German Joint Venture Signals Big Changes in European Defence Industrial Base

By Dr Henrik Heidenkamp, Research Fellow, Defence, Industries and Society Programme

With declining equipment budgets and less spending on research and development, companies active in the European defence market face a multitude of strategic options to address the new realities of their professional environment. They range from portfolio consolidation, the focus on exports and support work, the investment in emerging defence markets, the pursuit of adjacent markets, to a strategic exit from the defence sector.[1]

An example of this is found in Germany. Under the name Rheinmetall International Engineering GmbH, the German automobile parts and defence equipment manufacturer, Rheinmetall, will team up with global plant construction and engineering service provider Ferrostaal to create a joint venture, incorporating Ferro­staal’s Oil and Gas business.  Rheinmetall has taken a de­cisive step for the future strategic orientation of its business activities. The joint venture will inter­natio­na­lise Rheinmetall’s defence business and diversify the Rheinmetall group’s overall income basis, there­by making it less dependent on the company’s traditional German and European home markets, which present an increasingly difficult business environment for defence products.

Investing in Emerging Markets

Marketing Rheinmetall’s broad defence product portfolio in combination with Ferrostaal’s expertise to build local production facilities, Rheinmetall International Engineering will be well positioned to win business in growing defence markets like India, Brazil and Abu Dhabi. As international customers, governments in these countries increasingly seek to balance their defence imports with the develop­ment of domestic defence production and service capabilities.

For example, in its recently released ‘Defence Procurement Procedure’ (DPP), the Indian Ministry of Defence (MoD) introduced a procurement hierarchy with ‘Buy (Indian)’ as the most preferred category, followed by ‘Buy and Make (Indian)’, ‘Make (Indian)’, ‘Buy and Make’ and ‘Buy (Global)’ in an effort to boost the Indian defence industry. Any foreign company winning an Indian defence contract over $60 million must spend at least 30 per cent of the contract value, including the re­search and development phase, in procuring services or supplies from Indian sources as a means of encouraging the transfer of critical technology.[2]

The joint venture will provide Rheinmetall with a promising base to win contracts in growing defence markets like the Indian market. It will enable the company to better present itself as part of indigenous defence industrial bases and more effectively market its equipment as indigenous products. Moreover, it will diversify the geographic distribution of its income base – arguably an imperative for long-term commercial viability in the current and future global defence business environment.

In its efforts to set up local production facilities in global target growth markets, Rheinmetall follows the example of other defence companies like Cassidian, which in 2011 opened its first Indian production facility in Bangalore as part of its efforts to increase its revenues outside of Europe to 50 per cent by 2016. Both Rheinmetall and Cassidian will likely find followers as this commentator argued in Indian newspaper The Economic Times: ‘[C]ompanies have to be seen less as an external provider of equipment and services and more as a reliable domestic partner that not only provides a military kit but also offers domestic economic and technological value.’

In the mid- to long-term, this trend will fundamentally affect the nature of many large Western defence companies. They will transform themselves from pre-dominantly Western-based suppliers of defence equipment for primarily domestic customers to multinational corporations with multiple geographic home markets for their products and services. The second component of the Rheinmetall-Ferrostaal joint venture – the extension of the Rheinmetall’s Group business activities in the oil and gas sector – is also indicative of this change.

The Pursuit of Adjacent Markets

As an adjacent market to the defence market, the oil and gas sector features a market environment defence companies like Rheinmetall are well positioned to conduct business in. With governments heavily regulating the access to and conduct of business in the oil and gas sector, established government defence contractors will be able to bring their long-standing expertise to bid for and deliver on government contracts to the table. Moreover, through the support of deployed military operations, many defence companies have gathered extensive experience to work under difficult conditions in remote locations. This experience may also be applied in the oil and gas market where production sides are often located in remote areas with at least partially similar conditions.

In this sense, defence companies like Rheinmetall follow the path non-defence commercial companies have taken in the past. Using their proven experience in commercial markets and established customer-supplier networks, companies successfully set out to win business in the defence market. For example consider US-based Kellogg Brown & Root (KBR), whose International Government, Defence and Support Services (IGDSS) business unit is particularly active in the support of military operations with currently more than 4,000 contractors being deployed in Afghanistan.

More fundamentally, with regional target and core markets in the oil and gas business being partly identical with those of the company’s new defence technology activities, substantial synergies through the intermeshing of sales networks of both companies seem possible. Particularly in the emerging markets in South America, Asia, North Africa and the Middle East, the relevant key stakeholders and decision making authorities are often the same for oil and gas as well as the defence sector.

Rheinmetall’s pursuit of the adjacent oil and gas market highlights, therefore, that the diversification of a defence company’s business activities must not necessarily weaken the traditional core business. If companies turn to new markets by reflecting upon the existing corporate expertise profile, old and new business segments can sensibly support each other in the mid- to long-term, thereby ensuring companies’ overall commercial viability. In this sense Rheinmetall CEO Armin Papperger states ‘Our business consists of contacts, which take years to be build. With the Joint Venture this will happen quicker.’[3]

Challenges for European Governments

The Rheinmetall-Ferrostaal joint venture highlights the substantial pressure on Western defence companies to internationalise their business activities in the defence as well as in adjacent commercial sectors. Of course, the exploitation of such new defence and commercial target markets will likely affect companies’ corporate identity and eventually the nature of the Western defence industrial base as a whole. The governance structures and processes for multinational defence business must keep pace with these changes.[4]

First and foremost, European governments’ must ensure that the internationalisation of its defence industrial base does not in the long-term come at the expense of losing key defence industrial capabilities within Europe itself. By building up defence research, development and production capacities and exploiting new commercial markets outside of Europe, companies may increasingly feel detached not only in their geographical distribution of income but also in their corporate identity as multinational business entities from their traditional home markets. Therefore, European governments have to build a clear business case for their defence industry with a sufficient sustainable income base and a balanced defence industrial sponsoring-regulatory policy.

With regard to the latter, in close co-operation with industry, a sensible ring-fencing approach must be enacted that controls the transfer of critical information and technology from the European-based arms  companies to their non-European locations in the new target markets. BAE Systems, whose US subsidiary BAE Systems, Inc operates under strict firewall regulations that restrict the transfer of critical information and technology from the US arm to British headquarters, is a case in point here and indicative of the challenges both governments and industry face.

Furthermore, the influence of stakeholders in the new home markets on corporate strategy and thereby indirectly on the European defence industrial base must be managed effectively. European governments must acknowledge that the more European defence companies will be regarded as indigenous parts of domestic defence industrial bases like in India and Brazil, the more governments in these countries will seek to influence corporate strategy through the developing customer-supplier relationship. Long-term partnering agreements between suppliers and customers in the new home markets may arguably be of particular relevance in this regard.

In summary, the Rheinmetall-Ferrostaal joint venture is a clear sign that industry is very much aware of the significant market pressures in the defence sector and is ready to act in order to ensure long-term commercial viability. Accordingly, more companies making up the European defence industrial base will seek to explore new business venues similar to Rheinmetall. Governments, though, can hardly afford simply to allow the market to operate. As stated above, there is much to consider if industry’s contribution to European defence is to be sustained and endured.

Given the global nature of these changes a purely national response will be insufficient. At the European level, the forthcoming meeting of the European Council in December 2013 will offer an adequate forum to discuss a coherent multinational approach among European partners. A mandate by European governments to generate a European defence industrial strategy that could address the challenges identified here would certainly be of great benefit.