The best form of De fence

The best form of De fence

In theory, it would be a far more sensible solution to see theEuropean industry rationalised with a bout of takeovers, mergers andprivatisations.

‘Europe’s defence industry is heading for three or four very exciting years. There has been a huge process of consolidation in the US – now they are hungry for exports and are beginning to hunt European companies.

This will mean a lot of restructuring, joint-ventures and programming within Europe,’ says Keith Browne, a partner with aerospace and defence responsibilities at Coopers & Lybrand.

The approaching ‘excitement’ comes on top of a decade of upheaval as the industry battled with the end of ‘cost-plus’ contracts and the global recession – not to mention the end of the Cold War. This last in particular has sent reverberations through every corner of the industry as specifications are re-written, orders cut and procurement budgets slashed.

Given all this turmoil, coupled with the rise of the ‘ethical investor’ posing awkward questions at agms and scrupulously avoiding firms with links to the arms trade, one might think some of the UK’s biggest manufacturers would be rushing to quit the defence sector, but not a bit of it.

In fact, the country’s biggest defence company, British Aerospace (BAe), is actually specialising more and more in the sector. Military aircraft now account for almost all profits and lie behind the company’s recent spectacular performance on the stock market. Overall, it reported half-year profits to 30 June of #215m, but only thanks to pre-tax profits from the defence division of #255m on sales of #2.17bn (a margin of 11%). There seems every reason to believe this dependence will grow over the coming years with more than #9bn-worth of weapons orders on the books. Since the end of the accounting period, BAe has also secured a further #2.4bn from the Ministry of Defence (MoD) for Nimrod maritime patrol aircraft and cruise missiles.

‘BAe is now predominately defence,’ says Browne. ‘On the civilian side it really only has Airbus – the small aircraft division based at Prestwick is having serious difficulties. By the end of the century, BAe could be entirely defence-based.’

The company’s achievements within the sector should not be underplayed.

It has hardly been out of the news this month, see-sawing between elation and despair. Qatar is spending #500m on a package of UK arms, including BAe’s Hawk Trainer jet. Australia too is just buying #1bn-worth of the same aircraft. But, less happily, the US has just knocked the company’s consortium off the shortlist to build the new Joint Strike Fighter. A bitter pill: the contract will be worth #100bn and the plane will eventually replace BAe’s own Harrier.

Defence is a tough market to operate in and BAe is one of the few companies to emerge from the last decade with a smile on its corporate face, until the US body blow at least. One of the most difficult issues which it has mastered is long-term planning. While most sectors are grappling with predicting markets two or three years in advance, defence companies have to think 20 or even 30 years ahead. For example a ship commissioned today will probably still be in service in the year 2020.

As if this was not difficult enough, customer requirements can change suddenly. The most dramatic recent example was the effects of the fall of the Berlin Wall. Almost overnight one of the two military powers which had divided Europe for almost 50 years disappeared. Not surprisingly, defence needs were transformed. Germany was probably the most affected, finding herself with two armies, the prime aim of each to fight the other.

In light of this, it was not surprising that the Bonn Government started to look around for potential savings.

Eurofighter

The collaborative project between Western nations including France, Germany, Spain and the UK to build Eurofighter was an obvious candidate. Conceived prior to the fall of the Wall, the fighter was designed to attack massed tanks pouring westwards across the Central European Plain – suddenly no longer a serious military possibility. Struggling with the costs of reunification, Germany threatened to pull out of the project entirely and was only retained as a partner by the combined weight of diplomacy and a face-saving re-drafting of the specifications.

‘It’s a highly political industry, particularly when it comes to sales: nothing is simple,’ says Richard Gane, a partner at Price Waterhouse.

‘There are very few straightforward deals based simply on price and specifications – instead sales depend just as much on jobs, political allegiances, international alliances and so on and this means calculating costs can be extremely difficult.’

These difficulties are compounded when it comes to development costs which can be astronomical. Modern weaponry is increasingly technologically sophisticated, with specific systems developed for each product: ‘In an age where planes, ships and vehicles are really little more than platforms for sensory equipment and defence systems, the ability to integrate very complex systems is increasingly important,’ says David Essex, partner specialising in the aerospace and defence industries at Ernst & Young.

