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The Defence Industryin the 21st Century

Thinking Global … or thinking American?

“With nine countries (andtheir collective industrialprowess) involved in itsdevelopment, the F-35 repre-sents a new model of inter-national cooperation, ensuringaffordable U.S. and coalitionpartner security well into the 21st

century” – Sources: Photograph byUS Department of Defense, Quoteby Lockheed Martin Corporation


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“With nine countries (and their collective industrial prowess) involved in its development, the F-35 represents a newmodel of international cooperation, ensuring affordable U.S. and coalition partner security well into the 21 st century” –Sources: Photograph by US Department of Defense, Quote by Lockheed Martin Corporation


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Overview

The end of the Cold War left the defence industry at a major turning point.Since the end of World War II, most countries had developed the idea that amajor feature of security policy was the Defence Industrial Base (DIB).Instead of converting car or bus production to manufacturing fighter aircraftor tanks in times of war, nations maintained their own defence industries,constantly ready to respond to threat. And nations knew where the threatwas likely to arise. The Cold War period offered that kind of certainty. Thishelped both defence planners and defence companies: clear priorities, longtime horizons and relatively stable programmes.

At the start of the 1990s, three years after the fall of the Berlin wall, the worldwas beginning to look very different. Defence spending fell by about a thirdin real terms between 1989 and 1996. The nature of warfare had prompted amove away from large arsenals of traditional weapons to new innovativeweapon systems promoting rapid deployment and extreme precision. Newshared risk and reward agreements and strategic alliances ranging fromconsortia to joint ventures were becoming increasingly popular to reducethe risk associated with major procurement programmes.

The defence industry has evolved dramatically as a result. Twenty four of the100 largest defence companies in 1990 had left the industry by 1998. Thosethat remained grew larger through a series of consolidating mergers. A morecollaborative international security community appeared to be emerging torespond to what were largely regional outbreaks of war.

What now? In 2005, the world has changed again, with regional conflict joined by international terrorism as dominant factors in security planning.

Defence spending is being adjusted to focus on more flexible, responsiveand mobile force structures with an increasing focus on logistics and life-cycle support. At the same time, unrelenting pressure on public fundsmeans new methods are being used to develop, acquire, finance andsupport defence equipment, including a determined effort to make wideruse of cheaper, non-specialised Commercial, Off-The Shelf (COTS) tech-nology wherever possible.

The defence industry is therefore again at a crossroads. It is under enor-

mous pressure not just to win work but also to ensure that, when it does, itdelivers on time and on budget – and ensure that what it delivers remains fitfor purpose throughout its intended lifetime. It is doing so in what is poten-tially an extraordinarily volatile international environment where the war in


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Iraq has raised major questions on the future of the UN, where the stance ofthe USA has left Europe divided and the world waits anxiously for the nextterrorist outrage.

In the following pages we have reviewed how the industry has changedsince the end of the Cold War and we discuss what has driven thesechanges. We focus in particular on two major issues: the continuing declineof the DIB since World War II and the consolidation of the defence industryfollowing the end of the Cold War. These are long term trends. This is a longterm industry.

We have also looked at the implications of these changes for contractorsand set out our view of what should be the five main elements of anydefence contractor’s business strategy. Taken in isolation, they are fairlystraightforward. Addressed together, they constitute a complex, sophisti-cated and radical change:

1. Maximising the value of the domestic national market

2. Investing in the right capabilities and partners

3. Developing international markets – especially breaking into the US

4. Securing scale and scope economies in an industry that discouragesintegration, and

5. Leveraging Industrial Participation and COTS technology within thesupply chain

Finally, we have speculated about the future and how the industry mightlook if current industry trends prevail. The choice would appear to lie some-where between two extremes that most observers would find either unpalat-able or unlikely. At one extreme, the US would dominate the supply of theworld’s arms completely and so effectively dictate when and where theycould be used. At the other, defence technology would flow freely betweenallies and no one nation would have the complete industrial capability towage war without the support of its allies. But, if both extremes appearextraordinary to us now, what will need to happen if another, more balancedvision is to be created?


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Source: Photograph by Sergeant Jack Pritchard © Crown Copyright/MOD, image from www.photos.mod.uk.


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Page 5

The Decline of theDefence Industrial Base (DIB)

The end of the Cold War left thedefence industry at a major turningpoint. Since the end of World War II,most countries had developed theidea that a major feature of securitypolicy was the DIB. Instead ofconverting car or bus production tomanufacturing fighter aircraft or tanksin times of war, nations maintainedtheir own defence industries,constantly ready to respond to threat.

The fall of the Soviet Union replacedthe established world order withuncertainty, increasing the pressure on

governments to make new decisionsabout preserving national security. Atthe same time, social, political andeconomic pressures have beenbuilding to reduce public spending.Sustaining a domestic defence manu-facturing capability – a DIB – obviouslyincreases a nation’s self-reliance.

However, it is an expensive attribute tomaintain and most governments haverealised that they simply cannot afford

to have an appropriate national capa-

bility in every area of defence. Theyhave responded in three ways:reducing the cost of maintaining adomestic industry, generally by privati-sation; actively engaging in the inter-national trade in defence equipment;and forming alliances and poolingresources with like-minded nations.

This is why the trade in defence equip-ment is such a vital component ofnational security policy. Put simply, itenables governments to adopt a moreflexible response to resolving the tradeoff between spending and security

(see Figure 1). Off-the-shelf importsare cheaper than an indigenousprogramme, while the acquisition costcan be offset by securing related oreven unrelated work packages fromthe exporter for domestic industry.Offset, or reciprocal trade, is now asignificant element of the internationaltrade in defence equipment. Successin developing export markets forhome-produced defence equipmentwill secure scale economies and there-

fore reduce unit costs.

Influence of

international

security & economic

alliances

Defence Spending

Political & economicpressures

Offsets

Defence

imports

Defence

exports

Trade in Defence

Equipment National Security

Source: PricewaterhouseCoopers LLP

Figure 1: Trading off national security and defence spending priorities

We should not be surprised then that

most governments actively supportthe defence equipment trade. This isthe role of the Foreign Military Sales(FMS) Program (sic) – and severalsimilar initiatives – run by the USDepartment of Defense and thepurpose of the UK Ministry of

Defence’s Defence Exports Services

Organisation (DESO). It is also why theworld’s largest defence exportingcountries maintain similar capabilities.


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Page 6

The US Department of Defense administers a variety of programmes to provide security assistance to selectedforeign countries. It describes such programmes as follows:

International Military Education and Training (IMET): This program provides military training to select foreign militaryand defense associated personnel on a grant basis. Individuals either attend military schools in the United States, orsubject-matter experts travel from the United States … to teach groups of individuals on a regional or bilateral basis.The Department of Defense decides the IMET funding levels for each participating country annually. The Departmentof Defense, through the Defense Security Cooperation Agency and respective military representatives in UnitedStates Embassies, administers the program. When individuals travel to the United States for training, course tuition,travel, lodging and living expenses are paid for with IMET funds. Countries can augment IMET funding (ie: pay fortravel themselves) thereby stretching their IMET account to pay for additional courses.

Expanded IMET (E-IMET): The E-IMET program provides specialized education and training in four key areas:defense management resources, military justice and human rights, civilian control of the military and cooperation

between military and police forces for counter-narcotics law enforcement. E-IMET management is identical to stan-dard IMET, ie: funded by the Department of State and conducted by the Department of Defense. Countries do notreceive additional funds for E-IMET courses.

Foreign Military Sales (FMS): FMS is the government-to-government channel for procuring United States defenseequipment, services and training as a total package. The Department of Defense manages FMS on a no-profit andno-loss basis. The advantage of using FMS is the total-package concept where purchasing nations obtain UnitedStates manufactured equipment along with the logistics support and training. Countries can purchase United Statesdefense equipment using national funds or by using Foreign Military Financing (FMF) grants.

Foreign Military Financing (FMF): FMF is a grant program that helps United States’ allies and friends purchase UnitedStates defense articles, services and training through the FMS program. … This program also purchases the training

package for countries participating in the United States-sponsored African Crisis Response Initiative (ACRI). Coun-tries receive annual allocations form the Department of State. The Department of Defense, the Defense SecurityCooperation Agency and military representatives in United States Embassies administer the program.

Direct Commercial Sales (DCS): Countries can also purchase United States equipment directly from the manufac-turer using national funds. The Department of State must grant license approval prior to purchase. DCS purchasesdo not include United States government-provided services and training. … Countries wishing to purchase UnitedStates military equipment coordinate with their respective military counterparts in the U.S. Embassy. The DefenseSecurity Cooperation Agency and the military security assistance representative at the United States Embassy assistwith purchases.

