric, IBM, all of the others developed varying size of defense sectors. And they were attracted, I think, by the – you know, the R&D spending in the government, by the long production lines and, sometimes, the countercyclical nature of the – of the defense industry to some of their other industries. All of this led to the structure.

This structure lasted – the first one lasted about 150 years. This lasted about 50 years, till the end of the Cold War, that fourth inflection point, and that led to a third defense-industrial era. If you go to one more chart – what happened was – you’re all familiar, I’m sure, with the Last Supper, where Les Aspin and Bill Perry called defense industry in, in 1993, and, essentially, laid out – and, actually, Steven, I, at PA&E, did a bunch of the chart showing, here’s how many production lines we have and here’s what we think we can support in various sectors – and put it to industry that there was going to have to be some internal consolidation if we were going to maintain the strength of the industry with these – with these lower budget levels.

Now, of course, you can’t read all the little lists there of companies, but that’s OK, because they’re all gone. What came out of this was the, you know, five – and you could add BAE to this as they grew – large defense first-tier companies, and they really became, whereas the prior era they were conglomerates, these are now defense specialists.

So you ended up with – if you go one more chart – you ended up with something that looked more like this, where, with the exception of Boeing with its aerospace, General Dynamics and Gulfstream, and then UTC, which, I think, retains the nature of a true conglomerate – it’s really defense – the defense industry – the top-tier of defense industry was dominated, now, by companies that existed before, but they didn’t have the dominance – Lockheed, Boeing – Boeing took McDonnell Douglas, and so on. So we have this much smaller group of structure – of companies.

At the same time, over time, if you go to the next chart, the clout of this industry which had been very, very strong through the – you know, the ’70s and ’80s, started to decline as just somewhat of a natural – both a demographic trend and a financial trend. The size of the defense industry relative to the economy is falling, which is – which is what that shows; it’s now 3 (percent), 4 (percent), 5 percent of the economy down from the – you know, the 8 (percent), 6 percent in the Reagan years, 10 percent in the – in the ’60s during Vietnam.

And correspondingly, of course, the employee base is falling – you know, if I put the – I don’t have the employee numbers, but if I put them up there, they would have the same trend, and that – you know, that translates as well into clout with Congress. So we’re starting to see a world in which the defense industry is less important to the economy and less powerful in the – in the halls of Congress. At the same time, it’s not any less important to the security of the United States, so this is getting towards the message that we’re going to have to manage this sector, this structure if we’re going to maintain the kinds of advantages that we’ve gotten out of something that was larger economically before.

Another change, if you go to the next chart, is we’re not seeing the same level of R&D investment today as we did before. And in particular, relative to the rest of the economy, it’s been – it’s been shrinking. At this – over time, IRAD spending has been flat or declining while the rest of the economy has been investing. And so at this point, Boeing, Lockheed, Northrup, Raytheon and L-3 combined spend about $3 billion in R&D collectively. And if you see, that doesn’t put it on the chart – all of them combined doesn’t even put in on the chart of the top 20.

Now to be fair, that doesn’t include customer-funded R&D and defense is, much more than any other industry, in a – in a customer-funded R&D market, but I think it makes the point that the – it makes two points. One, we’re not investing in defense technology the way we were. It also, I think, starts to make the point that the technologies that we need are increasingly coming from outside the defense industry.

It used to be the case that, on balance, defense was a net exporter of technology. You’ll think of, you know, the GPS system, the internet itself – not to go down Al Gore’s path here – but the internet itself, what, you know, came out of ARPANET and DOD. So a lot of – a lot of technology was developed inside Defense and then pushed into commercial application. That still happens, but it’s – I think you’re seeing a more dominant move the other way, so you see, you know, 3-D printing, nanotechnology, the Cloud, autonomous vehicle technology, a lot of that is being done outside Defense, and so you need a structure that pulls it into the – into the national security arena and then operationalizes it for our military force. I think that’s going to be one of the key steps we need to take if we’re going to maintain that edge.

Just to make – footstomp the point, we’ve got one more chart here, just show that investment. If you do capital expense, which is basically R&D and some other capital expenses, basically been flat for, you know, a decade whereas – but the defense industry has been wildly successful in this period. They’ve generated a lot of cash, where’s it going? It’s been more to financial needs. It’s been dividends and buybacks has been where the uses of cash have gone.