The costs of developing such systems are multiplied by small production runs and high levels of robustness, leading to astronomically high R&D bills.

Until the late 1980s, these were paid for on the basis of ‘cost-plus’ – effectively underwriting development costs and guaranteeing a reasonable profit. Such a cosy arrangement was inevitably subject to criticism, however, and under the leadership of Sir Peter Levene, the MoD discontinued the practice. Instead, contracts became fixed price, shifting the burden of risk to the private sector. ‘Looked at from the business planning perspective, product development costs are now carried out of the company’s own pocket rather than guaranteed by the Government,’ says Gane.

‘You cannot over-emphasise the degree of change that produces,’ agrees Essex. So, for example, instead of farming out the Merlin contract for the EH101 helicopter to a UK electronics company like Marconi or GEC, the deal went overseas to IBM as the prime contractor: ‘Although the precise reasons have not been revealed, we can speculate that IBM’s size was a factor for a very complex systems integration project,’ he says.

Essex believes that, although the shift to fixed price contracts has certainly produced some savings, the trend probably went too far: ‘There are very few companies which can afford to take a #1bn hit on a big failed project,’ he says, pointing out problems were exacerbated by changing specifications in light of the collapse of the Soviet Bloc and the global recession.

Today the industry is under pressure to demonstrate value-for-money as never before. The problem is that just as the Government is demanding more sophisticated products at lower prices, so it is forcing up costs by cutting back heavily on its procurement budget, halved since the fall of the Berlin Wall.

One way of minimising the costs and risks is with co-operative ventures – frequently with arch rivals. Thus a highly competitive tendering process between defence companies is frequently followed by close co-operation.

In fact, some big operators even bid against themselves for big orders (for example recently BAe was bidding for both the Orion P3 and Nimrod airborne warning systems). Although Gane says the concept seems alien to many outsiders, the industry is used to the procedure: ‘It is a game they understand,’ he says, adding that the real skill comes in cherry-picking within co-operative projects: ‘There’s an art in dominating contracts – getting the lion’s share of the most profitable work.’

There are other reasons for co-operating, particularly across borders.

One principle benefit is increasing the market. ‘You have to look at it in terms of critical mass,’ says Essex. ‘Not one European country has the critical mass to service a specific industry.’ In contrast, US defence spending outweighs the buying power of all European governments combined, making the country self-sufficiency in arms production in every sphere.

Level playing fields with the Americans

One answer for European manufacturers is to tie in several governments to a product. This maximises sales and thus reduces costs, allowing European products to play on a more level playing field with US competitors. It also reduces the temptation for the customer to change the rules midway through development (for example, when Germany abruptly decided to abandon the Eurofighter, she was prevented by the combined diplomatic weight of her partners).

Not that such agreements aren’t painless. ‘Many deals are made much more inefficient for political reasons,’ says Essex. He cites the example of the new Tornado being built in three different countries. Not only does this lead to duplication of plant, machinery and workforce skills, but it severely hampers management from getting the full benefit of the learning curve and this handicaps Europe’s defence industry when competing in international markets. In addition, such temporary co-operative deals pose serious intellectual property problems.

In theory, it would be a far more sensible solution to see the European industry rationalised with a bout of takeovers, mergers and privatisations.

This would cut prices and lead to greater choice by allowing procurement decisions to be taken purely on cost and specification. Unfortunately for taxpayers the process is all-too-often blocked by a combination of national security concerns and political unpopularity. Would it be safe for the UK to depend on German tanks, particularly in view of the events of 1939-45? Even if it were, how many politicians could face announcing the imminent redundancy of thousands of defence workers?

Thus when BAe attempted to form a consortium with Daimler-Benz Aerospace to bid for the profitable German defence company STN, the bid collapsed after the defence ministry in Bonn said it would prefer the company to go to a German buyer. The reason was that STN makes fire control systems for Germany’s Leopard tank and thus the deal might compromise national security.

Not withstanding this set-back, Browne expects BAe to continue to look for European manufacturers to take over: ‘It has to consider further acquisitions around Europe,’ he says. ‘One attractive proposition is Thomson which is about to be privatised, although it remains to be seen whether the French Government would allow ownership to go abroad.’

