CNBC Business | ALLIES IN DISGUISE

ALLIES IN DISGUISE

European defence companies are camouflaging themselves as Americans in order to penetrate a booming but tightly regulated market, says Mark Joyce

The traditional US-made Sikorsky choppers of presidential taxi service Marine One, seen here, are to be replaced by a variant of the European AgustaWestland EH-101

There are few items of military hardware more iconic than those of the Marine One fleet. The 19 helicopters in which the US president and his aides are ferried around the country has, since the mid-1950s, been built by Connecticut-based manufacturer Sikorsky. A symbol of engineering excellence, the success of the Sikorsky helicopter has long been held up as testament to the benefits of buying American, so there was widespread dismay when the US Department of Defense decided last year to replace the ageing Sikorsky fleet with a European helicopter. From 2009, the famous green and white of the US Marine Corps will adorn a variant of the AgustaWestland EH-101, designed in Somerset, UK.

Owned by Finmeccanica, Italy’s second-largest industrial group, UK-based helicopter manufacturer AgustaWestland will adapt a design originally sold to the Royal Navy for use in anti-submarine warfare. As well as providing the design, the Anglo-Italian consortium will manufacture around one fifth of the helicopter’s components, pocketing a large chunk of the €4.6bn awarded to the project’s prime contractor, US giant Lockheed Martin.

The success of the Anglo-Italian bid sent shockwaves through a US defence industry grown used to having everything its own way. The Bush administration was accused of playing politics with a crucial contract by seeking to reward the UK and Italy for supporting the US-led war in Iraq. Both Tony Blair and Silvio Berlusconi have pushed the bid during separate visits to the White House.

A US Army M48 A3 Patton tank

To view the Marine One contract as merely the result of high political horse trading is to underestimate its significance as a model for modern international defence transactions, however. As military systems grow in complexity and cost, and with key technological know-how becoming increasingly globalised, it is harder than ever to construct major defence contracts on a purely national basis. Yet with defence still one of the most heavily regulated and protected areas of industrial activity, companies must become increasingly creative in doing business across national borders. For Europeans seeking to cross the Atlantic, this often means reinventing themselves as Americans.

Distasteful as it may be, the incentives for this reinvention are clear. World military expenditure topped $1 trillion (€770bn) in 2005, corresponding to 2.5% of world GDP or an average spend of $173 (€133) per capita. The US was responsible for 48% of this total, distantly followed by the UK, France, Japan and China with 4%-5% each. As well as being by far the largest spender on defence, the US is also the most dynamic market, with an annual budget set to top $500bn (€385bn) by the end of the decade. The major European nations, by contrast, have stagnant or declining defence budgets that are insufficient to sustain the continent’s large defence industrial base. As a result, European companies must increasingly look abroad for business – and in the great majority of cases, this means the US.

The extent of European penetration of the US market is notoriously difficult to assess. As Pierre Chao, a defence industry analyst at the Center for Strategic and International Studies in Washington, puts it: “Assessing the current state of transatlantic defence relations is similar to commenting on modern art – everybody sees something different. Where some see progress, improvement and opportunity, others see lack of reform, obstacles and risk.”

A Marine One Sikorsky lifts off from the White House lawn

About €770m of direct European defence sales to the US in 2005 represented a superficially unimpressive 1% of the total US defence market. Chao points out, however, that this was a 100% increase on the direct sales of 10 years ago. More importantly, European companies have over the same period acquired 67 US defence firms, collectively worth €7bn, making Europeans an increasingly important indigenous player in the US defence marketplace.

The best example of this trend is BAe Systems, the company formed in 1999 through a merger of British Aerospace and Marconi Electronic Systems, the defence arm of the General Electric Company. The merger enabled BAe to establish itself as a domestic defence supplier in the US, a position it has consolidated through a series of major acquisitions of US firms in the last eight years.

In 2005, BAe purchased US arms manufacturer United Defense Industries for around €3bn, financed in large part by the sale of some of its stakes in various European businesses, including Finmeccanica and Saab. The deal made BAe the fifth-largest defence contractor in the US and helped to propel American sales to 37% of BAe’s global revenues, making the US a more important market than the UK. The sale last year of BAe’s 20% stake in Airbus to majority stakeholder EADS indicates that BAe intends to focus ever more intensely on the US market in the coming years.

Even for the most trusted and established partners, the US is an extremely difficult market in which to operate. A web of complex technology transfer regulations prevents foreign governments and companies from accessing much of the information they need for meaningful cooperation, while a lack of coordination between the executive branch and Congress means that bilateral trade deals frequently run into problems of execution.

The best recent example is the Joint Strike Fighter (JSF), a state-of-the-art military aircraft being developed by the US in partnership with the UK, with additional support from Australia, Italy, the Netherlands, Canada, Turkey, Norway and Denmark. Despite agreeing to contribute around 10% of the development costs, the UK government and BAe Systems have become increasingly frustrated by congressional refusal to relax technology exchange regulations, which the UK requires if it is to be able to maintain and upgrade its share of the aircraft without depending on the US. The disillusionment produced by the JSF saga has been so great that it has caused many to re-examine the broader US-UK relationship.

As Mike Turner, CEO of BAe Systems, put it to the Washington Economic Club in May 2006: “If the US cannot find a way to share US systems technology then, speaking more as an individual British citizen than CEO of BAe Systems, I am concerned about the consequences. I believe that British ministers will face two unpalatable choices. Either they will be unable to send UK armed forces into operations because they lack the required capability, or they will have to look somewhere other than the US to try and find alternative sources for capable equipment solutions.”

Although Congress justifies its intransigence on grounds of security, many suspect that the refusal to share key technologies is based on nothing more than old-fashioned industrial protectionism. Much of the technology to which trusted international partners are being denied access is relatively benign. As Chao puts it: “We trust the UK with nuclear weapons, but we don’t trust them with an eight-inch rubber hose.”

The F-16 Fighting Falcon is manufactured by Lockheed Martin, the largest player in the rapidly consolidating defence sector

Frustrated with the vagaries of US regulations, some European governments have made exploratory forays into other growing markets, such as China and Latin America. The Spanish and French governments provoked fury in Washington in 2005 when they argued for a relaxation of the international arms embargo against China and arranged a sale of military patrol boats to Venezuela. American threats to take punitive action against European companies operating in the US caused France and Spain to back down on both issues, providing humiliating evidence that any country serious about making money from defence has no choice but to stay on good terms with the US.

In spite of political tensions, market forces point to ever-closer integration between the transatlantic defence industries in the coming years. The US and European defence industries have now consolidated to a point where a handful of prime contractors dominate on either side of the Atlantic: Lockheed Martin, Northrop Grumman, Raytheon and General Dynamics in the US, and BAe Systems, EADS, Thales and Finmeccanica in Europe.

The dominant current trend is towards increasingly close and convoluted cooperation between these major industrial powers, with European companies securing business in the US – and vice versa – by partnering with local firms and undertaking to conduct the bulk of the work in the purchasing country. When it works well, this approach enables expertise and profits to be shared across the Atlantic while appeasing native defence industrial lobbies. Although legislative intransigence in Washington and in the European capitals continues to present serious obstacles, market forces are beginning to provide solutions where politics has failed.