I would, I guess, gently suggest that’s not a long-term strategy, it has – it has certainly been an effective short-to mid-term strategy in terms of the success of defense companies, but I think at some point – and you’re starting to see it tick up at the end and you’re starting to see some defense companies now start to talk about bigger investments they’re making. And they’re talking about making investments outside the defense industry as well. And I think both of those are things we’re going to have to push further.

Let me turn to the last part of this, go to one more chart. I – here, I’ve dropped my Pentagon motif. Normally, in the Pentagon – as Sean Hass (sp) know, what you do is you give three options. You give a ridiculous option, a hopeless option and then the one you want people to take. I’ve only given you two. One is kind of – kind of silly. It’s stay the course, we’re going to be static, restricted, protectionist. Obviously, we’re – this isn’t a fair setup.

What I think we need to do is three things. We need to look, frankly, at greater consolidation. I’m not sure we can maintain the structure we’ve had with the, you know, 20 (percent) to 30 percent lower budget, maybe more. I’ve been talking about commercial technology; I think we need to pull more of that in. And then finally, I’ll talk about the global – I think the coming global nature of defense. And let me – let me take each of those in turn, if you go to the next chart.

Consolidation. This is controversial at the Pentagon now, it was controversial when I was there before. There’s a pushback to a degree on that. I understand the pushback because you want competition, and I agree we do want competition, but I think in certain arenas we are going to have trouble getting it, particularly if we don’t go to globalization. I’ll talk about that in a second.

But you’re already seeing here in this chart here the percentage of competitions that are going with no competition. As you can see particularly in the Navy and the Air Force, they’re growing. And if I did – that’s I think in – this is contract obligations – if you actually looked at the Navy in terms of tonnage of ships, only 4 percent of our tonnage right now is actually competed, the rest is either sole-source or allocated.

So the – you know, in terms of shipbuilding, there already isn’t much competition. As we go down, you know, the aircraft, we – you know, the F-35 is the only aircraft in development. There are others in production, but how long is that going to last. Are you going to be able to maintain competition there? If so, how are you going to do it?

Competition does remain – and this goes to the commercialization point – in other areas, in robotics, vehicles, missiles, electronics, communications. And indeed – so I think when you’re thinking about consolidation, we may want to worry less about competition in the platform arena and focus more on competition in the other arenas, partly because it’s just a fact of life and partly because I think that’s where the future is.

If you go to that next chart, the second trend is increasing reliance on commercial technology. You can see just in the left-hand side there the last few years we’ve gone from about 10 percent commercial goods to about 30 percent in terms of the contract, and I think that reflects – a lot of that, I think, is IT spend, and that’s – but it’s more and more we need to pull in from the – in the commercial sector.

And then finally, I want to make the point on globalization, if you go to the third chart. The third trend is that we are seeing a more global defense industry, and I – that I would argue is a good thing for three reasons. I talked about this when I was deputy secretary. One is to have competition in many sectors. You only – you may only have one U.S. supplier but there are international suppliers. You’re going to get a better product with better technology at a better price if we have competition. We need to make sure that we have the – a global approach to this. It’s also not all the best technology is U.S. If we’re – if we’re going to compete, we need to take advantage of worldwide technology (not) just U.S. technology.

And then third, from a point of view of self-interest, in terms of – you know, you’d say, OK, well is the U.S. defense industry going to fight this, I would argue they should not because all of the major defense companies are talking about growth in international markets. If they expect to have those markets open, we’re going to have to have some access to our markets here. So I think there’s a self-interest part of that.

And as a final point here, I would suggest I think we’re moving down the same path as the auto industry, say, circa 1980 – ’75, ’80, ’85. If you – back – if you remember in those days it was basically unpatriotic to buy – you know, drive a European or Asian car. You know, you’re supposed to buy the big name plates of, you know, GM, Chevrolet and so on. Well look what’s happened now, if you go to the next chart.

This is a little bit complicated, but if you look, the top 10 most American made cars now, five of them have foreign name plates. The most exported car, the car in the – that has the most U.S. exports? BMW. Honda builds more cars in the U.S. than they build in Japan. This has become a truly global industry. It doesn’t mean you don’t have U.S. jobs – I mean, obviously, Honda, BMW, they are hiring U.S. people. But the name plate, you know, what the shareholder base of the company is, I think in the auto industry has become much less important. It’s the technology. You know, jobs remain important, but international companies have international production bases and I think that this is the kind of path the defense industry is going to have to go down.