Excess Defense Articles (EDA): This is United States-owned equipment eligible for transfer to countries or interna-tional organizations after being dropped from United States inventories. These items either may be sold under FMS

or transferred on a grant basis to eligible recipients. The EDA recipient usually pays for transport and refurbishmentof the items. Because EDA equipment is decreasing both in quantity and quality, and the costs of refurbishment andtransport can be excessive, the program may have little use for most … nations. The Department of State determineswhich countries are eligible to receive EDA and the Department of Defense, through the Defense Security Coopera-tion Agency and military representatives in respective United States Embassies, manages the program.

Source: Department of Defense, 2005


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Page 7However, as one would expect,prudent governments will only tradewith like-minded allies and confeder-ates. Hence, the trade in arms hasbeen governed or constrained by acomplex network of internationalalliances and co-operative arrange-ments, addressing both economic andsecurity issues.

This is a principle feature of what isbecoming an increasingly complexinternational defence market. Thiscomplexity has been heightened bythe transfer of ownership of most ofthe world’s largest defence companiesto the private sector. One outcome of

this trend is that management teamsnow seek, above all, to maximiseshareholder value. Their goal is nolonger to preserve national security.They are driven by financial markets tominimise cost and maximise revenue.In an ideal business world, maximisingsales would mean pressing for openaccess to worldwide markets. It wouldnot involve constraints on exports

imposed by national security issues.However, in defence, this is a normalbusiness objective that cannot besupported by governments. They needto be careful about who they tradewith.

In 2000, on the wall of the company reception area at ElOp Electro-Optic Industries in Rehovot, just south of Tel Avivin Israel, was a brass plate bearing an inscription that stated that one of the company’s principal aims was to supportthe security objectives of the state of Israel.

ElOp is now part of an enlarged defence electronics group called Elbit Systems and, while primarily based in Israel,this is a US NASDAQ-listed company.

In Stockholm in 1996, Oluf Lund, then Chief Executive Officer of Celsius Group, a producer of naval submarines,armoured vehicles and defence electronic systems, sat in the company’s boardroom questioning what he saw asradical changes in Swedish procurement policy. He wondered how the company should be expected to maintain thenation’s defence capabilities with a reducing level of encouragement from his government in the form of continuingwork.

Celsius’s shipbuilding and armoured vehicles businesses were subsequently sold and, in 2000, Celsius itself becamepart of Saab, a listed company. Saab, in turn, is now part-owned by BAE Systems, a UK company listed on theLondon Stock Exchange. This pattern has been repeated in numerous states all over the world.

Defence companies have been encouraged to reject the notion that they owe support to the State – with the implica-tion, as Oluf Lund (and any other CEOs in similar companies) had been accustomed to believe, that the State wouldreciprocate. This notion is now perceived in the media as not just out of date but an excuse for inefficiency andwaste. Small wonder, then, that modern management teams are compelled primarily to seek to maximise value forprivate shareholders.

Business students and managementtheorists are familiar with the conceptof goal congruence – the alignment ofthe goals of each of a company’s

stakeholders – and the fundamentalimpact this has on company perform-ance. Achieving alignment between anational government’s security andspending goals and the businessobjectives of a privatised nationaldefence company has never been amore challenging task.

The international security structurethat emerged after the Cold War hasbeen described as a series of concen-tric circles that integrate a collection ofvarious economic and securityarrangements (see figure 2). It providesa useful framework for assessing howthe defence industry and governmentscan work together to maximise exportsales. They can do so in a co-ordi-

nated manner within a defined, inte-grated economic and security environ-ment. It can act as a guide toachieving goal congruence. The inner-

most circle constitutes the defencecontractor’s home market. This, likethe other circles, has changed sincethe Stockholm International PeaceResearch Institute (SIPRI) publishedthis figure nine years ago. Joint forcedoctrine is changing the character ofnational defence forces and theirrequirements. Their interaction withthe defence industry has also changedas privately-financed companiesbecome involved in funding equip-ment, taking on jobs previously carriedout by the military and providing facili-ties previously owned and operated bythe government.


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Page 8

Source: SIPRI 1996

1. National defence forces & alliances

2. Bilateral & multilateral security & economic arrangements & agreements

3. Security organisations & structures

Examples:1 Integration of South African Defence Forces; Australian-Indonesian security agreement.2 Arms control, disarmament, trade & economic alliances, eg: Wassenaar Arrangement, CTBT; EU, EMU.3 NATO, UN.

Figure 2: The Post Cold War International Security Framework

In addition, changes to NATO haveaffected the nature of the outsidecircle. NATO has expanded with theaddition of new members and now hasa working relationship with Russia.Tensions within the UN, in the wake ofthe second war in Iraq, have hinted atmore change. The European Unionhas developed a common defencepolicy, the European Security & Defence Policy (ESDP), and, while thishas already changed the character of

the middle circle, it remains to be seenwhether this will also bring about somekind of joining together in Europe ofthe first and second circles.

These shifts in the international secu-rity environment shape the marketdynamics in which defence companiesoperate. To be successful, they mustrespond to changes in the structureand culture of their national securityforces and support or reinforce theirhost government’s policy on interna-tional alliances, investing in the localDefence Industrial Base where neces-sary in export countries.

For US companies, this has meanttaking advantage of particular exportopportunities in the South-East Asia, Australasia and the Middle East. ForEurope and the UK particular, itmeans, right now, an increasinglypressing need to develop a closerassociation with the US market.

“Our Armed Forces will need to be interoperable with US command and control structures, match the US operationaltempo and provide those capabilities that deliver the greatest impact when operating alongside the US.”

Source: Delivering Security in a Changing World: UK Defence White Paper (December 2003)

For defence companies operating inthis changing environment, defencespending cuts have increased pres-sure on prices but national securityissues have tended to offset this insome areas of supply. In other words,governments have decided that theymust maintain certain indigenousdefence industrial capabilities in order

to preserve skills, technologies, jobs or

perhaps simply a guarantee of supplyin times of conflict. The effect of thesepressures tends to vary across thedefence portfolio. Ammunition supply,for example, is considered by mostcountries as an important local capa-bility, compared with combat aircraft,which most consider can be importedwithout severely compromising

national security (see Figure 3).


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Page 9Of course, spending pressures andsecurity priorities also vary fromcountry to country. The US alone stillmaintains a major presence across theindustry’s major segments of land, seaand air, together with a significantinvestment in the state of the artsystems capabilities (often referred toas the Revolution in Military Affairs or

simply RMA) that tie capabilities inthese domains together. Other nationsneed to prioritise the indigenous capa-bilities they wish to maintain as theytrade off cost and security pressures.These choices will affect the DIB. Ifthey are made explicitly, industry canadjust investment plans appropriately.

Cost pressure

Security pressures

High

HighLow

Source: PricewaterhouseCoopers LLP; Illustrative only

trend line

• Ammunition• Naval/field guns

•

• Armoured vehicles

• Combat aircraft

• Communications

• Reconnaissance

& surveillance

• Command

& control

• C 4 ISR

Underwater

systems

Figure 3: Cost/National SecurityTrade Offs

The trend is for cost pressure increas-ingly to dominate choices, with Euro-

pean governments apparentlydemanding fewer and fewer indige-nous capabilities. This favours indus-trial groups with the largest scale ofoperations. Since it follows that thebiggest defence spending countrieshave the largest DIB, then they willincreasingly dominate supply. Andsince it is by far the biggest spender– by 2006, its military expenditure isexpected to equal that of the whole ofrest of the world put together – theUSA is in the driving seat.

The message for management teamsin all this – apart from the obvious

opportunity for US contractors tomonopolise the industry – is that theywill fail to maximise value if they fail todefine accurately the businesssegment in which they operate. Arethey competing predominantly onprice, though life cost, performance, amixture of these, or something else?Similarly, governments can destroyvalue if, for example, procurementpolicy reflects a focus on cost or scalewhere differentiation based on adher-ence to the national doctrine is the real

driver.


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Source: Photo by photopool @ Ulrich Zillmann – Remnants of the Berlin Wall


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Post Cold War Consolidation

At the start of the 1990s, three yearsafter the fall of the Berlin wall, the worldwas beginning to look very different.Defence spending fell by about a thirdin real terms between 1989 and 1996.The nature of warfare had prompted amove away from large arsenals oftraditional weapons to new innovativeweapon systems promoting rapiddeployment and extreme precision.

Twenty four of the 100 largest defencecompanies in 1990 had left theindustry by 1998. Those that remainedgrew larger through a series of consoli-

dating mergers, prompted by threemajor factors that forced a major

restructuring of the industry as itadapted to a new, post Cold War envi-ronment.

Global expenditure on defencereduced significantly

In fact, according to the InternationalInstitute for Strategic Studies (TheMilitary Balance), following its peak in1987, world military spending (on R&D,equipment procurement, maintenanceand military personnel) fell by about athird in real terms between 1989 and1996, from around US$1,300bn to

US$800bn.

