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<TITLE>Mr. John Weston...The European Defense Industry In the Global Market</TITLE>
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<CENTER><FONT SIZE="+4">The European Defense Industry</FONT></CENTER>
<CENTER><FONT SIZE="+4">In the Global Market</FONT></CENTER>
<CENTER><FONT SIZE="+2">Mr. John Weston, CBE, FRAeS; Chairman</FONT></CENTER>
<CENTER><FONT SIZE="+1"><I>British Aerospace Defence Ltd</I>.</FONT></CENTER>
<CENTER><B><FONT SIZE="+1">THE CHALLENGES OF DEFENSE CONSOLIDATION</FONT></B></CENTER>
<P>During the 1980s, British Aerospace Defence Ltd. grew at a rate of 17% a
year, partly due to a strong export performance and partly to the
commitments to increase NATO defense spending, which eventually succeeded
in forcing the USSR to concede the arms race and with it the Cold War. The
fall of the Berlin Wall brought about a significant reduction in NATO
procurement budgets and encouraged industry to rationalize and resize in
order to remain profitable. </P>
<P>The effects of the Cold War retrenchment were handled differently by the
various NATO countries. The largest impact in terms of research and
development and equipment procurement was felt in the United States, where
these processes bore the brunt of the cutbacks and the closure of bases
and reductions in the armed forces were left to a later stage in the
cycle. In the UK, cuts were made with the aim of maintaining the
front-line fighting forces and the defense equipment program. Even so,
there has been a 20%-30% reduction over the last four to five years.
Germany suffered equally badly, principally due to the problems of
reunification and the absorption of the East German armed forces. France
alone, of all the NATO countries, seemed immune to these problems, but now
is facing up to a 25%-30% reduction in defense equipment expenditures at
the same time as its nationalized industries are requiring large sums for
recapitalization. </P>
<P>Procurement budget reductions, however, have had little impact on
defense spending in the Far East, which is the fastest growing market in
the world, or the Middle East. What did make an impact on these markets
was the sharp reduction in U.S. defense business, which meant that those
businesses largely dependent on the home market have to turn with renewed
vigor to the export market to try to make up the difference. Backed by the
most aggressive U.S. government selling activity that we have yet seen,
the export market has become even more competitive than it already was.
</P>
<P>Within the U.S., the Department of Defense has devised an overall plan
for the rationalization of the defense industrial base. If this plan is
seen through to completion, the U.S. defense budget will support about one
half to one third of the number of contractors on twice the combined
defense spending of the UK, France, Germany, Italy, Spain, and Sweden. In
the long term, this is a recipe for making the European defense industry
unable to compete. </P>
<P>The pace of United States defense industry restructuring has accelerated
exponentially over the past three years, with almost $30 billion worth of
transfers. Hughes acquired GD missiles; Lockheed acquired GD military
aircraft, merged with Martin, and then absorbed Loral; Northrop and
Grumman merged and subsequently absorbed Westinghouse; and Boeing and
McDonnell Douglas began talks though later broke them off. This inexorable
drive toward creating U.S. defense giants that turn over $35-$45 billion
per year creates a real competitive challenge to the European defense
industry, whose major companies turn over $10-$15 billion per year.
Although big is not necessarily beautiful, these U.S. corporations have
significant opportunities for large reductions in cost, cutting out
duplicate overheads and attaining economies of scale and research and
development spending. However, there is also a downside-even Norman
Augustine cannot lobby for 150 different programs in a single half-hour
meeting with his Secretary of State! And there are the usual challenges of
trying to maintain fleetness of foot and customer responsiveness while
extracting the benefits of economies of scale through centralization. But
the opportunity is there. </P>
<CENTER><B><FONT SIZE="+1">THE CHALLENGES FOR EUROPE</FONT></B></CENTER>
<P>The challenges in Europe are greater. We still have a fragmented series
of nation-states with their own industries and their own procurement
programs and processes. In the UK, the defense industry is private and
horizontally integrated, with much rationalization behind it. In Germany,
it is vertically integrated and privately owned, but it is in the early
stages of rationalization. In France, it is more fragmented, with
substantial portions that are still in government hands and experiencing
recapitalization, privatization, and heavy rationalization all at the same
time. In Italy, the industry is vertically integrated and state owned.
