The Merger Between EADS and BAE Systems is Long-Overdue

Like many a romantic engagement, the secret slipped out too early. Confirmation of talks about a possible merger between defence giants BAE and EADS has surprised us all. Under current UK regulations, they have until 10 October to announce whether this is going ahead, so there will be ample time for the families of the happy couple to bicker and worry.  

In crude political terms it may seem attractive to create a non-American, high-tech group that would have revenues of $93billion as opposed to Boeing's $68billion or Lockheed Martin's $46 billion, and with market capitalisation of $49 billion against Boeing $53 billion.  This would go down well in many political quarters across Europe and look good to parliamentarians of all persuasions.  The Europeans would at last be looking the Americans in the eye in the highest of high-tech sectors - in civil and military aerospace - ship building and marine technology, military land systems, cyber defences, security technologies and a lot more.  The two companies' products complement, rather than compete, with each other so the marriage might be a good one even if the engagement is a bit rocky.

But if the advantages of this marriage are so obvious, why didn't it happen years ago?  The truth is that the in-laws probably won't get on.  Too many governments are involved; the US and the British governments in the case of BAE as its major customers, and the German, French and Spanish governments in the case of EADS, who between them effectively hold just under 50 per cent of EADS shares either directly, or through state-orientated companies, such as Legardere and Daimler.

Governments in the US and Britain worry that placing sensitive defence contracts with such a big conglomerate might lead inevitably to the leaking of vital technologies to other European states in whom we don't have entire confidence, and thence to third parties in whom we have none at all.  The US Congress is paranoid about the transfer of software codes embedded in military equipment sales in case they leak elsewhere, as they have in the past.

Conversely, the French and German governments are concerned that they will lose the influence they have enjoyed in a company they have used blatantly to foster their domestic industrial policies.  It is as if they fear that their cash-rich, obedient daughter will be lost to some vulgar, free-market cad who will turn her against them. 

In fact, both sets of in-laws are probably right, but if the engagement is broken off before 10 October, they will have to face the reality that something like it will probably be on again before too long. 

Although this may look like a leap in the dark for a very European EADS, and a surprising reversal of strategy for a very transatlantic BAE, the attraction between them is a response to some long-term political and strategic pressures. 

Preparing for Shrinking Defence Budgets

The defence equipment market is contracting dramatically.  Fewer ships, aircraft and vehicles - even fewer weapons themselves - will be produced in the future, while more effort goes into the technologies behind them and the integrated systems that add game-changing effectiveness to military hardware.  This is a difficult transition for companies to weather. 

BAE makes a point that its competitive edge is in doing the hardest technical tasks - those on the frontier of defence engineering - rather than going for volume.  But when governmental defence budgets are falling, volume still matters, and BAE reported a 14 per cent fall in sales last year and a 7 per cent fall in profits.  EADS is far less dependent on its defence sales which dropped 5 per cent last year, but it grew its non-defence side by around 4 per cent. 

Nevertheless, both companies can see the writing on the wall. The US will be reducing its defence expenditure over the next decade by at least $400 billion and possibly a good deal more once the presidential election is over. European defence budgets are drifting inexorably downwards.  Britain's £38 billion defence budget is just about 2 per cent of its GDP.  Most of our European partners are spending about 1.7 per cent of their GDP, or less, on defence and will go on reducing their spending as the euro-crisis bites. 

The US and the Rest

Only really big companies will be able to operate in this environment, and while BAE has concentrated on defence there is a clear imperative to reverse some recent trends and diversify into security technologies - such as cyber and corporate security hardware - as well as to integrate more of the civil technology sectors that EADS brings with it.

Not least, the writing on the wall indicates that the US is becoming a different sort of power in the world - more unilateral in its approach to defence, 'pivoting', in its own words, towards the Asia-Pacific region, and determined to maintain the sovereign integrity of its defence industrial base.  When foreign companies operate in the United States, even under their own names, they do so under such restrictions that they have effectively to become American companies.

Despite what politicians in Europe would probably applaud, this marriage will not create a bipolar defence industrial competition between Europe and the United States. The defence business is not that simple.  But it will increase the difference between US defence industries and defence industries in the rest of the world at a time when some good new players in Latin America and Asia are coming into the market at a high technological level.  In the long run, this may be a trend that favours a merged BAE and EADS over US competition, but in the short run it also has the merit of being a good defensive strategy in the face of America's global reorientation.

But then, even if the happy couple are resolved by 10 October, will the in-laws see it this way? If there is one outraged parent who will hate to see a marriage that celebrates an Anglo-Saxon version of free market principles, it will surely now be in Paris.

A shorter version of this article appeared in the Daily Telegraph on 14.09.2012