Europe's Defense Industry: No More Flying Solo?

The BAe-DASA merger may spur deal mania in defense

After years of talk about streamlining Europe's inefficient defense and aerospace industries, there are finally signs of action. Two of the biggest players, British Aerospace PLC (BAe) and DaimlerChrysler Aerospace (DASA), confirm that they are in "advanced" talks on consolidating. The duo would form the cornerstone of a European defense group, with sales in the $25 billion range, on a scale to compete with U.S. giants such as Boeing Co. and Lockheed Martin Corp. BAe is a world leader in airframes and has a lead role in building and designing the Eurofighter. It is far ahead of its European rivals as a low-cost manufacturer. The smaller DASA is strong in aircraft assembly, space technology, and avionics.

Their union would signal that Europe's defense sector is at last beginning to behave more like other industries. Scores of European corporations are in the throes of a merger boom, sparked by globalization and the imminent single currency. But Europe's defense contractors have long resisted the changes that have reduced the U.S. industry to just three major players--Boeing, Raytheon, and Lockheed Martin.

DEATH KNELL? Now, with the cold war long over and defense procurement budgets slashed by half, Europe's balkanized defense Establishment of 10 or so medium-size companies no longer seems sustainable. Indeed, nearly every one of them is looking for a partner. "Facing lower-cost competition from Boeing and Lockheed Martin, the Europeans feel obliged to match it," says Nick Cunningham, an analyst at Salomon Smith Barney in London.

The BAe/DASA talks could also sound the death knell for Europe's dream of a single defense behemoth. Instead, an industry with several centers may take shape, one BAe/DASA, and others built around French companies. Britain and Germany, most observers agree, appear to have made a decision to plunge ahead without France, which is increasingly out of step with its two aerospace partners. "The notion of a single company is harder and harder to believe," says Robbin F. Laird, an independent defense consultant in Washington.

Despite the efficiencies the merger will bring, the betting is that in this most political of industries, the new company still won't be operated entirely on commercial principles. For example, executives are likely to make a big effort to preserve jobs in Germany. In addition, the future of commercial aircraft builder Airbus Industrie, in which both BAe and DASA have a major ownership stake, is far from settled. Some analysts dismiss the BAe/DASA talks as a bluff intended to prod the French, key players in both Airbus and European defense, into getting serious about privatization and restructuring (box).

Nevertheless, Europe's arms chiefs realize that they can't maintain the status quo forever. With defense budgets constantly under review and demand for exports in the Middle East and Asia no longer so strong, they have little choice. Rules against foreign ownership of defense companies and procurement procedures that favor nationals are also gradually on the way out. "We believe defense is becoming a global business," BAe CEO John Weston said recently. "We want to become part of one of the two or three largest global players."

On the German side, the deal fits in with DaimlerChrysler CEO Jurgen E. Schrempp's goal of making the struggling DASA competitive. And the merged company would offer huge cost savings, especially on the Eurofighter, which is just beginning production. Cunningham estimates that $415 million per year could be slashed from the project's cost just by combining the two companies' assembly, avionics, and other operations.

MORE MUSCLE. Some smaller players seem likely to join the BAe/DASA group. BAe purchased 35% of Sweden's Saab for $440 million in July and is helping to market Saab's new Gripen fighter. BAe also has a missile alliance with Matra High Technologies. BAe's Weston says the ultimate goal is a tie-in with one of the major U.S. contractors. Raytheon Co. and Northrop Grumman, midsize American players, are possible partners. But many Europeans think they have to whip their own industry into shape first. "We need to build up muscle to talk to the likes of Boeing and Lockheed Martin," says Saab CEO Bengt Halse.

For their part, the U.S. companies want to grab more of the $50 billion European defense market from today's 10%. BAe, seen as the best managed of Europe's defense companies, is already bidding with Lockheed Martin for development work on the next-generation U.S. warplane, called the Joint Strike Fighter, which Britain may also buy.

A wild card is General Electric Co., BAe's British rival. Under George Simpson, who became CEO in 1996, the defense electronics giant has been shuffling assets and trawling for partners. Simpson is known to have talked with BAe, and he could still go for such a link-up. But joining with a U.S. players, such as Lockheed Martin or Raytheon, might be a hotter ticket. Simpson recently bought Tracor Inc., a U.S. defense electronics maker, for $1.4 billion. He has hinted that he is close to wrapping up a bigger deal. If the British-German deal goes through, it's likely to be just the first tremor in Europe's long-delayed defense shakeup.

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