BAE puts transatlantic merger at heart of battle plan

As world's defence industry gathers in Paris, speculation mounts over a US-UK tie-up

Beneath the roar of the fighter jets, the talk inside the plush company chalets at this year's Paris airshow is all about the 'big one'. Not the last great military conflict in Iraq or indeed the whereabouts of the next war but the prospects of a giant, transforming transatlantic defence merger.

The big hitters of the US defence industry - including Phil Condit of Boeing and Vance Coffman of Lockheed Martin - may have decided to give Le Bourget a miss this week along with the Pentagon's top brass in order to demonstrate American anger with the French for their lack of support over Iraq. But that has not prevented the speculation mounting about a tie up with one of the US behemoths and BAE Sytems, Europe's biggest defence contractor.

A transatlantic tie up has been on BAE's radar screen for at least the last three years. But in recent months, the company has moved to a heightened state of alert, promoting the benefits of a transatlantic alliance with increased enthusiasm and, significantly, dropping its insistence that any deal must be a "merger of equals".

As Mike Turner, BAE's chief executive, says bluntly: "The technology is in the US, the money is in the US. We have made no secret that that is where we want to be."

Boeing's chief executive, Phil Condit, has been making equally positive noises of late about the US company's desire to "acquire more capability in the UK" whilst carefully denying that it is actively pursuing a deal at the moment.

For these reasons a Boeing/BAE merger remains most people's favourite bet although BAE is careful to stress that it has an open mind and has invited pundits to perm any one candidate from a list which also includes Lockheed Martin, General Dynamics and Northrop Grumman.

It is easy to see why BAE is drawn to the US. The UK's military support for the US-led invasion of Iraq has strengthened relationships between the two countries and left "old Europe" in the shape of Germany and France, out in the cold.

Moreover, the US is one of the few countries where defence budgets are galloping ahead. The Bush administration is proposing to increase military spending this year alone by $48bn - more than the UK's entire UK defence budget - so that by 2007 the US will be spending $470bn, of which procurement will account for $100bn and research and development a further $54bn.

Added to this, the productivity of the American defence industry is a long way ahead of the UK's. The sales figure per employee is $198,000 in the US compared with $169,000 in the UK. The long-term trends seem clear. As a UK government taskforce on aerospace warned last week: "By 2022 there could be a clear structural shift in industry towards the US. This will be driven by the importance of US-led collaborative programmes, defence budgets and technology generation and the poor rate of market integration in Europe."

Up until now, BAE has relied upon smaller scale acquisitions and joint ventures - such as the partnership agreement with Lockheed Martin on the F35 Joint Strike Fighter programme - to expand its presence. But Mr Turner says that is no longer enough. "Joint venturing doesn't work with shareholders, without clarity of responsibility," he says. "The US doesn't understand them. We've only done joint ventures to satisfy the governments, but it's not efficient."

Nevertheless, a full-blown deal involving, say, BAE and Boeing, would be a complex one to pull off. First the two companies would require the approval of their respective governments. Then they would have to sort out what to do with BAE's shareholding in Airbus, which would have to be divested to allay competition concerns. Finally, they would need the support of their respective shareholders - not an easy circle to square when Boeing is worth four times more than BAE. For these reasons, not everyone is quite so gung-ho about the likelihood of a big merger deal coming off in the near future. Raytheon's most senior executive in Europe, Norman Ray, says: "It will be a gradual process. I think we will see a few discrete equity investments, where the US is trying to buy a little market access. A big merger is more difficult because of the regulatory and business environment. In our business everyone is talking to everyone, I wouldn't hazard a guess on who is talking to whom and how seriously but I would be personally surprised if I saw a big merger any time soon."

He says the merger between Raytheon and Thales of their respective interests in air defence command, control and communications could be the model that others follow. "People are paying attention and seeing if that is the way ahead. If you are merging two large complex businesses, you are taking complexity to the 'nth' degree and managers will be extremely careful before you go down that route," he adds.

Mr Ray also points out that European restrictions on ownership and US restrictions on the transfer of sensitive defence technologies could yet get in the way of large-scale mergers. Only this month, an influential US Senate committee rejected a request from the Bush administration to ease the technology transfer restrictions in the case of the UK.

Even Boeing executives play down the likelihood of an imminent deal. Shep Hill, vice president business development for Boeing integrated defence systems, says: "There is no great impetus for a big transatlantic merger. European companies are interested in accessing the US defence market but I don't sense a great sense of urgency that a deal has to be done."

He too looks at stagnant or falling military budgets in Europe and questions how US interests would necessarily be served through a big merger. "When we look at acquisitions we look to see what new capabilities are brought to the US, or what opportunities they present to expand in accessible markets. We understand that European companies want to have the technology and R&D of the US, but that has to be a two-way street. It can't just be in one direction."

If BAE were to forge a transatlantic alliance, the other intriguing question is how the rest of Europe would react. Would Thales and EADS, the Franco-German aerospace and defence giant, seek their own American merger partners or would they get together to form one huge continental European company to act as a bulwark?

Philippe Camus, the joint chief executive of EADS, says: "We will play a key role in any future collaboration in Europe but I have no interest in acquiring a stake in Thales. Acquisitions are not a major priority for us and in any case I am not sure there are any real opportunities today."

As for North America, he says EADS has not suffered any big setbacks yet because of the Franco-German stance over Iraq.+ "I take a very long-term view. We have to go further in terms of integrating defence procurement in Europe because it will strengthen transatlantic co-operation. It is a win-win situation."

BAE may just be getting ready to upset that equation.