The arms suppliers go to war: Domestic defence cuts have hurt US and UK contractors, so winning the export battle has become the key to survival, argues Richard Thomson

THE AIR over Farnborough this week will echo to the sounds of the latest, most sophisticated and expensive fighter aircraft in the world. Western countries will be vying as always at the airshow to find customers for their weapons. But this year the selling will be more intense than ever. Among the European manufacturers particularly, there is likely to more than a hint of desperation.

For the Western defence industries, the world has changed over the last three or four years more rapidly than for a generation. The Cold War is over and with it has gone a huge slice of business.

Western governments have radically cut back defence spending, leaving weapons manufacturers fighting ever more fiercely for the crucial export markets of Asia and the Middle East. And some of these customers, such as the Gulf states, are less cash-rich than before and have been scaling back defence spending too. For many weapons manufacturers, the new competitiveness will be a fight to the death.

The dollars 10bn ( pounds 6.5bn) merger between Lockheed and Martin Marietta announced last week, which will create the biggest defence contractor in the world, sent a shiver of fear through the European industry. It was another reminder, if one were needed, that the US is adapting to the new order faster than Europe. US firms, once feather- bedded by soft Pentagon contracts, have cut costs and rationalised with remarkable speed. It has been good business - their share prices have performed beyond all expectations over the last two years.

'In the past, the European defence industry was more concentrated than the US, which made it more efficient,' says Wyn Ellis, defence analyst at S G Warburg. 'But now the US has leapfrogged it.'

Additional competition is also entering the market from elsewhere. Manufacturers believe that very hi-tech weapons that could only be produced by a small number of suppliers will be less in demand over the next few years, as economy and quick delivery become more important to customers.

That will open up the market to a range of other low-cost suppliers, particularly from Japan and Eastern Europe. A standard European-made hand-grenade, for example, costs about pounds 8, but one made in China is a mere pounds 3; a sophisticated European rifle costs around pounds 400, while a Russian- made AK-47 costs about pounds 60.

The threat of intensifying competition is serious for the British defence industry, which is Europe's biggest, and arguably most efficient. By the late 1980s, Britain had become the second biggest arms exporter in the world after the US. But hanging on to export markets as the Americans grow ever more competitive is becoming increasingly difficult.

Like the rest of the Western world, the UK Government has cut down defence procurement. Stockpiles have been dramatically reduced since the threat of Russian tanks sweeping into western Europe has disappeared. Even equipment for training has been reduced.

Meanwhile, products such as the Challenger tank, the Harrier vertical take-off jet and the Hawk training aircraft, which have sold well abroad in the past, may now face damaging competition from cheaper, less sophisticated weapons in the export market.

One option for weapons manufacturers - already taken by many US companies - is to stop making arms altogether. But although some smaller arms companies are likely to be forced down this route, few British companies see much future in it at present.

Royal Ordnance, a subsidiary of British Aerospace, is using its explosives expertise to diversify into civilian products such as an aircraft baggage container able to save aeroplanes by withstanding the blast from a terrorist bomb the size of the one that caused the Lockerbie disaster.

But although it has the technology, BAe does not have the skills to manufacture and market such products and so ends up licensing them to other companies. 'Diversification will never replace our weapons business either in volume or profitability,' said a spokesman.

The other option is to rationalise. UK weapons makers have already made considerable efforts to increase efficiency. When it was privatised in 1987, Royal Ordnance employed 18,000 people. But even after the acquisition of German and Dutch weapons companies since, it now employs only 5,500.

Takeovers and mergers of defence companies to produce economies of scale is another route that has born considerable fruit in the US but is taking longer in the UK. Westland, the helicopter group, was bought by the tank maker GKN this year but remains one of few examples of this kind of rationalisation.

Most attention now focuses on the two giants of the UK arms industry, British Aerospace and GEC-Marconi, the defence electronics arm of GEC. Both companies have taken steps to rationalise their defence operations.

'We've been pretty impressed by BAe seeing the need to adapt to the world after the Berlin Wall came down. But now the real need is to respond to what the US manufacturers are doing,' said S G Warburg's Wyn Ellis.

Lord Weinstock, GEC's chief executive, has made no secret of his desire for some kind of close link with BAe. He missed his chance of a takeover three years ago, when the aircraft manufacturer's share price was on the floor because of management upheavals and doubts over its survival.

A merger or takeover would make considerable sense from a product point of view, providing vertical integration of electronic components and airframe building rather like the Lockheed-Marietta deal. The greatest problem would probably be the huge differences in company culture between BAe and GEC, which might render a merger unworkable.

'I think there will be closer collaboration between the two companies but no major exchange of equity,' said Mr Ellis. 'Unfortunately, this would not produce the required rationalisation.'

Certainly, BAe has shown no enthusiasm for a merger with GEC so far, preferring to chase collaborative deals on the Continent instead. The advantage of cross-border collaborations is that in the chauvinistic world of defence procurement, it opens the door to new markets. A joint venture such as BAe's attempt to merge its missiles business with France's Matra-Hachette would open up the French market to the British company.

Yet collaborations are fraught with difficulties and often fail to materialise. 'Straightforward takeovers are difficult enough, but collaborations are even harder,' said one defence executive. BAe has still not clinched an agreement with Matra, for example. And the Eurofighter project between Britain, Germany, Spain and Italy has run into repeated delays and was nearly scrapped.

The stock market, according to some analysts, was telling BAe it thought a merger with GEC-Marconi was essential when it marked up the aerospace shares by 22p to 503p following the Lockheed announcement on Wednesday. But others claim the mark-up merely reflected an overdue catching up by BAe's underrated stock.

What is certain is that the Lockheed deal has thrown down the gauntlet. From now on in the defence industry, it will be nothing less than war.

(Photograph omitted)