Country 1986 1996 absolute change

France 8 9 1 )

Germany 9 4 (5)

Italy 5 2 (3)

UK 11 7 (4)

US 101 48 (53)

Japan 8 8 0 )

Total 142 78 (64)Table 1: Change in Defence Procurement Spend: 1986–1996 (US$bn) Source: IISS

This decline was driven by the USA.Under President Clinton, it wasspending only half as much onweapons procurement in 1996 as ithad 10 years previously (see Table 1). As by far the world’s biggest spender,it was this reduction that triggered themajor changes to the industry world-wide. According to an Economist

Global Defence Industry Survey at thetime, Lockheed Martin managementsaid that it spent $2.3bn on rational-ising its many mergers. As a conse-quence, it expected to save $2.6bn ayear in cost savings. In fact, employ-ment in the US defence industrydropped to 2.1m from 3.9m in 1987. Additionally, profit margins rose fromless than 1% in 1992 to 6% in 1996.

While its Government’s dramaticreduction in spending prompted USindustry to consolidate and rationalise,it also stimulated a major US defenceexport drive. With its governmentleading the way, US contractorstargeted the major export markets inEast Asia, the Middle East,

Australasia. US government actionalso opened up markets previouslyconsidered off-limits like Latin Americaand even the former Soviet Union. Thispresented other countries’ defencecontractors, notably in Europe, withnew, substantial and aggressivecompetitors in export markets. Presi-dent Clinton explicitly made defence

exports a vital component of USdefence policy. To even have a chanceof being competitive in exports, Euro-pean industry had to adapt quickly.

Technology focus shifted

Changing defence requirements –driven by changes in the scale, natureand location of conflict – forced anadvance and shift in focus of tech-nology. Combined with an increasing

demand for “value for money” prod-ucts and a desire to maintain a tech-nical leadership position, this resultedin further cost pressures to maintainresearch and development capabili-ties. In spite of falling defencebudgets, the USA maintained expendi-


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Page 12 ture levels on research and develop-ment. So, while it began cuttingspending on defence equipment in1991, by 1998 the proportion ofprocurement spend on R&D hadreached 80%. In contrast, there was amarked reduction in R&D investmentin Europe from about half of allprocurement in 1995 to below 40%.Many countries realised that they no

longer possessed the scale or criticalmass required individually to support aviable domestic defence industry.

European defence procurementbecame increasingly collabora-tive

Europe was developing an increas-ingly collaborative approach todefence procurement, typified byprogrammes like the Eurofighter

Typhoon (the German, Italian, Spanishand British combined effort to developa multi-role combat aircraft), Horizon(now a Franco-Italian venture to createa new generation of frigates) and theMRAV (the German, Dutch and Britishproject to develop and supply a multi-role armoured vehicle). France,Germany, Italy and the UK also formeda common procurement agency, theOrganisation Conjoint de Cooperationen matiere d’Armement (OCCAR), for

managing such programmes more effi-ciently. European contractors werecompelled to collaborate across inter-national borders in order to win a placeon such a programme. Winnerssecured R&D funding – Europe, unlikethe USA, focused the majority of its

R&D spending on specificprogrammes – and a forward orderbook. Losers were compelled to leavethe industry or merge with formercompetitors.

So, faced with a decade of decliningglobal defence expenditure, changingprocurement patterns and technolog-ical advances, the number of defence

players contracted dramatically. Inview of the scale of its defencespending cuts, the US led the way. In1993, Pentagon officials informed theassembled heads of the country’spremier defence and aerospacecompanies, at a dinner since dubbedthe Last Supper, that fewer than halfwould survived the defence budgetcuts to come. A wave of mega-mergers followed, partly facilitated byfinancial support from the Clinton

Administration, which allowed theindustry to expense consolidation andrationalisation costs against therevenues generated by governmentprogrammes.

Lockheed acquired Martin Marietta in1995 and Loral (which had alreadybought former giants like FairchildWeston and Unisys Defense) in 1996.Raytheon acquired Texas Instrumentsand Hughes Aircraft in 1997; andBoeing acquired Rockwell Defense in1996 and McDonnell Douglas in 1998.In all, more than $55bn worth of mergerstook place, and 40 different US aero-space companies engaged in theaerospace industry wholly or in partwere reduced to five.


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Page 13

Lockheed Martin (LMT)GD Fort Worth

Sanders

Lockheed

Martin Marietta

Gould Ocean Systems

GE Aerospace

RCA

GD Space

Loral

Goodyear Aerospace

Fairchild Weston

Honeywell-ED

Ford Aerospace

Librascope

LTV MissilesIBM Federal Systems

Unisys Defense

COMSAT

Northrop Grumman (NOC)

Newport News

Complek

Ryan Aeronautical

UTC Norden Systems

Westinghouse Electronic Syst

Vought

Grumman

Northrop

DPC Technologies

Federal Data Corp.Litton Industries

TRW

Raytheon Corp (RTN)

Magnavox

CAE Link

GD Missiles

Hughes Aircraft

E-Systems

Raytheon

CTAS

Texas Instruments

Boeing Co. (BA)

Hughes Electronics Argo Systems

Boeing Co.

Rockwell Aerospace

McDonnell Douglas

Hughes Helicopters

General Dynamics (GD)

Motorola Inc.

Primex

Ceridian

Bath Iron Works

General Dynamics

GTE Government Systems

NASSCO

Galaxy Aerospace

1985 1990 1995 2000 2005

Lockheed Martin

Northrop Grumman

Source: Deutsche Bank Securities Inc. estimates and company information

Raytheon Corp.

Boeing Co.

General Dynamics

Table 2: US Defence Primes Consolidation (1985–2002)


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Page 14 In Europe, a different response wasdeveloped. Unlike the USA, Europeancompanies had to contend with anumber of barriers to consolidation,primarily and unsurprisingly due to thefact that Europe’s industrial leadershad to address the varying policies ofa relatively uncoordinated collection ofnation states. Notwithstanding thesedifficulties, European companies had

to take some action and, as in theUSA, while mergers and acquisitions

characterised efforts to consolidate,they were focused predominantly on anational level. Aerospatiale acquiredMatra Hautes Technologies in 1998,British Aerospace merged with GECMarconi in 1999, the formation ofFinnish Defence Industries (later tobecome Patria Industries) combinedFinland’s major defence and aero-space assets in 1995 and Saab

acquired Celsius in 2000, creatingSweden’s largest defence company.

1990 1995 1997 1998 1999 2000 2001

Saab Ericsson Space

Ericsson

Saab AB

Celsius

Saab AB

Westland

GKN

British AircraftCorp

General

Electric Racal

Rolls Royce

British

GKN

SI Group

Matra

Aérospatia le

Dassault Aviation

Alcatel

Thomson-CSF

Snecma

MTU

Dornier

MBB

Fiat Avio

Aerital ia

Selenia

Agusta

OtoBreda

Aermacchi

Agusta

CASA

AISA

Alfa Romeo Avio

Deutsche Aerospace

Fokker

Marconi

TI Group

AllisonEngines

Eurocopter

SEP

EADS

AMM

Astrium MBDA

DASA

CASA

Source: Aerospazio, National Aerospace Industry Association

Ericsson Saab Avionics

Matra BAE Dynamics

Lucas WGSD Vickers

Smiths

Industries

BAE Systems

Rolls Royce

Dassault Av

Alcatel

Thales

Agusta Westland

FIAT Avio

Finmeccanica

Aermacchi

MTU AeroEngines

EADS

Snecma

Matra Marconi Space

Lagardére

Aerospatiale-MatraMatra HT

Satellites (Cannes)

Alcatel Space

Messier

Alcatel

Rolls Royce/

Snecma

Hurel-DuboisLabinal/Turbomec

Thales/Raytheon Syst Airbus SAS

Alenia Marconi Systems

Alenia

Siai Marchetti

Table 3: European consolidation 1990–2001


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Page 15Consolidation on both sides of the Atlantic has made the sector lookincreasingly concentrated. In 1990, theten largest defence companies

accounted for 37% of all arms salescompleted by the industry’s top 100firms. In 2003, they accounted for61.3% (see Table 4).

Rank Company Country 2003Defence Revenue ($M)

1 Lockheed Martin U.S. 30,0972 Boeing U.S. 27,360

3 Northrop Grumman U.S. 18,7004 BAE Systems U.K. 17,1595 Raytheon U.S. 16,8966 General Dynamics U.S. 12,7827 Thales France 8,4768 EADS Netherlands 8,0379 Finmeccanica Italy 5,896

10 United Technologies U.S. 5,300

Total 150,703

Table 4: The World’s Top 10 Defence Companies in 2003 Source: Defense News

Creating value from mergers and

acquisitions is difficult in any industrialsector. In defence, creating value fromconsolidation has been extraordinarilydifficult.

