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Arms deals: making sense of the EADS-BAE super merger

It might seem like a natural corporate fit, but will politics get in the way of the merger between defence behemoths BAE Systems and EADS? AAP

It would be the world’s largest aerospace and defence contractor. Bigger than Lockheed Martin. Bigger than Northrop Grumman. And even bigger than the current global No. 1 defence corporation, Boeing.

The prospect of a £29 billion ($AUD45 billion) merger between BAE Systems (BAE) and Franco-German-controlled EADS (European Aeronautic Defence and Space Company) has created a serious buzz in both defence and financial circles.

Pundits are already labelling the anticipated conglomerate “BEADS”. Among global defence firms, EADS currently ranks second by revenues, while BAE holds fifth place. EADS owns Airbus Industries and, via a subsidiary, builds the Eurofighter Typhoon with BAE.

While EADS’ military arm is focused predominantly upon European defence procurement, BAE plays a major role in the technology development and manufacturing for the US market, including the F35 fighter aircraft for Lockheed Martin, and the Type 45 destroyer for the Royal Navy.

BAE and EADS are a natural corporate fit. The two companies already collaborate on a large number of projects, while BAE was a major shareholder in Airbus until 2006, a position it inherited from one of its predecessors, British Aerospace. But BAE also suffered an 11% fall in revenue in 2011, losing its No. 2 position in the global defence firm rankings, due partly to UK defence expenditure cuts. By contrast, EADS saw a year-on-year 13% revenue increase for 2011, finishing a hair’s breadth behind No. 1-ranked Boeing.

But this prospective merger is also causing furrowed brows in the Pentagon and on Capitol Hill. Why? Because BAE is a major player in the highly-sensitive and ultra-secretive US defence industry.

A privileged partner

Britain not only has a “special relationship” with the US, but it is also a privileged partner. The UK is a “full collaborative partner” on the F35 Joint Strike Fighter (JSF) project (Australia is mere “Level 3” partner), with billions of dollars invested in development. BAE also happens to manufacture a significant number of the major components for the F35 platform.

The US and Britain have one of the closest defence relationships in the world. AAP

In 1994, the Lockheed Martin-designed Trident nuclear submarine entered service; Prime Minister Tony Blair renewed the UK’s £20 billion Trident contract in 2006. Given its close defence ties with the US, going back to Polaris in the 1950s, the UK is afforded a level of access to US defence technologies without parallel — although certain Canadian firms are significant collaborators and contractors within the US defence industry.

Perhaps even more importantly, the UK gains high-level intelligence from Washington, of particular benefit in combating terrorism; London also supplies Washington with its own high-quality human and signals intelligence. UK-US intelligence cooperation is exceptionally close: for example, a CIA representative sits on the Cabinet Joint Intelligence Committee (JIC).

BAE has spent big in America, acquiring or gaining contracts with myriad US defence contractors, including United Defence Industries, Tracor, Lockheed Martin Control Systems, Mevatec, Boeing Commercial Electronics, Alphatec, and DigitalNet Holdings. The US market now accounts for more than half of BAE’s revenues.

Consequently, with projects like the JSF, BAE has access to much privileged information – so much so that Chinese cyber spies reportedly hacked into BAE’s servers to gain information about the JSF’s design, particularly its radar system.

For decades, British governments and defence firms attempted to obtain an ITAR exemption (International Traffic in Arms Regulations). Successive US presidents, from Clinton to Obama, promised to issue what is known as an “ITAR waiver”. But none of them could ever get an ITAR waiver past Congress, which takes its role as protector of US defence technology very seriously indeed.

Until now. In May this year, the US finally conceded to an ITAR exemption, significantly enhancing defence cooperation with the UK. Now, this exemption does not mean any British defence contractor can do business with, or gain access to, highly-sensitive US defence technologies. Instead, it creates an “approved community” of UK firms that are permitted a given level of access to certain technologies.

There are multiple hoops through which British firms are forced to jump in order to achieve this level of access to the US market. All firms are vetted thoroughly. They are all forbidden expressly from sharing any information or technologies with third parties. Which is where the problems start.

Enter left, EADS

The US’s special relationship with the UK does not extend to continental Europe. Washington does not share sensitive defence technologies or, indeed, the highest-level intelligence with its European allies, despite the fact that most European countries are members of the US-led North Atlantic Treaty Organisation (NATO). For example, Echelon, an intelligence-sharing program operated jointly by the US, UK, Canada, Australia and New Zealand, is employed by Washington to assist its corporations in commercial competition with EU firms to gain Third World contracts. Neither the US nor Britain share any Echelon material with EU states, as it remains intelligence to which the ‘Anglosphere’ only is privy.

