Military Contractors: On the Defensive
It was one of the juiciest and most hotly contested defense contracts in Europe: the Polish Air Force's $3.5 billion order to replace its aging fleet of 75 Soviet-era MIG-21s. When Bethesda (Md.)-based Lockheed Martin Corp. walked away with the prize on Dec. 27, the European defense companies that vied for the deal--France's powerful Dassault Aviation and a joint venture of Britain's BAE Systems and Sweden's Saab--were left with a bitter taste in their mouths.
The award, after all, came less than two weeks after Poland was formally invited to join the European Union. Talk about a snub. "It would be like Mexico, the day after it joined NAFTA, opting to buy all-European military equipment," was how one top executive of Franco-German aerospace giant European Aeronautic Defense & Space Co. (EADS) put it. The Europeans were particularly irked that Washington granted Warsaw $3.8 billion in soft loans to help finance the purchase of the F-16 fighter jets.
The fumbled Polish deal could be the wake-up call that Europe's hard-pressed defense and aerospace industry so badly needs. Many in the industry argue that if Britain, France, and Sweden had agreed on a single offer to the Poles and backed it up with political pressure, they would have won the order. Already, the episode is giving new impetus to plans to boost joint spending on military research. It has even brought forth calls, notably from Serge Dassault, whose family controls the eponymous French aerospace group, to close off Europe to U.S. defense suppliers by giving "preference" to European manufacturers. So far, no European politician is willing to go that far. Nonetheless, the lost Polish sale is a stark reminder of the ever-growing competitive gap between American defense companies and European rivals like EADS, Thales of France, and BAE. "The gap between the U.S. and Europe will grow dramatically," predicts Horst Teltschik, a leading German defense expert and former national security adviser. "I'm very pessimistic."
The Europeans are making some efforts to catch up. One way is to boost the funds earmarked for defense research. In late 2001, Britain, Germany, France, Spain, Italy, and Sweden launched the European Technology Acquisition Program, endowed with a $1 billion budget for new aerospace technologies. And there has been talk of creating a European Security & Defense Agency, to coordinate defense policy, R&D, and procurement for most of the European Union.
These efforts may be too little, too late. For one thing, even while European funds for defense research are set to rise marginally, actual outlays for military hardware by the Continent's budget-strapped national governments are declining. The Americans were already outspending the Europeans before September 11 brought a huge boost in the Pentagon's budget. Compared with Europe, the U.S. spends four times as much on defense-related R&D--over $40 billion last year--and more than twice as much on military hardware. The U.S. boasts another clear advantage: Thanks to the waves of consolidation that swept over its defense industry in the 1990s, companies like Boeing, Raytheon, and Northrop Grumman tend to be vastly larger than their European competitors. They're more profitable, too: On average, U.S. defense contractors have operating margins one-third higher than their counterparts across the Atlantic.
European defense companies are under siege from all directions. Compared with their U.S. peers, the Continent's contractors must shoulder more of the R&D burden themselves. Thales, the French defense-electronics group, spent an average of more than 6% of sales on research in the 1990s, vs. 2% to 3% for Raytheon and Boeing. Now, European contractors are being squeezed because tightfisted governments, with the exception of France and Britain, are trimming defense budgets. At the same time, publicly traded companies are feeling unprecedented pressure from investors to improve margins. In response, Thales, whose 2002 revenues are estimated by Deutsche Bank at $11.5 billion, pared back R&D outlays to 4% of sales last year.
The big worry is over future programs. Because of the shift in U.S. military strategy toward high-tech "network-centric" warfare--the sort that was on display in the Afghanistan campaign--both the Pentagon and U.S. contractors have been moving resources to a wide variety of next-generation technologies, such as energy-beam and microwave weaponry.
Fears of falling behind in this high-tech arms race are forcing European governments to think of ways to work more closely together, partly so as to get a bigger bang out of each euro. The Organization for Joint Armament Cooperation (OCCAR), a joint military procurement agency set up by France, Germany, Italy, and Britain in 1996, is already acting as the lead purchaser for some of the Continent's biggest military programs, such as the Airbus A400M military transport plane, the Tiger attack helicopter developed by EADS, and the Anglo-French Meteor air-to-air missile. Yet the Bonn-based agency is totally dependent on individual country budgets. Germany and Portugal have sharply rolled back their planned purchases of the A400M, while other countries may pull out of the program altogether, possibly putting it in jeopardy. "OCCAR was supposed to be the solution, but look at the problems of the A400M," says Virginie Banet, a Paris-based European aerospace and defense analyst for Deutsche Bank.
It's a similar story with the multibillion-dollar Eurofighter consortium backed by EADS, BAE, and Italy's Alenia Aerospazio. Because it brings together various contractors with different agendas, budgets, and ambitions, Eurofighter has morphed into a defense white elephant. The original budget of $35 billion has now increased by 50%, while the entire program has been plagued by delays. Because of such snafus, the Eurofighter is losing ground to rival projects, such as the Joint Strike Fighter, in which Lockheed is the lead contractor. Hedging their bets, Britain, Italy, Holland, Norway, and Denmark have committed $5 billion toward the JSF's overall $226 billion development costs. Deliveries of the JSF are expected to start in 2008.
Growing U.S. dominance of European defense is creating a backlash. Dassault Chairman and CEO Charles Edelstenne argues that governments around the world should buy more European hardware for a simple reason--to keep the market competitive. Even now, top players have little incentive to pass on savings from economies of scale to their customers, argues Edelstenne. "The day when there will be no more competition," he says, "prices are really going to explode." But if the Americans sweep away all before them, the Europeans can only blame their own inability to get their defense act together--and back it up with cold cash.
By John Rossant in Paris