The European Defense Industry
In the Global Market
Mr. John Weston, CBE, FRAeS; Chairman
British Aerospace Defence Ltd.

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.

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.

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.

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.

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.


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.

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.

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.


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.

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.


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.

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!

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.

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.

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.

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.


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.

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.

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.

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.

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.

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.

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.


It seems, then, that we must embark on three major courses:

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.

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