Mergers are industry’s best defence

Date: 07/01/1999

By Peter Chapman

WHILE most of the EU's captains of industry were tucking into their Christmas turkey or preparing to spend their new euro, heads of the continent's defence firms were on manoeuvres plotting the future shape of their sector.

They have been locked in a complex web of talks with rivals in an attempt to transform themselves through mergers and coalitions from a handful of national champions - medium-sized on the world stage - into an élite corps of one or two mega-firms capable of taking on the US giants Lockheed Martin, Boeing and Raytheon.

First off the mark was the UK's GEC. It declared last month that it was splitting its civilian and military activities to pave the way for defence deals with rivals.

The move, said the company, was designed to allow it to lead the consolidation of the international defence industry.

GEC then announced that it would form part of a merger of space interests with France's Lagardère (with which it already has a joint venture) and Matra, and Germany's Dasa. The new firm is set to become Europe's leading space company with revenues of €2.7 billion a year.

Soon afterwards, on 29 December, GEC also admitted that it was talking to British Aerospace (BAe), America's Lockheed and Northrop Grumman Corp amid market rumours that it was close to a deal with one of the trio.

In the same week, France's Thomson CSF also confirmed that it was in talks with GEC over a possible merger with its Marconi Electronics subsidiary. The French government has promised not to block the move and says it would reduce its 40% shareholding to 10% or less in order to see a deal go through.

If this venture goes ahead, it would create Europe's biggest defence electronics firm, with expertise in state-of-the-art technology for missile, radar and underwater systems.

Meanwhile, in the latest twist in the increasingly confusing defence talks saga, British newspapers claimed that BAe and German aerospace and defence giant Dasa had agreed the main details of an estimated €21-billion merger. This came after the DaimlerChrysler subsidiary had insisted that horizontal integration of the European industry was an urgent priority.

Press reports suggested that the British company would make up 60% of the new group under the emerging deal. But with Dasa likely to keep its block of shares in the hands of its parent company, the German-US firm would have a powerful say in the running of the merged defence giant. Shares in Daimler rose following the rumours that an agreement was likely.

The speculation that a deal was imminent forced the two to take the step of issuing an official statement, aimed at the markets, admitting that they were "talking to each other" but claiming agreement was some way off. Dasa added that it would continue talks with all its European partners once the Christmas and new year celebrations were over.

Behind this frenzy of discussions lies the belief that mergers make sound economic logic. Experts say the benefits of consolidation and further cooperation in defence are there for all to see.

Forget the theory of perfect competition in which hundreds of small firms offer the same product at a price none of them can individually influence. To compete with the big boys, size really does count.

Economies of scale are the watchword. Small-scale output of missile systems, helicopters, fighter jets and troop carriers is just not viable.

Research costs are massive, while the likelihood that competition will keep down profits and sales makes the defence market a risky business for individual firms.

At the same time, argue the champions of consolidation, governments which normally espouse the benefits of the free market must be ready to turn a blind eye to market concentration in this sector to enable Europe's defence industry to compete on a world level.

They say that the benefits of consolidation and cooperation have been underlined by the success of the European Airbus civil aircraft consortium which brings together France's Aerospatiale, Dasa, BAe and Spain's Casa.

By working together, the relative minnows of Europe first saw off McDonnell Douglas - swallowed up by Boeing last year - and then, during 1998, knocked the US giant off its perch by emerging as the leading supplier to the big airlines.

Individually, members of the Airbus consortium would have come nowhere. The lesson of the past 12 months is that together, they are a force to be reckoned with.

It is a lesson which the American defence sector has already learnt. Over the past five years, it has whittled itself down to just five aircraft and helicopter firms, three missile manufacturers, two tank and armoured vehicle companies, and a handful of warship yards.

Its market is worth an estimated €212 billion a year, with Boeing notching up annual sales of €47 billion in 1998 and industry number two Lockheed Martin achieving sales of €23.7 billion. The European market is tiny by comparison, with the big defence procuring countries spending around €100 million a year and with many more firms supplying the equipment they require. The continent boasts nine aircraft and helicopter manufacturers, ten missile-makers and more than a dozen warship yards.

Happily for the industry, EU governments fully support the consolidation route. The British, French, German, Spanish, Italian and Swedish have all signed up to a joint proclamation calling for consolidation of the European industry into a single 'European Airspace and Defence Company' (EADC), expected to be based around the existing members of the Airbus joint venture plus others such as Sweden's Saab.

Additional firms such as GEC and Thomson CSF may wish to join depending on the outcome of their own merger efforts.

But EADC - widely seen as the 'big one' and the most desirable scenario for the Airbus partners - would be expected to operate on a profit-making basis and have a wide shareholder base.

This makes the continued public ownership of France's Toulouse-based aerospace national champion Aerospatiale the key stumbling block, with firms such as British Aerospace and Dasa suspicious of compromising their hard-won reputations on the markets by tying themselves to Aerospatiale in its current guise.

It is frustration over the difficulties involved in creating the EADC which has sparked the current escalation in merger talks.

Executives know they must act quickly. But they also fear the clumsy shareholding structures which could emerge from an overambitious deal. That is why, according to industry analysts, a series of less ambitious deals is likely before the EADC dream is fulfilled.

The latest mergers are seen as a necessary precursor to the main event. This will come later when Paris matches its promises to take its state-owned Aerospatiale into the private sector with action. But the French government understands the risks of the company being left on the shelf facing a tough Dasa-BAe competitor.

If the Christmas frenzy of pre-merger talks is anything to go by, the defence industry is set to move a step nearer the EADC target by the middle of this year.

The NATO defence market - expenditure per capita in euro at 1990 prices

Source: adapted from NATO table, converted from dollars to the nearest whole euro

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