Now, it’s not the same as the automobile industry. There are security requirements. We need to be able to protect technology in certain cases. If you go to the next chart, and I’ll close with this one – that – you – DOD – this is where DOD comes in. DOD is going to need to adapt. We’re going to have to move away from a Cold War export-control policy where it was kind of us and them – them being the Warsaw Pact, you know, us being the forces of freedom.

It’s much more – it’s a much more nuanced world. And, as I said, there’s many more technologies that are both in the commercial and defense space. So I think you have to be much more targeted about which technologies you want to protect. You may want to put higher walls around those more select few, but you need to, I think, have more freedom to export the ones that are commonly available if you want U.S. companies to compete in this globalized world.

So the bottom line is I think we’re moving into the fourth defense industrial base era. I think it’s going to be marked by more use of commercial technology. It’s going to be marked by a global – a more global industrial base. And I think you’re going to see shifts in the industrial structure that’s going to result in additional consolidation in the platform era, but retain competition in the supporting areas – electronics, IT, robotics and so on.

I think the challenge of industry and the department alike is to manage this. There I think we have two very good precedents. I think the government managed the transition in World War II extraordinarily effectively. And I think, actually, the transition from the – kind of the conglomerate era to the specialist era, you know, with the Last Supper and the other elements of the department then, again, I think we managed it. And the test of a successful management is that we’re able to retain our technological edge, our industrial base edge even as the sector itself shifted shape and structure.

Let me stop there and turn to however you want to do questions, Steve. (Applause.)

(Off mic.)

MR. GRUNDMAN: That is terrific, Bill. Thank you very much. (Break for direction.)

That is – that is exactly the kind of address that I hope for in the Captains of Industry series indeed – giving us some context and sharing with us not least your expertise about what’s going on in the Pentagon that effects industry. The one thing you didn’t talk about – actually, let me – let me set some expectations here: I’m going to ask a couple questions and then I will open the floor to questions from the audience. We will end pretty near to 11:45 unless we get into something really interesting. And – my colleague is signaling me from the background – we are streaming this event live over our website and those of you who are not in the audience physically here who might like to ask a question can tweet a question to #ACCOI and my colleague, if you ask a really compelling question, will bring me a slip of paper – or a really difficult question – and maybe we’ll enter that into the conversation that we have in just a few minutes.

OK, so what you didn’t talk about at all was Finmeccanica-DRS. So – and I’m willing to admit that I think particularly a U.S. audience is not that familiar with Finmeccanica. DRS Technologies, those of us around the industry know pretty well, but I’m sure there might be a lot to say about this, but what might you say about sort of the strategy of Finmeccanica in the U.S. as exemplified by its acquisition and operation of DRS Technologies?

MR. LYNN: Well, I think Finmeccanica bought DRS with the intent of joining in a significant way the world’s largest defense market. Finmeccanica has been, you know, a top 10 defense company for quite a while, but they did not have too significant a presence in the U.S. and they felt that to be a global defense company they needed a U.S. presence. DRS has provided that, both an organic presence – we’re, I think – (inaudible) – a proxy company. So we operate as a U.S. company, but we also have other operating companies – Alenia, Agustawestland – that are more European based. So Finmeccanica is going both down the path of organic U.S. competition as well as competing in the U.S. through its other brands –Agustawestland, Alenia, Selex, Oto Melara.

MR. GRUNDMAN: And I suppose in one respect your own company’s experience would be some kind of a test of the prospects for a more globalized defense industrial base. You both have alluded to the vagaries, such as they are, of running a foreign-owned company in the U.S. What’s it like? Is it a – let me try (and caption ?) the question: Is it an open and welcoming market? Is it too hard? Does it need to get better? Is it good enough? Where are we on that?

MR. LYNN: I mean, I think it’s evolving. It’s kind of why I went with the auto industry. I think there was more chauvinism before. I think as you see the value of European technology – as I said, kind of the global nature of the defense market and the desire of U.S. companies to compete overseas – I think that that market is opening. You have to compete here through security structures, which add a layer of cost – but it makes it a little bit more difficult, but not insurmountable. I mean, Airbus, EADS has been successful with some of the helicopter competitions. BAE has been very successful in the U.S. We hope to follow that path at Finmeccanica.

