Europe’s defence industry. Revamping fortress Europe

Date: 21/06/03

Europe's defence companies are flying towards rationalisation

THE Paris Air Show this week seemed to be all about huge orders for Airbus wide-bodied jets from Emirates, Qatar Airways and Korean Air. But it was also an occasion for speculation about mergers in the defence industry. The Airbus orders are important for its 80% owner, European Aeronautic Defence and Space company (EADS). With its airliner division streaking ahead of America's Boeing, EADS is in a better position to work on building up its less successful military and space businesses: some 98% of the company's pre-tax profits come from Airbus. But with so many top Americans patriotically snubbing the event, transatlantic collaboration in the defence industry is becoming harder, just when Europeans most need it.

The big problem for European defence companies has long been how to break into America, which accounts for half of the world market for defence goods and is growing faster than Europe. America spends some 4% of its GDP on defence (some $400 billion is planned next year) while Europe spends barely half as much. The Pentagon's R&D budget will rise by 17% this year, and spending on new hardware will go up by 15%.

As America races ahead, the Europeans are left floundering. They could try to catch up on their own (unlikely without a big rise in defence spending and progress in joint procurement, along the lines of the Eurofighter). Or they could seek help from across the Atlantic. The British see American partnership as the answer; the French and Germans, inevitably, are inclined to consolidate and build a fortress Europe to match fortress America. In neither continent are foreigners completely free to own defence assets.

Even before the rift in relations between America and old Europe over the war in Iraq, there was much distrust in America about, for instance, granting the French access to defence technology, for fear that it would end up in dangerous hands. The only significant sales for the continental Europeans in America have been of helicopters and marine surveillance aircraft, which are in short supply because of America's huge homeland security programme to protect its coasts.

BAE Systems is the exception to the rule that Europeans cannot crack America. Whereas EADS and Thales, a big French defence company, have barely 1% of their sales in America, BAE has 21%, according to Nick Fothergill of Banc of America Securities. The British company's strength comes from subsidiaries acquired when it bought GEC-Marconi's defence interests in the late 1990s. Grouped under BAE North America, these have been run at arm's length from London for security reasons. But they ensure that BAE is taken seriously in America. It has a big stake, for instance, in the F-35 fighter project, likely to be the biggest military order ever, worth $200 billion.

On pain of exclusion

Philippe Camus, co-chief executive of EADS (a Franco-German-Spanish company), wants to buy Thales. It would help EADS build up its defence offerings, including the fancy electronics and systems integration that now account for so much value. But Thales dismisses any suggestion of a marriage. There are rumours of other suitors. BAE'S chief executive, Mike Turner, even let slip that a proposal to merge with Thales had been made by the French company's boss, Denis Ranque. Mr Ranque promptly denied this, and BAE back-pedalled. Relations between BAE and Thales have been strained after the French firm's design for two new aircraft-carriers was chosen by the British government in preference to BAE's. Although BAE won the overall contract, the design will be French.

There could be more troubles ahead for BAE. Last spring, it was outbid for TRW, a top American defence firm. This was partly because BAE's problems at home caused its share price to slump. The deal would have enabled BAE to join the inner circle and become a Pentagon prime contractor. But as there are no other American firms it could afford, BAE is now excluded from that elite.

Mr Turner makes no secret of the fact that BAE's future lies in America. There are constant rumours of possible mergers with Boeing or Lockheed Martin. Neither Boeing nor BAE denies that there has been talk: Boeing's chief financial officer, Mike Sears, even says Boeing is closer to BAE than to any other firm.

Would BAE be an attractive acquisition for Boeing? Its naval shipyards have suffered cost over-runs and delays. The latest rumour to be denied is that BAE might sell its naval yards to General Dynamics, a large American defence contractor that is big in shipbuilding and also interested in expanding in Europe. Such a deal could make BAE even more attractive to Boeing.

There are plenty of other questions about BAE's future. Its huge, long-running contract with Saudi Arabia, known as al-Yamamah, accounts for more than a quarter of its pre-tax profits, according to Mr Fothergill. But this is declining. The true financial performance of the firm is not easy to pin down, not least due to frequent surprise provisions in its accounts.

There are also restrictions on individual shareholdings, although this week Mr Turner said these did not amount to a barrier to being taken over. A merger could, however, go ahead only with the approval of the British government. If BAE were ever to land in the arms of Boeing, the British's company's one-fifth stake in Airbus would have to be sold, not least for antitrust reasons. Given Airbus's success, some analysts reckon that stake could be worth as much as $6 billion.

Who might buy it? EADS, obviously. But another potential buyer might be an American private-equity group. One such, the Carlyle Group, is nosing around the European aerospace industry in search of bargains. Les Echos, a French newspaper, has reported claims that Carlyle is an agent of the CIA, which probably says more about French anti-Americanism than about American activities. Carlyle is buying the aerospace arm of the troubled Fiat group, Fiat Avio, with an Italian partner.

On the eve of the Paris show, the French defence minister, Michele Alliot-Marie, said she was worried about American investors taking over defence assets in Europe, pointing to the recent purchase of HDW, a German naval shipyard, by One Equity Partners, an American investment fund. But Europe's defence firms must do something. It might be another five years before Thales and EADS combine - or BAE secures a future across the Atlantic. But one day it will happen.

Europe's defence industries are flying towards rationalisation.

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