The European defence industry is off track. But, perversely, European governments, in their desire to protect a national defence industrial base, may be holding back the entire continent's defence sector.
Four companies dominate the market: BAE Systems, Thales, EADS and Finmeccanica. They are among the 10 largest defence companies worldwide and had combined defence revenues of about $40bn in 2003. The top four US companies accounted for $93bn.
Consolidation in the European defence market is slowing, in part because companies are still digesting acquisitions made during the last wave of mergers in the 1990s. This has brought scale, but insufficient savings. The complex structure of the industry — with the Big Four involved in most important market segments through joint ventures — is not helping.
Three of the Big Four still have clear national identities: BAE is primarily British, Thales primarily French, and Finmeccanica primarily Italian. The exception is the French-German-Spanish entity EADS. Any further consolidation would mean countries having to "give up" a national champion.
European governments are not likely to initiate joint procurement soon enough to provide a stable home market for the Big Four. Public funding of research and development is small compared with the US, and the order flow is inconsistent. Thus, new development projects based on multinational procurement are riskier than in the single-buyer US market.
European companies' operating performance is dismal. US companies are much more profitable and have lower debt-to-equity ratios (at market value). European companies' weak performance constrains their ability to forge the large deals that would mark the next phase of consolidation. Asa result, US defence stocks have significantly outperformed European ones.
There are at least three plausible scenarios for the future. In the first, the Big Four consolidate to create two European "mega-prime" contractors. Europe could make this scenario more likely by accelerating progress towards joint procurement — helped by faster development of a common security and defence policy — providing the equivalent of a single buyer in the European home market. Mega-primes would be able to compete with large US companies for projects in both geographies. This would probably spur innovation and provide better value for the tax payer. It is unlikely to happen, however, because it would require major policy changes in Europe.
In the second scenario, disappointed shareholders and fragmented procurement force demergers. The smaller niche players created by these demergers become subcontractors to the remaining, mostly American, prime contractors. European contractors would probably be financially solid as they would focus on core competences and would be freed from the risk of negotiating and managing large-scale integration programmes. The political repercussions would be significant: European countries would be increasingly dependent on US companies, and therefore on US government permission, for defence purchases.
This scenario may appear superficially attractive for the US, because it implies that the European market would be more open to US companies. But there are drawbacks, given that the US market is already evolving towards an oligopoly — and perhaps even a monopoly in certain areas. In any case, the scenario would be politically unsustainable in Europe.
In the third scenario, European companies "muddle through". Consolidation slows as European groups rationalise. Joint procurement continues on an ad hoc basis. Nations provide enough orders and R&D financing to keep current players going, and thus cannot force a more radical restructuring. European technological capabilities fall behind those of the US. Many European markets would remain closed to US suppliers because European producers would be preferred, even when they were less cost-effective. The US would lose a healthy competitive challenge to its own industry. European armed forces' inferiority to US forces would become more acute, making it tougher to mount joint operations.
The "muddling through" scenario is the likeliest, but also the least beneficial for Europe and the US. But it is not inevitable. European governments could become more reliable buyers by moving towards joint procurement and making progress on European security and defence policy. They could encourage the creation of supra-national "mega-primes". Mutual market access could be improved. But for this to happen, Europe would have to abandon the pipe-dream of national champions and nostalgia for individual governments controlling the defence economy.
The writer, a doctoral fellow at the Pardee Rand Graduate School, is author of Off Track? The Future of the European Defense Industry (Rand Corp)
This commentary originally appeared in Financial Times on September 7, 2004. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.