Lockheed Martin had seen its shareprice plummet by the end of 1999 andwas criticised in the media for notseizing rapid control of its acquisitions.It also reportedly experiencedprogramme difficulties, notably inspace launchers and military trans-ports. Boeing had problems main-

taining civil aircraft deliveries duringthe same period while Raytheon’sshare price fell sharply between 1999and 2000 as investors voiced theirconcerns that management hadneglected day-to-day businessthrough its acquisition spree. EADShad to price its share issue belowearlier management forecasts in orderto attract institutional shareholders onits market debut in 2000. BAESystems management, having waited

10 months to finalise the deal,continued to explain how it woulddeliver an expected £2.75m annualsavings from its GEC-Marconi mergerfor over a year after the transactionwas completed.

While thousands of employees left theindustry during this period, a signifi-cant number of CEOs followed them.They include many who led theacquiring company only subsequentlyto fall.

So delivering value from mergers or

acquisitions is a tough challenge andeven tougher in defence. But if onethen considers the difficulties ofcombining different national culturesand satisfying different host govern-ment security objectives, then nowonder defence contractors initiallyfocused on acquisitions in their owncountries. As a result, relatively fewmajor cross-border transactions havetaken place. The formation of theEuropean Aeronautic, Defence andSpace Company (EADS) from the

French Aerospatiale Matra, theGerman DaimlerChrysler Aerospace(DASA) and the Spanish CASA in July2000 and the purchase of the UK’sRacal Electronics by the FrenchThomson-CSF (now Thales), fivemonths later were the two notableEuropean deals until Finmeccanicabecame active in the UK in 2004.

BAE Systems, meanwhile, took controlof a major US aerospace and defence

business when it merged with GEC’sMarconi Electronic Systems in 1999.

There have, however, been plenty ofother forms of international collabora-tion, using a range of strategic alliancestructures, ranging from co-operativeagreements and consortia to minorityequity investments and joint ventures(see Table 3).


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Page 16

Four features, in particular, played a big part in impeding cross-border consolidation during the 1990s:

Consolidation

Scale ofEuropean Task

World marketsmainly closed

Multipleprocurement

bodies

Lack of politicaldesire for

consolidation

Continualtechnologicaladvancement

Changesin defence

procurement

Decliningglobal defence

spending

Source: PricewaterhouseCoopers LLPFigure 4: Defence Industry Consolidation

1. The scale of the task. The European defence industry was so much smaller than the US defence industry that itwould take an enormous effort to close the gap. Would it be worth the effort?

2. The fact that most of the world’s defence markets are closed. The world’s biggest market – the US government –was highly protected. Only 2% of the Pentagon’s sales went abroad, half of them to British firms. So many ofEurope’s largest defence companies could only compete in the remaining foreign markets and many of these hadalready been tied up by larger US contractors.

3. The existence of multiple procurement bodies. In spite of the formation of OCCAR, defence procurement inEurope remained quite fragmented, with different national procedures and operational requirements. Major collab-

orative programmes suffered as a result. Britain pulled out of Horizon in 1999, France left the MRAV programme.

4. Lack of political will. In the mid 1990s, the EU had many more pressing items on its agenda than defence industryconsolidation, such as Monetary Union and enlargement. If Europe had consolidated its defence industrial base toa similar size to that of America, we estimated that it would have had to reduce the total number of Europeandefence companies from 43 to 14, resulting in the reduction of nearly 600,000 jobs. It is not clear that this wouldhave been politically advantageous for any European state.


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Page 17Some of these alliances have beeninspired by the customer, withcontractors compelled to participate incross-border consortia if they want tosecure a role in a particularprogramme. Others have been moti-vated by the desire to access overseasmarkets. Hence, for example, Boeingbought a 35% stake in Aero Vodochody of the Czech Republic in

1998. Thales has invested in Samsungin South Korea and Dassault, EADS,Snecma and Thales jointly bought a20% stake in the Brazilian aircraftmanufacturer Embraer. A further trendis the pooling of demand andresources in different countries inorder to make it more cost-effective to

retain some form of capability in asensitive area of supply. Hence, forexample, Patria (Finland), Saab(Sweden) and Raufoss (Norway)combined their ammunition busi-nesses to form Nammo in 1998.

In Europe, however, such allianceshave constituted a first step towardsthe longer term integration of busi-

nesses. A number of these arrange-ments – Thomson-Marconi Sonar, Agusta-Westland, Alenia MarconiSystems, Astrium – have recently beenor are now being restructured in orderto facilitate the full merger ofresources.


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Source: US Department of Defense – A US soldier picks up a little girl that was caught in convertina wire and carriesher out in front to wait for her father in Nasser Wa Al Salam, Iraq


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Page 19

The World after 9/11

In 2005, the world has changed again,with regional conflict joined by inter-national terrorism as dominant factorsin security planning. Defence spendingis being adjusted to focus on moreflexible, responsive and mobile forcestructures with an increasing focus onlogistics and lifecycle support.

The nature of warfare has changedsubstantially during the past decade,with more numerous crises of a widerrange and in a wider geographic area –including Kosovo, Macedonia, SierraLeone, East Timor, Afghanistan, theDemocratic Republic of Congo and,most recently, Iraq once again. The

threat of international terrorism hassimultaneously increased, with the riseof Islamic fundamentalism andgrowing hostility towards the US incertain quarters of the world. Globalsecurity has thus become more uncer-tain than it was a few years ago, andthe demands on defence forces every-where have become correspondinglymore complex.

Both these factors have caused aresurgence in expenditure on defence.Worldwide, spending fell by about athird between 1989 and 1996. But9/11 and the Second Gulf Warreversed this trend. According to theStockholm International PeaceResearch Institute (SIPRI), global mili-tary spending increased by 18% in realterms between the start of 2002 andthe end of 2003, reaching $956 billion.

The top five countries, measured bymilitary expenditure in 2003 – the US,Japan, UK, France and China –account for 64% of the world market(see Table 5). But the US continues to

account for by far the biggest share. In2003, it spent $417.4bn (47% of theglobal total), including the supplemen-tary budget allocated for the war onterrorism, which by itself is over 25%higher than the entire military expendi-ture of each of the next four countries.

Military expenditure: in MER dollar terms

Rank Country Level ($b.) Per capita ($) World share

1 USA 417.4 1,419 472 Japan 46.9 367 53 UK 37.1 627 44 France 35.0 583 45 China [32.8] 25 4

Sub-total top 5 569.2

6 Germany 27.2 329 37 Italy 20.8 362 28 Iran [19.2] 279 [2]9 Saudi Arabia 19.1 789 [2]

10 South Korea 13.9 292 2

Sub-total top 10 669.2

Table 5: The Top Spenders in 2003 Source: SIPRI

However, the rise in defence spendingmay well prove short-lived, except,perhaps, in the US. Congress hasoverwhelmingly approved a $25bnincrease in the Pentagon’s budget for2005. Conversely, the UK governmentplans to make swingeing military cuts.

Defence Secretary Geoff Hoonannounced in July 2004 that Britain’sarmed forces would be reduced by atenth, with the loss of 23,300personnel, more than 100 front-lineaircraft, 15 vessels and about 80tanks.

The key issue for defence contractorsis whether the axe will fall more heavilyon personnel or equipment. Theevidence is mixed. Between 2001 and2003, for example, NATO lifted itsexpenditure on equipment by 21.8%,more than double the percentage by

which it increased its spending onmanpower. But in the preceding fiveyears the reverse was true. It cut itsexpenditure on manpower by just3.7%, compared with the 16.8% bywhich it chopped its spending onequipment.


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Page 20

Nato total 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Personnel 203,361 196,148 186,518 186,960 183,678 185,325 188,818 184,860 200,400 202,536

Personnel change –4.6 –3.5 –4.9 0.2 –1.8 0.9 1.9 –2.1 8.4 1.1Equipment 122,181 109,330 103,133 98,638 96,507 96,165 90,922 101,719 118,035 123,917Equipment change 17.7 –10.5 –5.7 –4.4 –2.2 –0.4 –5.5 11.9 16.0 5.0

Source: SIPRI. Figures in US$m at 2000 prices and exchange rates. Figs in white are percentage changes from previous year

Table 6: NATO Military Expenditure on Personnel and Equipment, 1994–2003

In the meantime, the barriers to cross-border consolidation have been erodedby a mixture of market forces andgovernment initiatives (see Figure 5).Changes in government attitudes andthe commercialisation of the sector

have undermined the barriers toprogress within Europe. Five factorscontribute to this effect.

European military strategies

The Balkan wars of the 1990s showedhow weak European governmentswere when they tried to act alone. In1999, EU member states thereforedecided to develop a more effectiveregional security and defence policy: aEuropean Security and Defence Iden-tity (ESDI). EU defence policies andrelated competition policy came underreview. The second European Parlia-mentary Meeting on Defence tookplace late in 2003, moving towards aEuropean Defence Agency which willimprove cooperation in buying anddeveloping military equipment. The Agency is expected ultimately todeliver considerable savings. TheCentre for Defence Economics at theUniversity of York estimates that the

creation of a more integrated defencemarket could save up to 6bn a year –the equivalent of 60% of Europe’scurrent spend of military R&D.