Even within the UK there are candidates for takeovers, whether hostile or friendly. Browne points particularly to rumours about GEC being open to a deal: ‘George Simpson now sits on the boards of both BAe and GEC – that would seem to indicate a merger could be on the cards.’ Even at home nothing is simple: ‘The MoD is probably reluctant to see this happen because it would reduce competitions within the UK’.

Notwithstanding all the problems facing the industry, however, observers say it will remain a lucrative business for the big players for the foreseeable future. As PW’s Gane puts it: ‘Taking a rather cynical standpoint, people will be wanting to blow each other up for a long while to come.’

The Ethics Girl and New Man factor

‘Arms and tobacco are probably the issues which raise most concern among people wanting to invest ethically. In the first case, it’s prompted by concerns about sending weapons to oppressive regimes and, in the second, it’s mainly motivated by outrage about aggressive marketing in the Third World.’ As a senior tax adviser at Grant Thornton, Mike Warburton is familiar with the concerns behind ethical investment.

People within the defence industry – and particularly the strategists – certainly complain about ethical investment and say they are worried about its potential effects,’ confirms Richard Gane, a partner at Price Waterhouse, who thinks many of the alarmist stories about a new morality affecting business practices has been over-hyped by the press: ‘Personally I’m sceptical that it’s much of a danger,’ he says.

Growth in ethical products

All the same, it’s easy to see why companies with a heavy involvement in areas such as defence, tobacco, animal testing and alcohol should be concerned. Over the past decade there has certainly been a rapid growth in the number of ethical products: there are now some 43 trusts and funds open to investors. Over the past two years alone there has been a 26% rise in funds invested ethically (to over #1bn), prompting a wave of interest in the sector and apocryphal stories in the press about big companies withdrawing from controversial areas to protect share values.

According to Warburton, this is unduly alarmist: ‘A 26% rise sounds impressive but the whole stock market has performed well over the same period – I certainly haven’t noticed any discernible rush to buy ethically,’ he says.

And although hard facts and figures are hard to come by, he refutes the impression frequently given in the press that the funds are driven by younger investors: ‘They can be of either sex, but they tend to be older, simply because older people have more money and are therefore often not so worried about securing the highest possible rate of return.’

Avoiding ‘bad’ stocks

Warburton believes most ethical investors define themselves not by a positive step of buying ‘good’ stocks, but by avoiding ‘bad’ ones. In addition, he points out that the sector is a huge and fractured one. Although most ethical funds stress steering clear of animal testing, alcohol, tobacco and defence, one of the commonest scruples among his older clients is a refusal to put any money into Japan because of the last war. ‘There are a few people who do the opposite – actively buying, for example, environmentally friendly stocks,’ he admits, but he adds this should not be over-emphasised.

‘Most investors tend to split their money. They might put 10% into ethical stocks, but the rest is invested for a good return, even if that means say, defence or tobacco companies.’

His impression is backed up by research at Bath University where the Economic and Social Research Council has conducted a detailed study of 20 investors with investments worth between #10,000 and #250,000. Ten invested in ethical unit trusts while ten put money into Shared Interest, a company which invests in projects in developing countries. In spite of this commitment to the concept of morally-responsible investment, however, almost all (19) put the bulk of their money into mainstream investment vehicles, including companies clearly involved in ‘questionable’ activities such as deforestation and, crucially, weapons production.

As one Christian investor involved in the survey put it: ‘We felt we had some spare cash and it wouldn’t be disastrous if it went down the plug hole, it was more of a donation than an investment.’ Warburton confirms this is true of his experience: ‘Many of my older clients feel they have plenty of money and are not too worried about the rate of return,’ he says. ‘They don’t mind that ethical funds might not perform as well as other areas – although recently some funds have actually done very well.’

Cause for concern

Nonetheless, companies involved in controversial areas may have some cause for concern – at least in the long run. According to research conducted by NOP for Friends Provident earlier this year, only a fifth of people questioned (21%) had ever heard of ethical investment. In spite of this, virtually everyone (95%) agreed with the statement: ‘I want my investment to benefit companies which are helping rather than harming the world.’ It seems there is at least a potential for squeamish investors to influence long-term business strategy.

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