</P>
<P>Despite these differences, European countries have used international
collaboration for more than 30 years to divide up development bills and
achieve the economies of scale necessary for our defense products to be
competitive in the world market. These individual collaborative programs
have bred their own joint venture program companies, such as Eurofighter
for the Eurofighter 2000, Panavia for the Tornado, and European Helicopter
Industries for the EH101. We also have a number of direct joint ventures
with pooled assets and integrated management, such as DASA and
Aerospatiale's Eurocopter, Matra Marconi Space, and soon, we hope, Matra
BAe Dynamics. Such joint ventures will enable the necessary international
rationalization and specialization in centers of excellence. </P>
<P>But successful as these joint ventures have been, this collaboration
model will not meet the challenges of the future. Consolidation is
necessary. The immensely successful Airbus consortium, the result of the
vision, determination, and investment of the French and German
governments, has been able to awaken Boeing, the sleeping giant, which is
now tackling the market extremely aggressively by offering 30%-40% pricing
reductions for future deliveries. Europe must continue to respond in this
manner, and we do not have long to do it. </P>
<CENTER><B><FONT SIZE="+1">HORIZONTAL OR VERTICAL INTEGRATION,</FONT></B></CENTER>
<CENTER><B><FONT SIZE="+1">EUROPEANOR AMERICAN LINKS-</FONT></B></CENTER>
<P>There is much discussion in the UK about whether the defense industry
should be consolidated nationally on a vertical basis similar to the way
Germany and Italy have done it, or whether we should be concentrating on
European or transatlantic consolidation. The climate for transatlantic
cooperation is definitely improving, and the efforts of Secretary Perry
and Dr. Kaminski are to be much applauded. However, there are many major
obstacles to effective transatlantic collaboration, let alone
transatlantic consolidation. U.S. attitudes on security, black programs,
technology transfer, and export restrictions, such as allowing control of
foreign-owned U.S. defense subsidiaries only through proxy boards, are
hurdles. But in the long run, it should be in all our interests to make
sure we move to a truly global industry, one that requires a combination
of European and American assets. </P>
<P>At British Aerospace, we feel that European consolidation is a necessary
next step. Such consolidation would enable us to create organizations of
sufficient size and scale to measure up to the Americans, either as
competitors or as equal partners. This is certainly not possible at
present for the reasons already mentioned, but the pressure is on to make
some major moves forward in Europe. In five to ten years we hope that the
atmosphere in the United States will have changed enough for us to be able
to think about transatlantic links and truly global companies that can
then start to look for suitable partners in the emerging markets of
Eastern Europe and the Far East. </P>
<CENTER><B><FONT SIZE="+1">EUROPEAN RESTRUCTURING OPTIONS</FONT></B></CENTER>
<P>How do we begin to make progress in Europe- Continuing the trend toward
bilateral joint ventures in individual business sectors would produce a
number of national champion defense and aerospace companies sharing a
number of joint ventures, but would produce a situation in which many of
the parent companies would have a patchwork of different partners. Such a
system would produce some conflicts of interest, particularly if the
parent companies retained the right to interfere with the management and
planning decisions of the joint ventures. In the long run, we believe that
this is unlikely to lead to the most efficient structures in Europe, since
the differing levels of shareholding would hinder the true sharing of
Industrial Property Rights (IPR) and technology between the sectors where
these synergies can still be made to pay dividends. Such a system would
also create less efficient models of corporate management. </P>
<P>One solution that has been proposed is that one national company could
take over the control of one major sector. For example, the UK could lead
on military aircraft, France could lead on commercial aircraft, and
Germany could lead on space. Although this is a wonderful academic
suggestion, my personal view, after spending many hours over the past
years in smoke-filled rooms trying to achieve unanimous decisions on
collaborative programs, is that the effort required to get everybody to
agree to an orgy of asset swapping with all the problems of who has to
give up what and what it is all worth defies the imagination! </P>
<P>Another option that has been put forward is for each of the major
companies to come together in a series of mega-mergers and then
rationalize the whole industry on a sector-by-sector basis, leaving the
existing national champion companies as the investment vehicle for the
national stakeholders and as the national champions for interfacing with
the national governments in those areas where government support is
required. However, it does not take an M.B.A. to recognize that the
inefficiencies involved in these two levels of senior management activity
would produce a great deal of highly paid but low value-added activities
and would not be ideal. </P>
<P>Compared to the intermediate structures, however, this would further
increase scale and improve the authority of operational management, with
the holding companies retaining national identities and government
support. However, national interests and varying economic conditions would
prevent optimal efficiency, and the interests of the parent companies
would prevent fully autonomous decision making. </P>
<P>In our view, the best way for making progress in Europe is for the
mega-companies to merge, with national shareholdings held directly by the
shareholders in each country. Each operating company would be fully
integrated and its management would look only to the usual shareholder
financial interests. It would need to be structured in such a way that it
would retain a national identity in each major operating country. For
example, it could organize its facilities so that there would be a
national center of excellence and minimal duplication across a single
business sector. It would also need to organize so that each involved
nation retained a stake across the major business lines. This would be
particularly important for companies that expected to land significant
government contracts. There would also be inevitable linkage in tax-paying
democracies between the expenditure of very large sums of money on
military equipment and the votes that go with the jobs involved in
building the equipment. </P>
<P>Such rationalization at the major company level, however, is
insufficient unless similar economies of scale are also achieved in the
equipment and supply industries. Otherwise, benefits would be felt only by
the in-house-produced 30% of the value chain, with a corresponding loss in
international competitiveness felt by the bought-out portion. </P>
<CENTER><B><FONT SIZE="+1">A ROLE FOR GOVERNMENT</FONT></B></CENTER>
<P>Is this an issue that can be left only to industry- In an industry in
which individual governments are the markets and in which decisions on an
individual program can shape the success or failure of major companies,
governments do indeed have a role to play, particularly since the way in
which commercial negotiations develop has a significant impact on the
defense industrial base and its market. </P>
<P>For example, if Matra and British Aerospace complete their missile
merger and DASA and Aerospatiale complete theirs, should we combine the
resulting entities to form a company of sufficient critical mass to
compete with or partner with the Americans on an equal basis- In the
interests of maintaining European competition, should we let the two
groups remain, with neither truly large enough to compete with the
American giants on a global scale- If we want the two entities to be able
to compete in Europe with anything like an open market, the playing field
will have to be tilted in order to equalize the benefits American
companies would have on overall economies of scale. </P>
<P>In my view, therefore, it is necessary not only for industry to have a
clear view of its strategic goals, but for European governments to begin
to form some ideas as to what kind of defense industrial base and what
kind of overall European defense market they require for the future.
