EADS nv bids to take over largest British defence company BAE Systems plc

From Britain’s point of view, from every important standpoint: financial, commercial, employment, products and most important of all national defence and UK manufacturing, this takeover is total lunacy.  It needs to be resisted by the government (which holds a ‘golden’ share in BAES stopping actions not in the national interest), by the BAE shareholders, by its employees, by the forces, and by the general public.

Financial reasons

The salient figures for 2010 and 2011 are shown in the table as found from the two companies’ published accounts.

EADS nv (European Aeronautical, Defence and Space) is a Dutch registered company which was incorporated in 1999, made a loss in 2010 and a small profit in 2011, representing a 4.5% return on capital and a 2.9% profit margin on sales.  EADS was formed in 1999 by a merger of the German company, DASA (itself a merger of several companies, chief among them Daimler Aerospace, the French company Aerospaciale-Matra and the Spanish company CASA [Constructiones Aeronauticas sa]).  Seventy per cent of EADS’s sales are from Airbus which makes the wings at Broughton in North Wales.

The terms of the takeover applied to the 2011 figures in the table above would mean that BAES shareholders get 40% of dividends from combined profits of £2.38 billion or £950 billion instead of 100% of BAES’s profits of £1.26 billion, a reduction of 25%.  On the 2010 figures they would have got attributable profits of only £386 million instead of £1,080 million they actually got as dividends and retained profit.

BAES’s 2011 performance is no flash in the pan: the average over the 6 years up to 2012 is only a little less than the 2011 figures.

Other key figures are profit margins on sales and returns on shareholder capital.  Here again EADS’s performance compared with BAES’s is dire: profit margins less than half; return on investment (ROI) only 40% of BAES.  It should be said that EADS’s low margins and ROI are not that untypical of continental companies in the aerospace business.  Dassault for instance, their profit margin on sales in 2011 was 6.4%; Thales 4%.

Commercial Political Realities

The fundamental commercial realities are, for BAES, a declining order book over the 10 year time frame (though plenty of work in the shorter 3 year period) and for EADS a successful product (Airbus) with a longer 10 year order book but encumbered by the political need to spread the work around among its German, French and Spanish partners.  Both companies are partners in the Typhoon Eurofighter which is due to run for another 6 years.  It might be asked therefore why the partnership model cannot continue to work or even be extended to other products.

The answer is that EADS is not seeking any more big partnerships with BAES – rather it wants unlimited access to what it regards as the jewel in BAES’s crown – BAES Inc, its wholly-owned US subsidiary.  For the BAES board led by chairman Dick Olver and CEO Ian King, there doesn’t seem to be any specific objective of this sort – only a vague yearning for exposure to EADS’s civil aircraft Airbus business which accounts for 70% of EADS revenues.  Given that the wings for the Airbus 320, 330, 350 and 380 are already made at Broughton in NE Wales, it is unlikely to say the least that the Airbus management in any EADS-BAES company would push more Airbus work the UK’s way.

And this encapsulates the key commercial reality for BAES/EADS: with their existing range of products there is not enough work to go round when you consider the competition in the USA – Boeing, Lockheed-Martin, GE, Grumman, etc – and in Europe where the French government not only has a 15% shareholding in EADS, but it also has a major shareholding in its wholly French-owned Dassault and Thales which together have sales equal to those of BAES (around £19 billion).

It is clear that although Dassault and Thales would actually make a better fit to EADS than BAES does, the French government has no intention of letting such a development occur.  Rather with an eye to keeping an independent French arms industry in being and eliminating a major competitor at the same time, it is quietly cheering on the EADS’s takeover of BAES.

The EU dimension

In this, EADS is at one with the European Commission, which sees the takeover of BAES as a longed-for consummation of its project for an integrated European defence industry which would make it almost impossible for the UK to escape from without devastating job losses.  None of this prevents the usual siren voices wishing a “European” solution to BAES’s supposed problems.  Thus in the Times of 18^th September we read John Hutton, former Labour UK Defence Secretary, saying in the defeatist manner of the soggy centre “Standing still is not an option – does it (BAES) look across the Channel or across the Atlantic?”  Hutton and co still don’t get it: EADS is not a rescuer of BAES; it wants to ransack it, and the USA won’t let it, not at their end at least.  What needs to be put right in BAES has to be done by ourselves in the United Kingdom.

