The writing has been on the wall since the end of the cold war: Europe's defense contractors will never survive shrinking markets and exploding costs without massive consolidation. Now, weapons makers are biting the bullet. In early May, France'sMatra-Hachette and British Aerospace PLC (BAe) said they were on the verge of merging their missile businesses. The venture would result in Europe's largest producer of missiles, with annual sales of some $1.7 billion.The deal could be the big bang that trips a chain reaction around the Continent. Already, the new Franco-British alliance has opened talks with Germany's Deutsche Aerospace (DASA) and Aerospatiale of France about joining in. The European grouping would form a potent challenger to Hughes Aircraft Co. and Raytheon Co., the top U.S. missile makers, as all increasingly look to exports to offset shrinking orders at home. "The Americans have done a good job of building major economies of scale and now are looking overseas for growth," says analyst Nick Cunningham of S.G. Strauss Turnbull Securities. "That's the big threat the Europeans must respond to."

Indeed, in the last year, the U.S. missile industry has seen Loral buy LTV, Martin Marietta acquire GE Aerospace's operation, and General Dynamics sell out to Hughes. But so far, Europe has only pulled off small pairings of complementary specialists, such as the joint venture formed last March between guidance-electronics leader Thomson-CSF of France and missile maker Short Brothers PLC of Northern Ireland.

More European producers will have to link up if they are to match the Americans on price in global markets and survive defense-budget cutbacks at home (chart). Europe's 10 national missile makers, from DASA and Italy's Alenia to Britain's General Electric Co. and Bofors of Sweden, must converge into two or three, says Thierry Huon of Paris-based Finacor. That would surely accelerate the cutting of Europe's 1.4 million defense jobs, of which 20% or more are expected to go by 1995. DASA and Aerospatiale are already talking about deepening their cooperation in antitank missiles. But such development consortiums alone are no longer sufficient to stay competitive.

A Matra-BAe tie-up underscores the point. It cuts costs by joining their overlapping air-to-air missile programs and 8,200 employees. And their combined product line has a formidable range and customer base. Matra's medium-range Mica missile, the primary armament for France's Rafale and Mirage fighters, is a big seller to such growing customers as Taiwan, as is BAe's antiradar Alarm missile to Saudi Arabia.

PARTNER PATROL. The new venture could undercut U.S. hegemony in such expanding markets as the Middle East, where many countries will soon be refreshing their 1970s-vintage weaponry. Matra's Mica also stands a strong chance of replacing Hughes's aging Sidewinder missile in Spain, Italy, and other markets. And with a European backlash developing against U.S. trade policy, BAe and Matra may team up to knock out Hughes's AMRAAM as the front-runner to equip NATO's next-generation Eurofighter, due out in 2000, with medium-range missiles.

The Matra-BAe deal will also shake up the strategies of European rivals. It should give privately held Matra a loud voice in current talks over combining missile activities of state-owned Aerospatiale and Thomson in France, where it otherwise risked playing second fiddle. And in Britain, it heads off threats by GEC or U.S. companies to forge closer ties to Matra, whose air-missile technology is widely considered among the world's best. Indeed, says a senior British military official, defending its market share is one of BAe's "prime motivations" for doing the deal.

The merger could still stumble over such details as how to rationalize competing air-to-air programs. Similar problems helped torpedo a 1991 deal between BAe and Thomson. But both BAe Chairman John Cahill and Matra's Jean-Luc Lagardere are hell-bent on finding partners--and neither has been in such a strong position in years. Both won landmark orders last year: $1.9 billion worth of Matra Micas from Taiwan and $900 million for BAe short-range missiles from the British Royal Air Force. Now the combined firepower of Matra and BAe may send rivals running for cover.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE