A defence dream born out of necessity

 
By Alexander Nicoll

In December 1997 the leaders of France, Germany and the UK issued an unusual joint statement calling on their countries’ aircraft manufacturers to merge and create a company on a scale that could match US rivals. If talks revealed this week between BAE and EADS come to fruition, they will finally get their wish – but not by the route they intended.

Neither company then existed in its current form. What was then British Aerospace was working towards a merger with its German counterpart, Dasa, which was to be followed by a deal with France’s Aérospatiale Matra. But masterly negotiating tactics by the other big UK defence company, GEC, instead brought about in 1999 an all-British merger to create BAE Systems. The plan for a European aerospace giant to rival Boeing and Lockheed Martin was confounded. Furious, the continental companies retaliated by combining as EADS.
 
Today’s reversion to the original goal is driven by a decline in western defence spending – just as the consolidation of the 1990s was. The difference is that, this time, Europe could be leading the inevitable rationalisation. Spending by 23 European Nato members fell 7 per cent in real terms between 2006 and 2010; the fall is set to continue with reductions in the UK and a defence review under way in France.

The specific problem facing military aerospace companies is that there are no new European manned aircraft in prospect once the present generation of fighters – the Typhoon, Rafale and Gripen – ceases production. Governments have various projects for unmanned aircraft but any future production runs are likely to be small. This is a looming problem that will force changes in the industrial base.
 
Between them, EADS and BAE have significant businesses in other areas of defence – ships, helicopters, missiles, armoured vehicles, space. But they can obviously get better global market clout by shelving rivalries and making a combined attack on remaining budgets.

To make headway in Europe, however, they will need something from their customers: better co-ordination among governments on procurement, and especially on research spending to generate new technologies. Europe does not have a glorious record in collaborative defence projects, and this has often prevented companies from achieving economies of scale.

EADS, after uniting bits of the French, German and Spanish defence industries, found that it still had to deal with its government customers separately, limiting the scope for synergies. The 2010 Anglo-French defence treaty was a positive step, but needs to be given real substance – and perhaps Germany will now need to be added to the set-up sooner rather than later.
 
The goal for European companies remains, however, the huge US market. BAE has built a substantial business with the Pentagon, while EADS has a large Airbus customer base but has suffered setbacks in bidding for contracts, notably for an air-to-air refuelling tanker. The US is, to be sure, a declining market. About $500bn has been cut from planned defence spending over the next 10 years. If “sequestration” were to occur in 2013, a further $600bn of cuts would be applied over the same period. But America will remain a significant source of business.
 
Never an easy market for outsiders to penetrate, the US will become more competitive as budgets decline. American defence companies have been feeling the effects: over the past two years, Lockheed Martin has cut 26 per cent of its executive-level personnel. A new wave of merger activity seems likely. All the more reason, then, for BAE and EADS to combine their efforts. They will face regulatory hurdles, but in the past these have been overcome by security agreements that ringfence specific sensitive activities.

The Middle East, where BAE has a key market in Saudi Arabia, and Asia, which is forecast by the International Iinstitute of Strategic Studies to overtake Europe in defence spending this year, will also be important longer-term goals in which a combined effort would help.

But terms must first be agreed; and then will come the challenge of combining two very different corporate cultures. EADS is itself a case study in how difficult and time-consuming such a process can be. Given the 60/40 shareholder split that has been posited, the proposed tie-up could be viewed in effect as an EADS takeover of BAE. So the UK group’s shareholders will be coy as they seek to extract the best value. If they are won over, the result will be a deal that makes structural sense – even if it is 15 years late.
 
The writer is director of editorial at the International Institute for Strategic Studies and the editor of Strategic Survey 2012: The Annual Review of World Affairs
 
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