THE BRADLEY Fighting Vehicle is one of the weapons systems made by United Defense Industries, acquired by UK-based BAE Systems in 2005.

In fact, with the trend toward consolidation of large, established defense firms inside Europe and the United States nearing an end, aerospace and arms anufacturers in both markets are looking to forge alliances, or even to merge with firms across the Atlantic, in order to grow. The potential to each side is clear: A burgeoning U.S. defense budget provides unrivaled opportunity for European firms to expand beyond their traditional customer bases and tap opportunities stemming from the needs of coalition warfare. Similarly, U.S. firms seek customers and partners abroad to limit their exposure to future fluctuations in the federal defense budget.

While politics in both the United States and Europe will continue to be an obstacle to global consolidation, the defense industry has already begun to forge successful multinational alliances that will serve as a new model for success. For example, U.S. aerospace giant Lockheed Martin and Anglo-Italian helicopter manufacturer Agusta­Westland currently partner in specific markets. Massachusetts-based Raytheon has a similar agreement with the French defense conglomerate Thales Group.

Such alliances will only grow—in fact they must. Companies that alienate themselves from transatlantic partnerships run the risk of losing international market access. Worse, they will be forced to compete against the combined resources of U.S.-European partnerships.

From the Halls of Montezuma
To understand the forces relentlessly driving defense firms to seek even the slightest global competitive advantage, one must look no further than the financial stakes at hand. Each year, the nations of the world collectively spend an estimated $1.1 trillion on defense; the U.S. government accounts for almost half that amount. According to government statistics, U.S. firms sold $11.6 billion worth of arms to other countries in 2005. The United Kingdom ranked second, delivering $3.1 billion, and Russia third, with $2.8 billion.

Traditionally, defense firms in Europe and the United States penetrated new markets and captured market share primarily through direct sales, which were often limited to opportunities where domestic industrial base concerns were minimal. If, for example, a U.S. firm manufactured a type of armament that a foreign country could not produce itself, decision makers in that country could purchase the armament without a domestic political backlash. When possible, defense companies also penetrated new markets through tactical acquisitions and limited global alliances. European defense firms achieved early success in accessing U.S. markets through joint ventures, alliances and partnerships with U.S. businesses, particularly on a subcontractor level.

To no one’s surprise, the business of defense often centers more on politics than on free-market principles.

U.S. companies have recently shown interest in awarding even more subcontracting work to European firms in exchange for international market access. Driven by the demands of coalition warfare and growing interest in the international marketplace, Washington has shown a certain willingness to grant foreign companies a more active, yet still limited, role in military programs, especially when teamed with U.S. industry.

Serious hurdles to further consolidation remain, however. Both industry and government are reluctant to break out of domestic comfort zones. Industry complains about lack of oppor­tunity in international markets, and governments seek to protect their domestic industrial bases—in particular by applying the U.S. trade control regime, the International Traffic in Arms Regulations. Since 9/11, industry and international governments have seen these guidelines as a massive hindrance to defense transactions. An Army War College report published in April 2005, The Transatlantic Industrial Base: Restructuring Scenarios and Their Implications, states: “The environment for consolidating a transatlantic defense industrial base is currently being poisoned by some U.S. politicians who seem to be going out of their way to antagonize European countries and their defense firms.”

To no one’s surprise, the business of defense often centers more on politics than on free-market principles. The reality, however, is that there is significant opportunity for governments to seek out foreign technology and for industry to enter and expand into new markets. Although far smaller than BAE Systems’ United Defense Industries acquisition, recent U.S. successes in the European market include L-3’s 2006 purchase of Advanced Systems Architectures, a UK systems engineering and software developer; Lockheed Martin’s 2005 acquisition of Insys, a UK IT firm; and General Dynamics’ 2001 purchase of Santa Barbara Sistemas, a Spanish vehicle manufacturer.

TOP VIEW  To exploit lucrative markets and ensure future growth, arms manufacturers in the United States and Europe are looking to forge  alliances, or even merge with counterparts across the Atlantic. While the potential benefit to each side is clear, serious political obstacles to transatlantic consolidation remain. Those companies that tread carefully and establish a foothold in niche industries will overcome this resistance and eventually gain much greater access to foreign markets.