MR. GRUNDMAN: Yeah, I mean, my own observation is it seems – it seems possible for a foreign-owned company to make a play here in the United States. It’s not easy, but then again, it’s not easy for some of the U.S. competitors to gain and retain their foothold after all.

The last question that I will exercise some prerogative to ask goes back to the beginning of your presentation and maybe in some sense back to our mutual days at PA&E. And it is a bow wave question. My observation is – and I’m interested in your reaction to this – is that from this point in time, yeah, we have a bow wave, perhaps incited by that $25 billion that the administration is hoping yet might materialize with relief from sequestration. But that, as compared to, say, 1992-’93, the bow wave is a lot smaller. And therefore, from industry’s point of view, the likelihood of perturbation is probably smaller. Am I right? Am I wrong? Is it something in between?

MR. LYNN: I think that’s fair. I mean, both – I mean, one, the base budget itself is bigger than it was in ’93 and the investment budget in particular is bigger. It’s, you know, 150 or (1)60 billion versus, you know, two-thirds of that. And I think you’re right. The bow wave – the base is bigger, the bow wave is smaller. So the challenge is a little bit less, but I would argue the challenge still remains. We’ve got more program than we’re likely to have budget. So I think there’s going to still be some fallout, you know, over the next couple of years, whatever the – whatever the final budget numbers are.

MR. GRUNDMAN: OK, thanks. OK, so I would welcome questions from the audience, or, again, online. And we have a really terrific audience here that I would expect to get some great questions from. Right there in the back row, please. This portion of the event is – actually, the whole portion of the – the whole event is full public, on the record. So before you ask your question, identify yourself and where you’re from.

Q: Sure. Tom Oakley. I work with the National Economists Club and also an Army Reserve officer. I’ve got a question in terms of globalization as it relates to a lot of the protectionism we see as well right now. I know we’ve seen TTP and TTIP and so there’s a – seems to be a reluctance to give up some of these cherished industries as well as –when (you ?) looked overseas, if you look at India, they have very high offset requirements. And so just like to know, how do you address that issue? And how do you go forward with dealing with those things? And following in that – and not to be coy – is some of the corruption issues that follow with that as well when going overseas. Thank you.

MR. GRUNDMAN: Well, there’s always – both in this country and in – overseas, there’s always a natural defense of home jobs and home industries. And there’s no, you know, magic antidote to that. I think what I’m arguing, and I think what others argue is, there’s a greater good over time – that if we’re going to get better technology, we’re going to get better prices for the taxpayer and, indeed, we’re going to get more jobs, which that parochialism tends (to work ?) – over time, we’re going to get more jobs. The challenge is the jobs might not be the same. In other words, you know, a plant might close and bigger plant might open. That’s not necessarily great consolation to the people in the plant that closed, particularly if they’re not nearby to the plant that opened. So there’s always a political transition that – and that’s – when I talk about the government, you know, managing this, I think, you know, the department is going to have to work with Congress to move down this path in a way that the – you know, the political bodies find acceptable.

MR. GRUNDMAN: There’s a question right here by the window. If you could just wait for the microphone to come over, I would appreciate it.

Q: Robert Sherretta with International Investor. Last week I attended an event that focused on nanochips. We all know that the kind of chips are – that can supply GPS and other data are getting increasingly smaller – or diminishing in size, I guess I should say. I saw some demonstrations of chips that were so imperceptible – well, let’s just say they could be attached anywhere. Some of them now were just devices that could be detected as a – as – let’s say a part went by a reader that any agent or someone could be in the vicinity of. How in the world are you going to stop that kind of technology from being embedded in devices that are coming from all over the world in order – in the subcontracting that’s involved here?

MR. LYNN: Well, you know, I think maintaining the integrity of your supply chain, which is really what you’re talking about, is always going to be a challenge. I think the one technique that’s not going to work is to try and build a fence around everything here in the U.S. and source everything here under guard. You know, there may be – there may be some specialized technologies that’s exactly what you want to do, but the broad sweep of technologies that we need, I think you’re going to have to do global sourcing. So you’re going to have to deal with the fact that somebody might be able to get inside your supply chain. So you’re going to need basically checks and balances against that.