Currently the UK operates on an open, competitive policy, which at least
up to the recommendation to Ministers operates almost entirely on a
value-for-money competitive basis. Only when decisions reach Ministers are
political considerations overlaid. France operates a nearly closed
procurement system, except with such entities as AWACS, when the
development of a domestic or collaborative solution will be unacceptably
expensive. It is arguable that France is now wrestling with some of the
consequences of this policy. Germany has a strong record of supporting its
own industry but also has a more open view than France on procurement from
the U.S. and elsewhere. In all these countries, which together must
eventually form the pillar of European procurement organizations, it is
recognized that things must change and move forward and, inevitably,
converge. </P>
<P>However, it is almost impossible to envisage a common and centralized
European procurement system unless we have not only a common European
defense and security system but also unified armed forces and unified
political control over the decision-making process. All international
collaboration programs limit the degree of authority that can be released
to the central procurement agency because of the need for the national
ministries of defense to be accountable to their own parliaments for the
disbursements of their taxpayers' money. </P>
<P>The formation of a European armaments agency is an important milestone
on the way to acquiring defense procurements on a Europe-wide basis. Such
procurements are impractical based on the current Western European
Armaments Group (WEAG) proposals, under which 13 countries all need to
agree. Building on the proposed French/German/British/Italian structure on
a step-by-step basis is probably a more pragmatic approach. At present
every individual collaborative program only spawns yet another
international agency on tax-free NATO agency salaries to coordinate its
procurement. Having only a single entity into which each new collaborative
program could be added would produce significant savings in overhead
support costs. An approach of this kind might also encourage the nations
involved to talk more closely about coordinating their procurement
requirements, the key to enabling successful collaboration. </P>
<P>The continuing consolidation of the European industry along
international lines will also help in this respect. Once Matra and BAe
Dynamics are together it will make more sense for the French and British
air forces to talk together about their future air-to-air missile
requirements. Conversely, if the governments pursue a policy of
collaboration with other nations on a bilateral basis running contrary to
the alignments that industry is seeking, the results will be neither a
harmonious relationship between customer and industry nor one between
industrial partners, who increasingly feel themselves pulled in different
directions by their national governments. </P>
<P>It is important that we avoid any suggestion that we are creating a "Fortress
Europe" through this policy. We wish to have reciprocal access
between the European and the American defense equipment markets, even if
that means opening up the American one a little. We should be
collaborating more across the Atlantic, not less. And while this probably
implies a less advantageous market for American contractors than they have
enjoyed in the past, it should put them under greater pressure to find
real partners rather than a collection of small companies to take offset
work. </P>
<CENTER><B><FONT SIZE="+1">CONCLUSION</FONT></B></CENTER>
<P>It seems, then, that we must embark on three major courses: </P>
<UL>
<LI>In the nations where industry has not yet been rationalized on a
national basis, we need to take the first steps of rationalization to
achieve internationally competitive operations.</LI>
<LI>We must consolidate the industry on a European scale, possibly with a
mixture of mega-mergers at the major prime contractor level and
sector-by-sector mergers with other partners.</LI>
<LI>Government needs to provide a strategy and a vision for the
development of the European defense market, a strategy that will enable
industry to produce a long-term rationalization plan with at least some
surety as to how the market is likely to develop. Awards of major
programs that can have a major impact on the patterns of consolidation
should be used where possible by the governments to steer developments
in the direction they would prefer. If this sounds like interventionism,
so be it; it is a natural consequence of governments being the market.</LI>
</UL>
<P>While there is no doubt that this is one hell of a challenge, with high
stakes and harsh penalties for failure, I believe it can be met. And there
is no doubt that these steps must be undertaken. </P>
<P><A HREF="Weston.htm">Go to top of page</A> <BR><A HREF="Workshop96.htm">Return to Warsaw '96</A> <BR><A HREF="../index.html">Return to Home Page</A> </P>
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