EADS CEO Tom Enders prepares to address the economic affairs committee of the German Bundestag on the proposed merger with British BAE. AAP

For Washington, EU defence firms, including EADS and Finmeccanica (Italy) are merely competitors. But EADS has long been the biggest target of US opprobrium. For two decades, Boeing and EADS’ Airbus subsidiary have fought a bitter conflict in the World Trade Organisation (WTO), as each accused the other of massive industry subsidies (both are guilty parties).

For this fight, which commenced in 1994, and paused only briefly with a WTO ruling in 2011, both sides mobilised their big guns: the EU’s Trade Directorate-General and the US Trade Representative’s (USTR) office. But only last week, EADS renewed the transatlantic air wars with a EU request to the WTO to levy $US12 billion in punitive duties on US exports in retaliation for alleged illegal subsidies to Boeing.

Back in 2004, the EU established the European Defence Agency (EDA), a seemingly innocuous central planning office, with a brief to streamline and harmonise EU defence procurement. The fragmented EU defence materiel market was inefficient, wracked with product duplication, and exceptionally costly. The lack of EU defence materiel integration meant that Europe imported 50% of its military equipment from the US. The EDA sought to change all that by “Europeanising” defence procurement.

But “European champions”, like the EADS conglomerate, made it possible for EU aerospace and defence industries to challenge virtual monopolies like Boeing in both the civil and military aviation markets. Platforms like the Airbus A320 were instant successes; the super-jumbo A380-800 is in direct competition with the Boeing 787 Dreamliner; the wide-body, carbon-fibre A350 is scheduled to take off in 2014; and the EU’s dependence upon the Boeing C-17 Globemaster III long-range, heavy-transport aircraft will come to an end once the Airbus A400M, its own long-range military transporter (and financial black hole) goes into service.

A delicate balance

Politics will affect any potential BAE-EADS merger profoundly.

The cultures of the two firms are entirely different. BAE is the quintessential transatlantic corporation, while EADS, although nominally “European” with its headquarters in Leiden, the Netherlands, is very much a Franco-Germany firm that is really run by the French and German governments – the latter via its proxy, Daimler (yes, the lovely people who make your Mercedes-Benz).

The problem is that Daimler has long wanted out of this cosy arrangement, as does France’s Lagardère. But Berlin wants an equal share of EADS to ensure that the traditional balance of power between Paris and Berlin is maintained by each retaining equal stakes in the firm. On September 30, France and Germany reportedly reached an agreement to take 9% each in a merged BEADS.

The French and German governments will need to bargain to ensure the delicate ownership power balance of EADS is maintained, even as Lagardère and Daimler seek to liquidate their shareholdings in the company. Meanwhile, a tussle has broken out: France and Germany reportedly want the BEADS merger ratio to be 65:35 in EADS’ favour, while BAE management want 60:40.

Cross-Channel rivalry reared its head on 1 October; the UK government reportedly does not want a BEADS dominated by Franco-German shareholdings, which would amount to Paris and Berlin running BEADS as a state-controlled firm. British may veto the merger if it doesn’t get the deal its wants. Moreover, BAE’s labour head count is more than double that of EADS, with most of the jobs located in the UK. Cameron is likely to want assurances from EADS that BAE jobs will not be off-shored to the continent.

In the interim, shareholders are getting out. Both EADS and BAE shares have fallen sharply in recent weeks, with Deutsche Bank advising clients to hold EADS rather than buy, while Investec has changed its recommendation on EADS to “sell”.

Allies, not friends

The EADS-Boeing war represents only one facet of the multidimensional trade and strategic conflicts between Washington and Brussels.

In Washington, a merged BEADS would give long-time Franco-German rivals access to lucrative and sensitive Pentagon defence contracts and technologies. And, given renewed Chinese pressure on Brussels to abolish the EU arms embargo on China that has been in place since 1989, Congressional fears of technology leaks or transfers to Beijing are not entirely unfounded.

A repeat of the Galileo fiasco, which would have seen the EU grant Beijing access to its dual-use GPS at a bargain-basement price, could be in the offing with the prospect of a BEADS merger. This would serve to empower the forceful and persuasive US defence industry lobby, which regards EADS as quite powerful enough already.

But in a US election year dominated by the politics of recession, don’t expect either Congress or the White House to be in a generous mood towards Europeans. Particularly ones who hit them with $US12 billion trade lawsuits.

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