BAE Systems began an acquisition process in the United States in the late 1980s, with the firm focused on increasing its U.S. capabilities while minimizing regulatory oversight and complaints from the U.S industrial base. Over several years, it was able to build critical mass in the military support services market until it became the largest engineering support provider to the U.S. Navy. With this critical momentum, BAE Systems was then able to acquire Lockheed Martin Aerospace Electronics Systems for $1.67 billion in 2000. This move proved quite the coup at the time because Lockheed’s division was involved in a number of classified high-tech military programs. The ultimate success of BAE System’s acquisition strategy in the U.S. came in March 2005, when the company acquired United Defense Industries for $4.2 billion.

Over the past decade, we have seen growth in acquisitions based on a greater need for foreign technology, integration and investment. This trend is almost certain to continue and may ultimately lead to more significant acquisitions outside of the recent successes of BAE Systems. Joint ventures, however, will likely be limited to less sensitive markets and legacy technologies, such as off-the-shelf communications equipment, noncombat vehicles and training and simulation systems. Acquirers will also target professional services such as engineering support, logistics, maintenance and IT management.
 
Restless in Washington
Three primary drivers will affect international market access in a positive way. First, transnational alliances are breaking up or are being relegated back to their constituent firms. Alenia Marconi, a 1998 defense electronics partnership between BAE Systems and Finmeccanica, dissolved in 2005. Astrium, a space-systems joint venture between BAE Systems and EADS formed in 2000, was bought by EADS in 2003. The disappearance of these alliances and others like them will spur global defense firms to further acquire and consolidate in order to reopen market access that these alliances once offered.

In the near term, most European firms will experience some opposition and will be limited to U.S. entry strategies based on alliances,partnerships and smaller tactical acquisitions.

The second driver toward increased cooperation has been growing—albeit slowly—support from the U.S. government. Despite public rhetoric to the contrary, senior officials have expressed support for greater cooperation. At a 2006 roundtable in Brussels, sponsored by the Center for Strategic and International Studies, Colonel Michael Ryan, a representative of the Defense Secretary’s Mission to the EU, said that a “needs-based approach would drive the [U.S. and European] allies to buy the best product on the transatlantic market at the best price, regardless of its point of origin.” Both the secretary’s office and pro-trade members of Congress have complained about the seemingly glacial pace of international alliance building. While most insiders at the Defense Department will not publicly demand greater cooperation, they feel frustrated that current efforts are no more than “studies of studies” with no viable and comprehensive solutions being brought to the table.

The final key driver will be the success of proper acquisition strategies. While new markets beckon to companies bent on consolidation, overtly aggressive acquisition techniques will raise red flags with regulators and defense industry executives who are likely to fight for important base markets both in the U.S. and overseas. The path to success requires a slow pace and patience with acquisitions in markets not as attractive to domestic industries. Most of the purchases of the past several years were small, and therefore did not prompt significant regulatory scrutiny. The acquisitions also tended to be vertical rather than horizontal, focusing on stable market growth. BAE Systems proved this strategy extremely successful. A long-term market commitment with an escalating acquisition strategy has put BAE Systems on even footing with other large U.S. defense firms.

However, despite BAE Systems’ success, most European firms will likely experience some opposition and will be limited (in the near term) to U.S. entry strategies based on alliances, partnerships and smaller tactical acquisitions. Similarly, European nations will not likely welcome with open arms a U.S. entity’s attempt to buy large European firms. Despite some small-scale buys within Europe, U.S. companies have expressed frustration with their inability to access European markets. Overcoming the entangled alliances of European industry remains a challenge for U.S. firms, as do the roles played and influence peddled by European governments.

Successful penetration into dual markets requires more than simply targeting products. Firms attempting a dual market presence must develop tailored entry strategies for accessible markets in order to achieve niche positions in the appropriate defense market. After defense firms establish this benchmark, they can pursue more aggressive growth strategies. Finmeccanica, for example, focused on new acquisitions, while maintaining Italian managerial oversight. Alternatively, Thales has focused on domestic leadership, leveraging in-country relationships. EADS has also relied on domestic leadership, but has shown more aggressive tendencies with new investments.

While UK firms have enjoyed the greatest success in accessing U.S. markets because of a joint development history and reciprocal market access, other international firms are meeting with success with less aggressive strategies. U.S. firms must make an effort to engage these new players or risk losing market share as a result. The time to act is at hand. Without a well-conceived strategic plan to meet the competitive alliances that are currently forming, domestically and even regionally focused defense firms run the risk of being left behind in the marketplace. 

John Kenkel is senior director of Jane’s Strategic Advisory Services in Washington, D.C.