COTS

The increasing commercialisation ofthe defence industry, in particular, theuse of COTS makes the restriction oftechnology and trade across bordersless workable.

Increasing use of commercialfinance

As privatisation becomes more widelyadopted and as new forms of com-mercial finance are used for govern-

ment projects, common principles ofinvestment appraisal are applied. Thisis relevant across the world, irrespec-tive of the apparent maturity of themarket. Hence, Poland contemplatesprivatisation of its aerospace and

defence industry while the USA isexamining the structure of its Govern-ment-owned contractor-operated(GoCo) activities.

Divergence of European andUS military strategy

The USA explicitly stated in its Joint Vision 2020, released in May 2002,that it aims to maintain “full-spectrumdominance” – defined as the ability,“operating alone or with allies, todefeat any adversary and control anysituation across the range of militaryoperations”. Europe, on the otherhand, has accepted the need for coali-tion support, primarily for communica-tions, logistics and transport. Thisimplies some form of industrial, as wellas military, co-operation.

USA RMA investment

US technological dominance has

accelerated, widening the gapbetween America and its allies. Theimplication is that some form of tech-nology transfer from the US to Europewill be necessary if US troops are tooperate within a coalition. The opera-tional infrastructure – command,control, communications, computing,information, surveillance and recon-naissance (C4ISR) – will not be work-able otherwise. The USA reviewed itsdefence trade policy in 2000 and

considered the implications of this –in President Clinton’s time, it hadsuggested that it was open to trans-atlantic industry alliances as a conse-quence.


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Page 21

Consolidation

Decliningglobal defence spending

Continual technologicaladvancement

Changesin defence procurement

Europeanmilitary

strategies

Divergence ofEuropean & US strategy

US RMA Investment

COTSUse of

commercialfinance

Lack of politicaldesire for

consolidation

Multipleprocurement

bodies

World marketsmainly closed

Scale ofEuropean Task

Source: PricewaterhouseCoopers LLP

Figure 5: Defence Industry Consolidation: The Erosion of Barriers to Change

The Clinton Administration had diffi-culty persuading voters to fund partici-pation in overseas conflicts, so anyinternational peacekeeping effortsseemed destined to be largely collabo-rative, with the UN playing a crucialcoordinating role. But 9/11 and thesubsequent heightened threat ofterrorism has provoked a moreaggressive attitude, exacerbated bythe presence of a Republican, GeorgeW Bush, in the White House.

The industrial consequences are

significant. Commentators doubt, forexample, that the BAE acquisition ofLockheed-Martin’s Control & Aero-space Electronic Systems business in2000 would have been sanctioned ifPresident Bush had been in office andfew observers feel it likely that anydefence technology will be transferredout of the USA in the current climate.This will create problems for thoseactively supporting US security policyoverseas and, according to the UK

press, UK Defence Secretary, GeoffHoon, wrote to his US counterpartearly in 2004 to express the UKGovernment’s concern at thisprospect on the Joint Strike FighterF-35 Program, in which the UK is asignificant investor. More recently, the

UK Prime Minister and members of hisCabinet have made representations tothe US government regarding securinga waiver to US International Trade in Arms Regulations (ITAR) for the UK sothat its armed forces can interact fullyon the battlefield with the technologyby their American allies.

But, while government policies willhave a substantial impact upon futureindustrial developments, changingcommercial imperatives have been apowerful influence for much of the last

decade. Yet the more a nation’sprocurement policies ignore theconnection between national securitypolicy and the DIB, the more it risksdestroying long-term value derivedfrom the programmes it has funded inthe past and the more it limits its abilityto develop a truly independent securitypolicy in future.


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Page 22

One of the side effects of BAE Systems’ decision to form a series of defence electronics ventures with the ItalianFinmeccanica group within a transaction called Eurosystems is that the controlling interest in the UK’s airborne radar

and electronic warfare (EW) industrial capabilities will transfer to Italy. The same is true of Britain’s helicopter busi-ness, now that GKN has sold its 50% stake in Agusta-Westland to Finmeccanica – a transaction that demonstrates just how much times have changed. In 1986, Michael Heseltine and Leon Brittan, then UK Secretaries of State forDefence and Trade & Industry respectively, both resigned during a very public debate about the future of Westland.Ironically, the government then ultimately favoured a US-orientated future for the business rather than the Europeanoption … involving Agusta.

The UK and Italy are by no meansalone in trying to deal effectively withthe questions raised by internationaldefence company mergers. The Swiss,

Austrian, Spanish and Swedishgovernments have already allowed USand British buyers – General Dynamicsin the first three cases and Alvis (thenan UK public limited company) inSweden – to acquire their armouredvehicle industries.

In 2004, the German governmentfaced a similar issue. The Röchlingfamily, which owned a 42% stake inRheinmetall, one of Germany’s leadingdefence contractors, was reported tobe interested in selling its holding andthis attracted interest from a range ofpotential purchasers. In Berlin, politi-cians were concerned that control ofimportant military capabilities couldpass into foreign or inappropriateownership.

When governments owned their DIB,they could control any change ofownership. While stimulating animprovement in industrial efficiency,

privatisation also either raised moneyfor the seller or at least reduced oreliminated a source of expenditure.

Importantly, governments coulddecide the nature and identity of thenew owner. They could maintain acontrolling interest, as in Finland, forexample. They could create and holdspecial share rights – sometimesknown as a “golden share” – enablingthem to block any future sale to an

unwelcome acquirer. They could evenimpose a limit on the amount of sharesowned by foreign investors (see Table7, following page).

Now, following a wave of full or partialprivatisations, any government influ-ence has to be exercised more subtly,since it now addresses the sale of

commercial businesses to commercialbuyers. This was the case with Rhein-metall.

Sale to a major international defencecompany like General Dynamics,EADS or BAE would be subject toscrutiny by the buyer’s shareholders.Investors will examine the potentialadded value. And if the acquiringcompany’s management team fails todeliver an improved performance thatmeets expectations, the conse-quences are usually dire. The post dealagenda will therefore focus onincreasing revenue and reducingcosts. In Rheinmetall’s case, this couldhave meant factory closures and thetransfer of technology out of Germany.This may not appeal to any Germangovernment accustomed to viewingRheinmetall as part of its DIB.

In similar circumstances elsewhere, itappears that private equity has been

seen to provide the answer. Privateequity houses, formerly known asventure capitalists, may be perceivedto have no political or national affilia-tion and are interested only inimproving the performance of theacquired business – not in combiningit with an existing, possibly foreign,entity. For example, Carlyle Groupbought a 34% stake in Qinetiq,formerly the Defence Evaluation andResearch Agency, from the UK

Government in 2003 and Kohlberg,Kravis, Roberts (KKR) acquired theGerman aero engine manufacturer,MTU, also in 2003.


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Page 23The Carlyle Group has a particularlystrong track record in the defencesector with investments ranging fromUnited Defence Industries and UnitedStates Marine Repair in the USA toBofors Weapons Systems in Swedenand Avio in Italy. Inevitably, Carlyle isidentified as a potential buyer whenany defence sale is rumoured.Currently, for example, the UK’s ship-

yards as well as its Defence Aviation

repair Agency (DARA). Potentialbuyers for the Röchling family interestin Rheinmetall were identified in themedia as a number of US privateequity houses. This might signal a newapproach to European consolidation.Let private equity houses – and theirfocus on generating cash – rather thannational ‘champions’ decide theindustry’s future.

Year Country Company Share Form of privatisation Buyer Nationalityprivatised (%) (sale of shares) type

1990 Norway Raufoss 47.0 Public offering IS –

1993 Netherlands Fokker 51.0 Private sales C F (FRG)

1993 Norway NFT 49.0 Public offering IS –

1993 Sweden Celsius 75.0 Public offering IS –

1994 Brazil Embraer 55.0 Private sales IS D/F (USA)

1994 Germany IABG 45.0 Private sales C F (USA)

1995 Germany IABG 23.0 Employee buyout – D

1995 Argentina AMC –– Leasing C F (USA)

1995 Australia ASTA Majority Private Sales C D/F (USA)

1997 Greece Elefsis Shipyards –– Private sales C D

1998 Czech Republic Aero Vodochody 34.0 Private sales C F (USA)

1998 France Thomson-CSF 33.0 Public offering IS –

1999 Australia ADI 100.0 Private sales C D/F (FRA)

1999 Bulgaria Arsenal 51.0 Employee buyout – D

1999 France Aérospatiale –– Merger – –

1999 Norway Norsk Jetmotor 33.0 Private sales C F (SWE)

1999 Spain Indra 66.0 Public offering IS –

1999 Sweden Celsius 25.0 Private sales C D

2000 Bulgaria Trema 50.0 Employee buyout – D

2000 Greece Hellenic Vehicle Ind. 43.0 Private sales C D

2000 Italy Finmeccanica 38.0 Public offering IS –

2000 Spain CASA –– Merger – –

2001 Czech Republic Tatra 91.6 Private sales C F (USA)

2001 Finland Patria Industries 26.8 Private sales C F (EUR)

2001 Greece Hellenic Shipyards 51.0 Private sales C D

2001 Italy Fincantieri 17.0 Public offering IS –

2001 Poland PZL Warszawa-Okecie 51.0 Private sales C F (EUR)

2001 Poland WSK PZL Rzeszow 85.0 Private sales C F (USA)

2001 Spain Santa Barbara 100.0 Private sales C F (USA)

Table 7: Major cases of company privatisation 1990–2001 Source: SIPRI


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Source: US Department of Defense – Senior Airman Erik Gustafson looks over the shoulder of Airman 1st Class Meghan Tobin as she checks voltage points on a backup transceiver


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Page 25

Implications for Contractors

There are clearly a number of uncer-tainties ahead. From budgets, pro-grammes and procurement processesto the nature and location of threats tointernational security. But, there arestill clear imperatives for managementteams now. We have set out our viewof what should be the five mainelements of any defence contractor’sbusiness strategy – right now.