There are companies that already – I mean, Microsoft and some of the IT companies are actually already very good at that – at that kind of thing, and they do things like randomization of where the parts are going to go. So when you’re building, you know, that nanochip in – offshore, you don’t know whether it’s going to go in the Joint Strike Fighter or it’s going to go in a microwave oven. And so you can’t – that’s just one technique, but, you know, and then you need – you know, you need, you know, random testing, you need – there’s a whole series of techniques, none of which are going to be perfect, but I think you can establish enough security.

And as I say, I use the IT companies as an example. I think it’s possible to do this, and – but I think it’s misleading to think that, OK, well, we can just protect it by putting our – you know, our arms around it and we just – we’ll just guard everything we build here and we just won’t let anybody in to see it and touch it.

MR. GRUNDMAN: I think it would be fair to say – right? – that this is almost a mindset issue about security of supply and about, frankly, defense technology that we’re going to have to change in order to allow for more commercial and global sources of supply. It’s kind of –

MR. LYNN: Exactly.

MR. GRUNDMAN: You know, it’s a 50-year frame of mind that needs to evolve. Not to be flippant about it, but evolve from absolute protection to more like immunity, I’ve heard it described. OK. I have a question right there – middle of the second row.

Q: I’m Walter Stadler, with – currently with National Defense University Foundation, and we really appreciate your interest and involvement in that. The question I have is about what I see as a great advantage on the part of a number of European companies as we talk about consolidation in various precision industries, and that is the existence of an apprentice program by a lot of companies in Europe and Germany, where I’ve served, and U.K. and whatnot. This is not a simplified matter, but is very demanding and education and whatnot. And companies looking at the car industry and whatnot is – automotive industry companies such as BMW and whatnot have really done extremely well, and it’s partly due to the fact that they have this wonderful program.

What do you see as far as American corporations are concerned? Are they going to become more involved in this? And I know that there have been variants of that, but I would think that there is a definite European advantage, and I wonder if you could talk a little bit about that.

MR. LYNN: Yeah, I mean, I think we have a little bit different kinds of structures. I think Europeans tend to be more organized, heavier union content. One of the consequences of that, I think, is – are programs like apprenticeship. I think U.S. is more market-driven. There’s still obviously, you know, relatively presence of unions, but not as high.

There are – you know, we tend to have cost advantages in the way we do things with the market. I think you’re right that there are some longer-term advantages. There’s always a fair amount of talk of how we – you know, how do we manage the transition of the defense workforce as it ages; how do we, you know, pass along the expertise; how do we recruit a younger cohort to avoid that bubble moving through. I think – I think – I don’t have a magic answer. I think it’s harder for us. I think we get some advantages, but I think it’s harder for us to have that – to do that structural management than it is in Europe.

MR. GRUNDMAN: Question all the way in the back, please.

Q: Hi, Secretary Lynn. Michael Bruno with Aviation Week/Space Technology. The RD-180 engine for a very long time seemed to be a great example of the promise of foreign-sourced technology, and now it seems to be a bit of a case of peril. Can you describe or address how that example falls into greater globalization and foreign sourcing of technology?

MR. LYNN: Well, there’s always, I think, you – international politics isn’t going to disappear, and you’re going to have, you know, conflicts where nations have their interests that collide, as we’ve had with Russia and the Ukraine. And then there are – there’s a commercial fallout from that, whether it’s through sanctions or – you know, with the RD-180, it’s more kind of a move to kind of move away from that system.

I don’t think it’s that different than the commercial world. You don’t – because you have these, you know, political conflicts in the international arena, it doesn’t mean we don’t do business. We are going to have to do business, you know, that strengthens everybody’s economy. It leads to growth, the higher living standards and so on.

But you are going to have to manage your way through these conflict situations. Again, I wouldn’t – I wouldn’t say the way to manage is to abandon, you know, economic relationships with countries that can at some points be in an adversarial posture with us. So I don’t have a global answer beyond that we have to work our way through those. And they are going to come up. There’s no way to avoid it.

MR. GRUNDMAN: I do feel like I’ve avoided the left-hand side of the room here, so I’ll take a question in the second row and then come back over here.

Q: Thanks. Hi. Jacob Markish, Renaissance Strategic Advisors. Just to follow up on the interesting discussion around internal research and development investment and R&D, the stark contrast between the commercial world and the defense world, do you see that kind of ground as you look – whether inside Finmeccanica or at, for example, the European industrial base, which has traditionally had to rely more on their own investment rather than lots of government R&D, do you see a shift? Do you see more of an imperative at the corporate leadership level to invest more in internal R&D? How’s that playing out?

