It Might Be Time for a “War Dogs” Sequel

A remarkable report from the Pentagon’s inspector general released this week reveals that TransDigm Group, a parts supplier, “earned excess profit” on nearly every parts contract it made with the Defense Department.

Pentagon procurement officials responded to the report by vowing to seek $16.1 million in voluntary refunds from TransDigm, the approximate amount of excess profits on $26.3 million in contracts. TransDigm has yet to respond.

The report offers powerful evidence about TransDigm’s much-maligned pricing practices, which gained scrutiny nearly two years ago in a series of short-seller reports and news items targeting the company as the “Martin Shkreli of defense contracting.” More of a private equity conglomerate than a defense contractor, TransDigm uses mergers and acquisitions to corner the market on sole-source aircraft parts sought by the military; thereafter, critics attest that the company jacks up the price. About a third of TransDigm’s sales in 2017 were in the defense sector, according to the inspector general report.

Three Democrats — Reps. Ro Khanna of California, Tim Ryan of Ohio, and Sen. Elizabeth Warren of Massachusetts — requested the audit to see whether TransDigm was reaping excess profits in procurement.

Wednesday’s report shows that, well, yes, it was.

The inspector general reviewed 47 of the 113 contracts TransDigm made with the Defense Department between January 2015 and January 2017. “We determined that TransDigm earned excess profit on 46 of 47 parts,” the report states. One part yielded what the inspector general considered a “reasonable” profit of 11 percent. The other 46 ranged in margins from 17 to 4,451 percent.

Military procurement can be a mind-numbingly complex subject, but in general, procurement officers are supposed to analyze whether they’re paying a fair and reasonable price. This is often done through competitive bidding, but the overwhelming majority of TransDigm’s parts were sole-source, meaning that the company has an effective monopoly. Even in cases with a competitive bidding process, TransDigm was in many cases the sole manufacturer: The “competitive” suppliers all bought their parts from TransDigm before selling to the government.

TransDigm has also been accused by Khanna of creating the illusion of multiple distributors for a product, hiding the fact that the distributors are all owned by TransDigm. The inspector general did not fully address that charge, “because it was referred to the Defense Criminal Investigative Service for action deemed appropriate.”

Absent competitive bidding, procurement officers can ask the contractor for cost data so that they can apply a reasonable markup. From 2015-17, contractors were required to submit certified cost data in cases where the contract is over $750,000. But all TransDigm contracts except two came in below that threshold, evading the requirement.

This will only get worse. Congress increased the threshold to $2 million in 2017. The change was pitched as a way to “reduce administrative burdens” on private businesses.

For contracts below the threshold, procurement officers can request cost data. But contractors like TransDigm can simply decline the request. It did so in 15 of 16 cases; the only request honored was for a large contract, for which submitting the cost data was mandatory. That case, where the procurement officer received cost data, was the only one where TransDigm earned a “reasonable” profit, according to the inspector general.

Other TransDigm moves kept procurement officers in the dark, the report said. The company claimed that 32 of the 47 contracts studied were for items available in the commercial marketplace. Contracts for commercial items are exempt from cost data disclosure. But the inspector general determined that only four of the 32 items that TransDigm claimed were commercial actually were.

Procurement officers can also check against historical prices to test for price gouging. But just one inflated price snuck into a previous contract would increase the entire baseline. In 37 cases where officers checked historical prices of TransDigm parts, 34 of them were considered inflated, the inspector general wrote.

Overall, officers mostly had no way of determining whether they were overpaying for TransDigm parts. They did, however, urgently need the spare parts to keep aircraft in the sky and keep up with mission readiness. So they bought from TransDigm, giving the company the estimated $16.1 million windfall.

TransDigm is a relatively small Pentagon supplier within the $144.6 billion procurement budget. Penny-ante price gouging in spare parts, where the costs are relatively small on an individual basis and can get obscured in the total budget, fly under the radar. But if the practices are standard across the contracting space, the military may be squandering tens of billions of dollars.

“The audit’s findings clearly show that egregiously excessive profit was the norm on virtually all of TransDigm’s contracts and parts,” said the three Democratic members of Congress in a statement. The lawmakers have also requested a report from the Government Accountability Office on monopolistic practices in the spare parts market, “to see if there are more TransDigms out there.” That report is expected this summer.

TransDigm has made no comment on the inspector general report. The company’s stock, which had increased nearly 25 percent in the past month, dropped slightly on Tuesday, when news of the report broke, and fell again on Wednesday.

On a recent earnings call, TransDigm Executive Chair Nicholas Howley did obliquely reference the controversy, insisting that “there has been no allegation of any wrongdoing or illegality,” and that the Defense Department would be requesting “about $16 million” in voluntary refunds. Howley did not say whether TransDigm would pay the refund, only that it was “not a financial obligation of the company.”

In addition to recommending the refund, the inspector general wrote that the Defense Department should ensure that procurement officers get cost data when they request it, to help prevent the military from being gouged by suppliers. The report also called for better reporting when contractors deny requests for cost data, and additional studies to prevent unreasonable pricing.

The Pentagon agreed with all the recommendations. But in a letter attached to the report, a former director of defense pricing and Obama administration holdover, Shay Assad, wrote, “We need to look to other ways to address and combat the unconscionable greed exhibited by companies like TransDigm. The traditional recommendations of increased reporting and oversight, increased training, and revising departmental policies help but they do not get at the root of the problem. We will need legislative change to address price gouging and war profiteering.”

Assad, a former Raytheon executive, has been called “the most hated man in the Pentagon” for his aggressive scrutiny into what defense contractors charge the government. Only in Washington can you become “hated” for trying to save taxpayers from being cheated.

Fortunately for TransDigm and others like it, Assad has been reassigned. It remains to be seen whether Trump’s Defense Department appointees will ramp up scrutiny of procurement. Considering that the acting defense secretary was a longtime executive at major defense contractor Boeing, it would be an understatement to call this unlikely.