1. Maximising the value of thedomestic national market

No defence equipment company can

expect to succeed without maintaininga significant level of business in itsdomestic national market. Withnational identity still a source ofcompetitive advantage against foreigncompetitors in many segments of themarket, this should provide a numberof attributes (see figures 1 and 2):

• a clear view of potential businessbeyond the order book

• baseline/core business

• a source of development funding

• insight into military operationalrequirements and applications

• early indications of changes in mili-tary doctrine and in the securityenvironment

• credibility in export markets

• channels to export markets throughcollaboration domestically withsuppliers of imported equipment orservices.

“Saab can assume overall responsibility for getting various systems to work together. This competence has beendeveloped through its long term alliance with the Swedish defence forces, where Saab has principal responsibility foradvanced and in some cases unique development projects”

Source: Saab

To achieve this objective, defencecontractors need to focus on four maincapabilities:

a) Understanding local procurementprocesses

b) Maintaining insight into national

military doctrine, operationalrequirements and applications.

These capabilities are interdepen-dent and most defence companiesrecruit senior officers from the Armed Forces in order to gain aninsight into the people andprocesses operating within thisenvironment.

c) Working effectively with the right

partners

d) Sustaining an excellent deliveryperformance that is open to publicscrutiny

Much has been written in the USA andUK about the problems encounteredby contractors – from Raytheon,Boeing and Lockheed Martin in thelate 1990s to BAE more recently –meeting major defence programmedelivery and budget targets. Whiledifferent approaches have been

adopted by different nations in seekingto ensure value for money – rangingfrom cost plus to fixed price contractswith varying degrees of risk andreward sharing – a key issue here isthat poor performance attracts intensepublic scrutiny.

This undermines the confidence of notonly the general public but also ofinvestors, politicians, government offi-cials and the various constituencies

within the customer organisation.


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Supporting Activities

Primary Activities

ProductSystemsDevelopment

Systems

Integration

Integrated

Logistics

Support Inbound

logistics

Operation Service

& Support

Decom-

mission

Technology& Product

Develop-

ment &

Manu-

facture

Contractor value chain Buyer value chain

Technology

Product

Development

Manufacture

Infrastructure & HR Management Infrastructure & HR Management

Research and Development Research and Development

Procurement Procurement

Marketing Coalition interoperability

M a r g i n

M a r g i n

M a r g i n

Figure 6: The Defence Industry Value Source: Derived from Michael E Porter, 1990

Page 26 2. Investing in the rightcapabilities and partners

Governments are now more interestedin purchasing capabilities than equip-ment. For contractors, this means anemphasis on through-life supportrather than on delivering equipmentand returning only when it requiresspares or repairs. The driving force

behind this shift in emphasis is a

continuing effort to transfer risk – tech-nical, financial and operational – fromthe public to the private sector. This inturn stems from, once again, thecontinuing pressure on governmentsto reduce spending.

The overall effect is to transform theconventional definition of the industryvalue chain (see Figure 6).

The interface between contractor andbuyer is therefore becoming less

clearly defined, with contractorsencroaching into areas previouslyconsidered the province of the user –financing, training, monitoring usageand performance, maintenance and soon, through to decommissioning and,potentially, replacement.

However, while the contractor valuechain is being extended, and asweapons and associated subsystemsand systems become increasingly

complex, the cost of maintaining abroad range of technical and industrialcapabilities is beyond the means nowof almost all contractors. This meansthat contractors are compelled tofocus on specific, selected areas ofexpertise. They now outsource certainareas of manufacture, buy in certainequipment, services and componentsand invest only in activities where theycan excel.

However difficult this transition mayappear for both contractors andcustomers, the vital contribution ofone specific capability is becoming

clear. Programme management mighthave been considered as a supporting

activity within the traditional valuechain. Now, with an increasinglycomplex mix of a greater number andrange of contractor and customeractivities, with the risks of potentialprogramme failure mounting and witha less clear interface betweencustomer and contractor, the ability tomanage programmes is a major –perhaps the vital – contributor to valuewithin a procurement.

It is less clear, at present, whether theprogramme management activityoffers real value to its provider. There isno doubt that investors perceive thatvalue has been shifting to the right –from designing and supplying originalequipment to supporting the after-market. The former activities attract agreater level of risk and uncertaintyand yet an increasing proportion of thefinancial return lies in through-lifesupport. The programme managermay well take on the risk of thecomplete product or capability life-cycle but can a sufficient financial


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Page 27reward be offered to compensate aprivate sector business?

3. Developing internationalmarkets – especially breakinginto the US

Exporting defence equipment hasbecome an important element of mostnations’ security policy (see figure 1).Indeed, the export potential of a newdefence programme is normally acentral feature of any government’sinvestment appraisal process. Conse-quently, governments of the majorspenders actively support theirdomestic industry in developing over-seas markets.

Contractors can seek to export equip-ment directly to the buying nation butmost importers expect some form of

local involvement. This explains whystrategic alliances of various forms(see Figure 7) characterise the defenceindustry. Clearly it is vital that compa-nies select the right form of alliancestructure to meet the circumstancesand this in itself can be the focus ofintense negotiation, given that it canindicate either a short- or long-termcommitment to the partner and itshost country.

The choices made regarding other,equally important factors will influencethe success or failure of overseasbusiness development initiatives.Three issues appear of particular rele-vance:

• transferring and exploiting tech-nology

• developing and maintaining anacceptable corporate governancemodel

• identifying, monitoring andmanaging contingent liabilities.

How free will a foreign contractor be toexploit intellectual property that itdeveloped overseas in other coun-tries? Will it be able to supply an over-seas country, say the USA, with intel-lectual property developed elsewhere,without maintaining it in the USA aswell? And how effectively will it be ableto manage its business, given that itsdomestic management will be prohib-

ited from seeing the details of anynationally secret programmes?

Most governments impose stringentsecurity requirements on all foreigndefence contractors so that any over-seas company acquiring one of itslocal operations will have to maintain itas a separate business with a board ofdirectors comprising local nationals. Inother words, it will be unable to mergeits domestic and foreign operations in

order to cut costs or create synergies.

Without the right governance model, itcould also expose itself to seriousdangers – including, at worst, a repeti-tion of Ferranti’s experience with itsacquisition of US defence equipmentmanufacturer International Signal andControl Group in 1987. This costFerranti an unexpected $1bn and ledto its collapse.

Even if the potential exporter developsa relationship with a local contractorthat falls short of an acquisition, itfaces the prospect of developingcontingent liabilities of which it may beunaware. These liabilities may beinsignificant on their own but, for majorexporters active in many regionsworldwide, the aggregation of liabili-ties built up through minority invest-ments, joint ventures and the like maybe substantial.


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Page 28

4. Securing scale and scopeeconomies in an industry thatdiscourages integration

Mergers and acquisitions createmarket expectations that managementteams must meet. If they do not, thecompany’s value deteriorates. Inreviewing a listed company’s plannedalliance, investors will calculate howmuch additional value it will achieve bygenerating synergy benefits. This willbe reflected in a revised price for theshares. Management must then meetthese expectations just to break even

– to keep the share price at itsexpected post-deal level. They canonly add additional value therefore byexceeding expectations.

Most management teams fail toachieve this. However, whilst it iscommonly accepted that the M&A

challenge is daunting anyway, thedefence industry offers particularlydifficult circumstances (see Table 8).

Integration is expensive. So compa-nies must be selective in decidingwhen it is necessary and the valueproposition must be clear. And thisapplies not only to mergers and acqui-sitions but also to existing groups thatown a range of businesses that arediversified by geographic location, by

customer or capability.