Needless to say, the French don’t worry about standing alone in the defence business.  They always have.  Instead of looking for the fee-rich mergers or takeovers so beloved of Corporate Britain, BAES management needs to develop new products and find its way out of its own problems (see below – new products).

Dick Olver, its chairman is a (civil) engineer by training with a long career in the oil industry behind him, where he was most recently deputy chairman of TNK-BP (until 2006).  Olver has recently publicly exclaimed that he has seen “a huge swell of support for manufacturing and it’s incredibly exciting”.  Now is both the need and opportunity to take advantage of just this “swell” for his own £11 billion engineering company.

The American dimension

As noted above, whatever the EU’s political objectives, the EADS board’s principal commercial object is to get access to the US defence market by acquiring BAES Inc which accounts for around half of BAES’s total revenues.  EADS’s defence electronic companies in particular would see this as an excellent way to feed their products into the US in direct completion with BAES’s UK suppliers either in BAES itself or in its supply chain.  As happened when BMW took over Rover, the supply chain quickly saw that the design authority had moved to Munich and reacted accordingly, as it would move to Paris if EADS were to succeed.

However, news is that the American management of BAES Inc is not at all keen to become part of a Franco-German setup.  The US Department of Defence is even more disapproving given their long established view of the French and Germans as unreliable partners in NATO operations in Afghanistan, Iraq and Bosnia.  The most likely outcome of an EADS takeover would be American pressure to sell BAES Inc to one of the smaller American competitors – Grumman perhaps – and all of BAES’s patient work in building its US presence would be destroyed.  There would also be renewed pressure to diminish BAES’s shareholders’ share of the combined EADS-BAES company in the light of the disposal of this major asset.

Employment Realities

BAES has for several years advertised itself as Britain’s leading employer of electrical and mechanical engineers.  As an amalgam of British Aerospace and Marconi Electronic Systems (the principal legacy company of GEC) in 1999, and Vickers Shipbuilding and Engineering (VSEL), BAE Systems is one of the three remaining major British engineering companies (along with Rolls Royce and GKN) with a global sales reach.  It is therefore an absolutely vital UK employer of both graduate and technician engineers.  If this takeover were to go ahead it will mean, in practice that a whole mass of British technological expertises and facilities – actual and potential – will be directed from Paris or wherever the new EADS HQ were established.

As happened when GEC merged its steam turbine interests with those of the smaller French firm Alsthom, but allowed it to keep its HQ in Alsace, GEC’s Rugby works (then the world’s second largest steam turbine manufacturer after GE of the USA) had its work transferred to its French factories, leaving only training and maintenance organisations – a bare shadow of its former self.

Defence Realities

A number of commentators, including Lord West, former First Sea Lord and Minister of Defence in the last Labour government, have drawn attention to national security issues like the Trident and Astute submarine programmes centred on Barrow-in-Furness, the old Vickers Shipbuilding and Engineering Ltd (VSEL) site.  Vague talk of “ring-fencing” these programmes and facilities to protect military secrets is absurd.  If there is any advantage in VSEL’s being part of BAES, which is doubtful, it will overwhelmingly centre on technical staff and knowledge interchange with the rest of the group.  To say that EADS staff wouldn’t see or hear any of this is nonsense: far better to demerge VSEL from BAES and set it up as British Submarines Ltd with all the security protections needed to interact with Lockheed-Martin on the design and fitting of the Trident 5 nuclear missiles and their successors which the US is rightly concerned to keep away from all other foreigners.

New Products

Of the three major components of BAE Systems, British Aerospace and the shipbuilders have grown up on government orders and subsidies.   Generating new commercial products will thus require a major shift both in outlook and senior personnel.  The third component, Marconi Electronic Systems – the electronics side of GEC was more commercial, but was more or less allowed to go downhill by its board before collapsing (merging) into BAE.  Dick Olver, the BAES chairman has come from big oil where commercial engineering is of paramount importance and hopefully will be able to get a new senior management culture dedicated to generating new products independently of government like the pharmaceutical companies have to.