MR. LYNN: Well, the numbers bear that out. I think the European companies – Airbus, Finmeccanica, some others – have higher investment rates than some of the U.S. companies. I think it – it’s a complex equation. They tend to have, you know, government ownership that, I think, leads to different imperatives than a – than a – you know, a private – privately held or – shareholder-driven, which tends to drive you more to, you know, return-to-shareholder type metrics. So I think the European companies have had some advantages in that way in terms of protecting their investment accounts.

On the other hand, I think you’ve seen announcements from some of the U.S. companies that they are looking, you know, over the longer term both to increase their internal R&D as well as to invest through acquisition in some commercial technologies.

I wouldn’t say you – don’t think you should look purely at IRAD. I think you also have to look with – particularly when you’re doing some of those smaller niche acquisitions, those often are buying technology. That’s just as good a way of investing in technology as – in fact, maybe better, because you get the technology faster, at a more mature pace. So I think there’s some recognition in the U.S. market that that has to – has to move up.

MR. GRUNDMAN: I want to actually pull on that thread in order to draw in a theme that has been building over the course of this series, although I think the points of view on it have been varied. And the question is, is the customer – is the Pentagon – is higher IRAD, independent R&D spending going to become a competitive advantage because the customer is no longer – or not ever, right, but is going to be spending less on early-stage development. They want to buy stuff at the technology readiness level 8; they’re not going to pay you to develop it from 2. Is that – in other words, aside from general virtue, will IRAD spending become a competitive advantage because customers want to buy stuff that’s ready?

MR. LYNN: Yeah, but it’s not that crisp, I think. It’s – customer-funded R&D in DOD has been and I think will continue to be a bet. I mean, you have to bet that DOD is going to go where you’re investing. And if they don’t, then the – you don’t get any return on that investment. If you do, which is really the – if you do guess right, bet right, then you get the return you suggest, you’re ahead of your competitors, DOD can buy it faster and cheaper from you, and you can get that return on investment. But it’s becoming a more commercial – I mean, that’s what, you know, commercial companies have to do is they have to bet on the consumer market, and they get a return.

The challenge in DOD is in the – in the consumer market, if you bet and win, you get very high margins. In DOD, your margins are more constrained, and the bargain has always been, well, most of the R&D is customer-funded, so the risk is less, so the margin – the return is less. As you – as you invest more, that bargain starts to fracture a bit, and so you then look at, you know, should you allow higher margins in defense to promote that. That becomes a political challenge to defend. So it’s – I think it’s a complex equation.

MR. GRUNDMAN: Yeah, thus the varied opinions I’ve heard on this very question.

OK, to this question right against the window here, please.

Q: Thank you. My name is Clay Lowery from Rock Creek Global Advisors. I thought your presentation was excellent. I was wondering about translating it into a policy agenda type of thing. It goes to Steve’s point about – I feel like there is a bit of a cultural baggage that’ll be hard to overcome, whether it is export control reform, procurements issues, SIFIAS (ph) type of issues. How do you overcome what is a very risk-averse culture in order to get towards what I think you’re saying is where the market is sort of heading, so as policy people., how do you get your government agencies to actually go where the market’s going?

MR. LYNN: Well, I think you’ve hit on the big challenge. You know, what I’m trying to lay out in the presentation is that I think we’re at the cusp of a shift in – you know, I call it the fourth defense industrial base era. I don’t think we know all of the parameters of that. I think – I’m suggesting trends, globalization, commercialization, consolidation, but what exactly do we end up with, you know, a structure that’s, you know, a mix of specialists and conglomerates more than we’ve had? Do we have more, you know, monopoly suppliers? I think all those things are possible. And what are the government policies, which is where you’re going, that are going to manage that? And I’m going down the path – I think that’s what we need to identify and debate. I’ve got some ideas. As I said, I think, you know, we need to be a little bit more relaxed in our – or more targeted in our view of consolidation. Don’t just oppose consolidation; see what you can do to promote competition where you can do it.

I think, you know, we need the – you know, the – there’s always the cry for acquisition reform. I don’t have – you know, we’ve been – I think I was on the 129th study of acquisition reform, and there’s been, like, 12 since. You know, so it’s obviously a very hard problem.