A stand-alone operat ing company isestablished

Partners undertake specific enterprises whichdo not entail creating a separate company

More than two partners collaborate to achieve sharedobjectives

Cooperative

Ventures

Operating

Joint

Ventures

Intended

Lifespan

Required integration

Low High

One-time

Finite

Indefinite

Equity

Investments

Consortia

Mergers &

Acquisit ions

StrategicAlliances

Provides as opportunity for cross border

penetration

One party takes a minority equity position in another

Figure 7: Strategic Alliance Structures Source: PricewaterhouseCoopers LLP


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Page 29

Survey indicate that these factors* drive value … but sector issues and attitudes may frustrate them

Revenue benefits are more likely to generate value than

cost reductions

Integration is expensive! Be selective

Pace is vital: move quickly or the benefits are lost –for ever

Pay the right price – for you!

The strategic objective must be clear and post-dealactions must be prioritised

Make people issues a priority

Synergies may be frustrated by the demands of

regulators

Scale has been considered vital

Regulatory approvals may create delays

With few major deals available, prices can be high

Political considerations may be a distraction becausethey are unclear or uneconomic

Openness can be difficult for security reasons

Table 8: Creating Value in Mergers: the Challenges in Defence

* NB: list not exhaustive. There are other factors, notably rigorous planning and using a robust process for managing and monitoring value delivery

Sources include: Feldman, M L and Spratt, M F, (1999) “Five Frogs on a Log”, Harper Collins; and Black, A, Wright, P and Davies, J (2001) “In Search of Shareholder Value”2nd edition, Financial Times/Prentice Hall

As such groups – Cobham andMeggitt, for example, in the UK, Ester-line in the USA, Elbit in Israel, evenThales in France – have grown, bothorganically and by acquisition, theincreasing span of control will create amajor challenge to management. Theprediction is that they will continue toaspire to grow – if nothing else, size

will keep them on the shrinkingpreferred supplier lists of the majors –and will therefore need to integratebusiness operations both to unlockvalue from the portfolio and make iteasier to manage and direct.

5. Leveraging IndustrialParticipation and COTSwithin the supply chain

Defence contractors have respondedto the pressures of a more competi-tive, international market by placingincreasing pressure on the supplychain. In common with the civil aero-

space sector, risk is being passeddown the chain, with suppliers beingasked to invest in more of the non-recurring costs associated with thestart of a new programme and tomanage broader areas of the supplychain itself. Indeed, the cost of devel-oping a bid to participate in a defenceprogramme in the first place is signifi-cant, further encouraging consolida-tion and the pursuit of scale. Sizematters.


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Page 30

In this environment, defence contrac-tors are alert to the opportunities forimproving profitability by sourcing inlower cost areas of the world. Just asthey would wish to sell equipment inopen markets worldwide, they natu-rally also aspire to develop supplierswho can offer cheaper componentsand sub-systems without sacrificing

reliability and performance. Govern-ments will seek to support this initia-tive, through a desire to reduce costsand to exploit COTS technologies. And COTS, by their very nature, arenot subject to the trading constraintsimposed on defence-specific tech-nologies

However, these aspirations have to bemet in a way that is consistent, onceagain, with the unique requirements of

the international trade in defenceequipment. As well as complying withits host nation’s international tradingpolicies, the contractor must complywith the export trade arrangementsagreed between defence importingnations and their suppliers. These canbe entered into on a government togovernment basis, like the AlYamamah defence procurementprogramme between the UK (theexporter) and Saudi Arabia (theimporter), or on a contractor to

importing government basis.

These arrangements usually include areciprocal trade or offset agreement,whereby the expenditure committed tothe purchase of arms is offset by anobligation accepted by the exporter toinvest in the buyer’s economy.

According to BAE Systems, “underreciprocal trade, export sales are

conditional upon the provision ofindustrial or economic benefits to theimporter’s country.” The exporter maymake this investment by sourcingmaterials, components or systemswith suppliers in the customer’scountry. These may relate to the armscontract alone (for example, F-18aircraft assembled under license byPatria Industries in Finland for theFinnish Air Force), or to that andsimilar contracts elsewhere (such as

Hawk aircraft components manufac-tured in Korea for both RoKAF Hawksand for other export aircraft), or tounrelated defence or civil contracts(like Patria supplying aerostructuresassemblies for the BAE RJ civil aircraftwithin a programme related toimporting BAE Hawk aircraft).

Figure 8: The evolution of the supply chain Source: SBAC / A.T. Kearney

Platform assembly OEMs System

IntegratorsSystems

Integrators

Past Emerging Future

Large scale integration

Small scale integration

Value-added parts

and assemblies

Make-to-print parts

and assemblies

Raw materials

• Primarily direct

supply

• Many direct

suppliers

• No real role for

“integrators”

• Many “supplier paths”

• Fewer, but still many

direct suppliers

• Limited role for

“integrators”

• Larger role for value-

adding suppliers

• Fewer “supplier paths”

• Far fewer direct

suppliers

• Extensive role for

value-adding parts

suppliers


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Page 31

ReciprocalTrade

• Counterpurchase• Barter• Buyback• Switch trading

“participation in the customer’sindustry in the manufacture andassembly of parts of theequipment to be supplied”

“also known as co-production,whereby manufacturingopportunities identified under adirect offset programme areextended to include deliveriesto other customers of the sameequipment”

“… subcontract work onprogrammes other than thatbeing supplied to the customer;purchases of industrial equipment;promoting and developing exporttrade from the customer’s country;involvement in the R&D programmesof equipment/product developmentprogrammes”

Direct Offset Indirect Offset Unrelated Offset

“The economic environment … in somecountries is not always suitable forintroducing offset or countertrade … (so)Reciprocal Trade can be used as a leverto promote industrial development whereoverseas support is required, say in theform of technology transfer or investment… to create commercially viable ventureswhich will develop or enhance localindustry. The aim of these activities is toincrease the country’s foreign exchangeearnings and reduce their reliance on

imports, while providing important socio-economic benefits, such as employmentand technology advancement.(The exporter) may be required to promote

joint ventures, introduce appropriatespecialist foreign partners and arrangeinstitutional funding, but would notnormally be investors themselves unlessthe activity could become part of theCompany’s core business”

Countertrade Offset Special Projects

Figure 9: Reciprocal trade: definitions Source: BAE Systems

Offsets have been banned by the EUand USA in every industrial sector –except defence. As well as becomingincreasingly commonplace in militarydeals, offset agreements arebecoming larger and larger. The dealsigned by the South African govern-ment in 1999 is probably the largest sofar. It covers a range of military equip-ment, including Hawk jet trainers,Super Lynx naval helicopters and

Gripen combat aircraft. Including anair defence system, submarines,ships, tanks and armoured vehicles,supplied by Germany and Italy too, thetotal package was valued by theFinancial Times and Jane’s DefenceWeekly at around US$5.2bn. Itincluded an offset, or Industrial Partici-pation, obligation said to be worthSAR.70 bn.


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Figure 10: The Gripen South Africa offset obligation

Sources and definitions:* Campaign Against Arms** Non-Defence Industrial Participation – % sourced from Mail & Guardian article, 8 August 2002*** The National Industrial Participation Programme of the Republic of South Africa

The original Gripen International offset obligation in South Africa was substantial in both scale and duration

R.70 billion by April 2008*

86% will be non-defence related (NIP**)

Approximately 30% to be implemented by April 2004

Objectives of the obligation*** span a broad range of industrial and business sectors: all to be aligned with national objectives

Sustainable economic growth

Establishment of new trading partners

Foreign investment into South Africa

Export of South African value added goods and services

R&D collaboration in South Africa

Qualifying criteria are well-defined and performance must be subject to public scrutiny***:

Mutual benefit – profitable for the seller and beneficial for the South African economy

Additionality – incremental or new business

Sustainability – economically and operationally sustainable

Causality – proposals must result from the purchase contract

Responsibility – lies solely with the seller

– Job c reat ion

– Human resource development

– Technology transfer

– Economic advantages for previously disadvantaged community

The size of the obligation covers the

total economic benefit to be generatedby inward investment by the year2008. This means effectively that thesuppliers must introduce projects intothe region that will ultimately yieldR.70bn of value to the South Africaneconomy. 14% of this obligation mustbe met by Defence-Related invest-ment.

The procurement options available to

a nation range from importing equip-ment ‘off the shelf’ to funding anindigenous programme. Off-the-shelfimports are cheaper, while the acquisi-tion cost can be offset by securingrelated or even unrelated work pack-ages from the exporter for domesticindustry.