It is worth noting too that joint inter-country projects, so beloved of the EU, can put up the development costs of complex products by a factor of 3 and manufacturing costs by 50% compared with one country doing all the work.  These factors easily outweigh the alleged economies of scale of multi-country orders.

The acquisition costs of the Typhoon Eurofighter for instance are likely to come out at £23 billion over the 15 years to 2020 for a total of 160 planes: £144 million each for a plane whose prototype, entirely built by British Aerospace, first flew in 1995.

BAES is bound into the F35 Lockheed Joint Strike Fighter programme, the most expensive variant of which (F35B – the vertical takeoff and land version) has been ordered for the Royal Navy’s new carrier(s) at a unit cost likely to be around $250-280 million.

These are unsustainable costs – even for the Americans.  A proper defence review urgently needs to be set up with an emphasis on the timely delivery of systems which are (a) good enough in terms of performance, (b) economical in service, and (c) of British manufacture.  Lessons from the Israeli Defence Forces (IDF) and Defence Industries could be usefully learnt here, as in other aspects of the Armed Forces[1].  Defence & Manufacture should be the future animating concept of a reformed MOD.  The products from such Defence & Manufacture programmes are likely to be far more exportable than those from the unwieldy multi-country programmes of the last 20 years.

With 18,000 engineering-related staff, mostly mechanical and electrical engineers, BAE Systems is the single biggest UK employer of engineers.  The total output of UK university engineering and technology graduates is about 24,000 per year of which about two thirds, or 16,000, are in BAES’s core mechanical and electrical specialisms.  BAE Systems thus accounts for roughly one whole year’s output from UK universities, in those fields.

It is therefore vital that BAE Systems uses the time it has before income from its major current programmes[2] reduces substantially in the 2020s, to generate a range of products for the new civilian markets likely to be found in Asia and South America.

The market for “drones” – unmanned aerial vehicles (UAV), is potentially huge and likely to grow fast both in range of applications, e.g. for the observation of agricultural crops, police work, land use mapping, construction, warfare, and in the number of quite small countries wanting to use them.

In the USA, where most drones are to be found, 40% of aircraft movements were pilotless UAVs in 2011.

Drones can be as small as 3 feet long, costing about £13,000, up to 8 tonne stealth jets, costing hundreds of millions.  It is clear that the civil market potential is vast, but it is entirely typical that BAES-MOD should focus on the defence market where orders will be small and limited to a few countries’ defence forces[3].  At the moment BAES’s one UAV – Taranis – is a £143 million “concept” programme.  BAES urgently needs to get a commercial drone programme underway to reduce its reliance on taxpayer subsidised defence projects.

Summary

1          For BAE Systems to be taken over by the Franco-German controlled EADS company would be a calamity for Britain and British Engineering of the first magnitude, worse than a battle defeat, more like a lost war.  This takeover proposal is not a solution to BAES’ declining defence revenues: EADS want only to obtain access and control of BAES’s US subsidiary in order to feed products from their own factories into the US defence market in direct completion with those from UK factories.  EADS don’t care about the rest of BAES – except possibly the shipbuilding arm at Barrow which has some of the largest machining centres in the world, but is the most security sensitive of all BAES’s divisions.

2          Financially the takeover on the 40:60 split of equity proposed would heavily dilute BAES earnings so UK shareholders would immediately suffer losses by the proposal.

3          BAE System’s board and senior management must not waste their time on negotiations to get over the political and security obstacles to these proposals.  They must get their heads down in order to capitalise on their undoubted technical strengths: embrace the Defence & Manufacture concept and launch major civil programmes as a matter of extreme urgency.

4          Taken together, UK government defence procurement, BAES’s technical staff and assets, and export opportunities, should constitute the most important first step in creating a national industrial policy (see “Produce and Prosper”), much talked about by the present government, but so far only that.

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