What I would suggest on acquisition reform is you need to make that hard problem probably a little bit harder, in that the focus of acquisition reform is generally on keeping costs under control and staying on schedule. That’s what you’re trying – you know, so it doesn’t take you 15 years to develop a fighter and so on.

I would add a third goal, which is we need to lower barriers to entry. It needs to be easier to get into the defense market, whether that’s reducing kind of DCAA, DCMA, structures and processes or doing more commercial off the shelf. We need a – it’s as hard as cost and schedule. I’m saying it’s now as important because if you’re going to pull from commercial industry, you need to make it more inviting, frankly, than it is for commercial industry to compete.

So I think those are the kinds of ideas, but I’m looking for a debate that – you know, what I would hope is over the next year or two, we would develop a more fully mature set of those ideas and try and help government and – help the executive branch and Congress accomplish it.

MR. GRUNDMAN: OK, question right here in the second row, please.

Q: (Name inaudible) – CSIS. How soon do you expect cyberwarfare and robotic warfare to displace other kinds of warfare?

MR. LYNN: I wouldn’t use the verb “displace.” I think you’re – I think you’re already seeing that we aren’t going to have conflicts at this point without both, that both have become integral.

And it almost doesn’t matter what the size of the conflict. I think if we had a major conflict with a peer competitor, they both would be central in terms of technologies that would influence the battle, but you’re already seeing it – you know, obviously, you know, robotics in terms of, you know, counterterrorism operation. You see, you know, cyber has been used in, you know, Estonia, in Georgia, a little bit, to a lesser degree, but it was also used in Ukraine. If we had, again, a major conflict, I would expect there’d be some kind of cyber preamble to that conflict and then cyber would become part and parcel of – so I don’t see cyberwarfare or robotic warfare as a separate – you know, separate activity. It’s going to be – it’s – you’re going to have to figure out how does it integrate with the – with the rest of the technologies and the rest of the forces, and that’s where, I think, you know, the institution of the Cyber Command was critical for DOD because DOD – DOD is obviously a large, complex, hierarchical organization, and you need doctrine and training and, you know, rules of engagement. And they’re all kind of mundane things, but the Cyber Command is working their way through those things, so it’s becoming integrated through all of our warfighting forces.

MR. GRUNDMAN: Scott Harris, second row, please.

Q: Thank you. Scott Harris, a member of the council. Bill, as you know, a whole parade of Lockheed Martin and Northrop Grumman and probably (BA/BAE ?) Systems and other executives could have made that similar speech over the last 15 years, and in fact did, but my sense is they’re not making it anymore. My sense is that after the presidential helicopter went away, and MIADs (ph) fell apart in the U.S. market, and the tanker deal collapsed, that the big American primes decided to go back to the traditional model. And they say they’re going to make their business international. What they mean is they’re going to export to places like the Middle East and Asia, and they’re going to give up on international cooperation for a while.

So do you think they’ve changed their vision, just changed their tactics, or are they not understanding what you’re understanding?

MR. LYNN: I guess I don’t see as big a change. I mean, obviously you cited some examples, like, you know, take for example the T-X competition, the new Air Force trainer, all of the big primes are in it with foreign offshore-based aircraft. So you’ve got Finmeccanica’s Alenia is teamed with General Dynamics. Boeing is teamed with Saab. Northrop is teamed with BAE, with the Hawk and the U.K.-based BAE. And Lockheed is teamed with the Koreans. So I don’t – I think they’re making individual decisions on kind of what is going to be their best path to win a particular program, and that’s going to sometimes mean foreign teaming. It’s going to sometimes mean what you called the traditional model. I guess I’m making a different argument. I’m saying at a, you know, broader level, the trend – that’s where I kind of use my auto industry – the trend is, you know, over time, if you look at a longer horizon, in five, 10, 15 years, companies are going to be more, not less global. They’re going to have more locations in more countries. There are going to be more foreign companies with plants and jobs here than there would – than there are today.

MR. GRUNDMAN: I’m going to draw this to a close on that – on that question, which I think is a fitting capstone on your address and to the conversation we’ve been having here. Thank you very much, Bill, for coming. Thanks for your support, both to the council, Finmeccanica DRS as a member of the council, and to me. I appreciate it very much. Thank you all. (Applause.)