IndigenousProject

Off-the-shelfImport

Collaboration

Licensed

production Co-Production

Direct Offset

Indirect Offset

Investment required HighHigher

Figure 11: Procurement Options Illustrative only


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Page 33If local industry has the right capabili-ties, offsets can indeed create value – jobs (the South African programmeenvisaged the creation of 65,000) –skills, technology transfer, trade andinward investment. Some commenta-tors (notably Chinworth and Matthews:“Defense Industrialisation ThroughOffsets: The Case of Japan”, fromMartin, S. (1996); “The Economics of

Offsets: Defence Procurement andCountertrade”; Harwood academicpublishers) believe that it was theskilful use of defence-related USoffsets that drove Japan’s technolog-ical development after the SecondWorld War. It was driven by a policyapproach known as kokusanka,embracing three principles:

i. Domestic supply the priority

ii. If domestic supply is not possible,licenses should be secured usingdomestic manufacture and equip-ment

iii. Equipment should have a broaderapplication than just specific to theproject for which it was purchased.

So, whilst there are a number of activeinterest groups, like the Campaign Against Arms and Transparency Inter-national, who argue against their use,offsets continue to play an importantrole in international sales of defenceequipment.

They also continue to pose an unusualand distinctive challenge to the

management teams in the world’smajor defence companies. Offsetsrequire them to originate, evaluate andcommit to a range of investments thatare, in the case of unrelated offsetsand special projects, frequently inunfamiliar product or service markets.This increases the investment riskprofile. Direct or indirect offsets mayalso undermine or compromiseexisting supply chain strategies bynecessitating a change in sourcing

that would not otherwise be contem-plated. Suppliers also need to developan appropriate process for monitoringand managing such investments whilenot having effective managementcontrol of the businesses throughwhich the investment is committed.


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Source: US Department of Defense – William Pasiechnik launches a Raven “Unmanned Aerial Vehicle” (UAV) to conductreconnaissance for insurgents in Iraq


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Page 35

The Future

What, then, will shape the future envi-ronment within which contractors willoperate?

Scenarios

One scenario – an extreme – might bedescribed as Americanisation. Itscharacteristics might be as follows:

• Spending: the US governmentcontinues to invest heavily in itsmilitary capability, continuing tospend as much on defence as therest of the world put together

• Technology: the USA maintains atight grip on its technology andprevents its transfer overseas

• Corporate activity: Americandefence companies acquire militaryproduction capacity overseas and

repatriate technology and jobs tothe USA;

– US private equity houses buydefence companies overseas andsubsequently realise theseinvestments through exits to USdefence company acquirers

• Programmes: only the USA is ableto launch major new defenceprogrammes and it only awardscontracts to US prime contractors

The alternative might be Interdepen-

dence, suggesting a global defenceequipment industry where its principalcharacters co-operate as a matter ofcourse since none have the capacityto work alone. This is not a newconcept but following 9/11, the war in Afghanistan and the second war inIraq, it is hard to envisage right now.

“The novelty of the situation today is that globalisation generates interdependence and co-operation. … The interna-tional security system should be inclusive and security co-operation and mutual reassurance should replace mutualdeterrence, associated with balance-of-power politics …”

Source: SIPRI Yearbook 2000

How might we characterise Interde-pendence? Some of the main featuresmight be:

• Spending: the rest of the worldincreases its spending on defence,whilst US spending is significantlyreduced

• Technology: technology flows freelybetween allies

• Corporate activity: the defenceindustry supply chain is globalised,with nations investing in certain corecapabilities in their country, unablewithout an allies’ support to delivera complete system or platform

• Programmes: an internationalstrategic alliance is the sole mecha-nism for delivering any militaryprocurement programme

If we employ these two scenarioswithin a simple framework to examinewhat the future might hold, there aresome interesting outcomes.


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Page 36 Low

High

Low High Global interdependence

Americanisation

DefenceIndustrial Base

No alternative:Buy US or nothing

PerfectInterdependence

Trade wars

A low level of both Americanisation

and Interdependence would take usback to a situation where every countrywould seek to maintain its own militarycapability – back to the concept of theDefence Industrial Base. Conversely, ahigh level of Americanisation togetherwith a high level of Interdependenceelsewhere in the world might lead to aTrade War. Mindful of the recurringdisputes over subsidies in the civilaerospace sector between Europe’s

Airbus and America’s Boeing Commer-cial Airplanes and between Bombardier

of Canada and Brazil’s Embraer, weshould not discount this prospect.

Trends

Recent events and issues shouldprovide some clues regarding thefuture. Here are our observations:

Defence spending: the US defencebudget has increased by over 60% inconstant US$ over the last ten years,

reaching US$442bn in 2003. The prior-ities of the Bush Administration’sstrategy emphasise a continuing focuson defence expenditure:

• defeating global terrorism

• restructuring the US Armed Forcesand global defence posture

• developing/fielding advancedwarfighting capabilities

• providing for US military personnel

There will be also be a continuingeffort to outsource more supportingactivities currently undertaken by themilitary to the commercial sector.

President Bush sent his fiscal 2006

budget to congress on 7 February,2005, requesting $419.3bn, a 5%increase on the previous year and,taken together with a supplementalspending bill providing for a further$80bn, totalling a massive US$500bn.Whilst there has been some differenceof opinion among analysts concerningultimate spending levels, with cutsbeing seen as a possibility by some,the fact remains that US spending willcontinue to outstrip the rest of theworld by a huge margin well into the

future. The debate appears to be overwhether growth in procurementspending will be relatively flat or willrise to as much as 17% in 2007 and11% in 2008.

Elsewhere, modest growth is forecastin Europe but there are some majorprogramme uncertainties, notably inthe UK, with the refuelling tanker(FSTA) and aircraft carrier (CVF)programmes but also including the

Watchkeeper UAV programme,awarded to Thales in the summer of2004 but still awaiting contract signa-ture in March 2005. UK spending iscurrently £33bn, with Deutsche Bankforecasting annual procurementspending rising from about £7bn by6% per annum to 2008. However, themajority of this spend is alreadycommitted to existing programmes,with nine projects accounting for 70%of the next four years’ budgetedspend. In France, the 2005 budget isworth Euros 32.9bn but the growth inprocurement and research and devel-opment spending of 8% each yearover the last two years will not besustained. Deutsche Bank predictsthat it will slow to 2% per annum from

Figure 12: Scenarios for the Defence Industry Illustrative only


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Page 37its 2004 level of around Euros 15.9bn(the procurement element of which isEuros 13.9bn). Expenditure inGermany has continued to fall behindBritish and French levels and willcontinue to do so. It now stands atEuros 23.8bn and, with FinanceMinister Eichel committed to makingcuts, this is unlikely to rise. The Italiangovernment has also announced cuts

in military spending – perhaps by asmuch as 10% – following an increase

of 7.5% in 2005 to Euros 15.2bn, whileSweden is planning to cut spending by8% (SKr 3bn) through to 2008. It willshut 15 military bases and lay off 5,000military personnel.

While we might speculate about theevolution of plans in China and easternEurope, we are not likely to witness asignificant change on the pattern of

the world’s spending on defence. TheUSA will continue to dominate.

“A more capable Europe is within our grasp, though it will take time to realise our full potential. Actions underway –notably the establishment of a defence agency – take us in the right direction. To transform our militaries into moreflexible, mobile forces, and to enable them to address the new threats, more resources for defence and more effec-tive use of resources are necessary. Systematic use of pooled and shared assets would reduce duplications, over-heads and, in the medium term, increase capabilities.”

Source: Council of the European Union, “A Secure Europe in a Better World: European Security Strategy”,Brussels, December 2003

We might expect this to increase thepotential for Americanisation … but itmay serve to unite Europe. With orwithout the UK.

Technology transfer: this is becominga major issue in the relationshipbetween the USA and Europe. Inparticular, it offers the potential toundermine the so-called special rela-tionship between the USA and the UK.Discussions between the two govern-ments have focused on the potentialfor the UK to be granted exemptionsfrom US International Traffic in ArmsRegulations. However, The US

Congress has so far frustrated anyprogress, prompting UK ForeignSecretary Jack Straw to comment asfollows in January 2005: “We weregreatly disappointed that the Congressdeleted the provisions for an ITARexemption from the Defence Authori-sation Act … It has been a constantsource of discussion between thePrime Minister and President Bush,Secretary Powell and myself and ourofficials. It is disappointing … particu-larly given what a reliable ally we havebeen for the United States throughthick and thin.”

“The ITAR waiver 162. Terms for a United Kingdom waiver from the US International Traffic in Arms Regulations (theso-called ‘ITAR waiver’) were agreed with the US Administration in May 2003. We noted in our last Report that such awaiver would permit the transfer without a US export licence of most unclassified defence items, technology, andservices to the British Government and qualified companies in the United Kingdom. In the Government’s view awaiver ‘would make a significant contribution to transatlantic defence industry cooperation and promote Alliance

interoperability’.”

Source: UK House of Commons Quadripartite Committee:Strategic Export Controls: First Joint Report of Session 2004–05; 24th March, 2005

We can predict an increasing level ofdiscussion in this area over the nextyear and this will set the tone fortran

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