Merger breakdown a disaster for BAE as defence business shrinks

Collapse of EADS deal is bad news for BAE: jobs are bound to go and the company's survival is uncertain

Column LAST UPDATED AT 07:46 ON Thu 11 Oct 2012

THE breakdown in the merger talks between BAE and EADS has been greeted with relief in some quarters, with investors, backbench MPs on both sides of the Commons, and Europhobes among the cheerleaders. Some MPs have gone so far as to say that jobs have been preserved that would otherwise have been lost. They believe new market opportunities lie beyond the seas, especially with our senior ally, the United States.
 
Never can rose-tinted spectacles have been rosier. The fact is the merger breakdown leaves BAE, one of Britain's few hi-tech companies with world renown and clout, facing a very uncertain future. Given the shrinkage in European and US defence budgets, downsizing seems inevitable. And adjustments will have to be made to tackle the reported deficit in the BAE pension fund, which some say is heading well above £1.5 billion.
 
BAE's senior management, which made such a poor job in presenting to the world and to this country the case for the EADS merger, now has to come up urgently with a Plan B to ensure the company's survival. Jobs are almost sure to go.
 
The main problem is the shrinkage of defence budgets in almost every key market. Roughly a quarter of all BAE's business in the UK is done with the British government. The UK market has been the base for operations in some 54 countries, most notably the hugely lucrative al-Yamamah project to supply combat aircraft and air defence systems to Saudi Arabia. Even that is not guaranteed to go on for ever.
 
Under this government, Britain's defence budget has been cut by roughly seven per cent. In the Strategic Security and Defence Review of 2010, the government said it had to cut now, but promised a real increase of one per cent per annum as things picked up after 2015.

There is now no chance of this happening, whether the Conservatives hang on to power after the next election or not. This means that the defence budget will bump along at around £30bn to £32Bn or less for the foreseeable future. Already there are dark mutterings about yet further defence cuts this winter.
 
This is all going to make life a lot tougher for BAE. This is why it made sense to combine with EADS, one of the world leaders in civil aviation. EADS would lead in aviation and aerospace, and BAE would lead in defence, not least because of its highly successful division in the US, which now accounts for more than one-third of the entire group's revenue.
 
We have come to a point where no major defence contractor can base its core business on the defence budget and revenue of a single European country. Nor is there an El Dorado in the US, despite what the merger's naysayers in Parliament seem to think.

BAE US does good business, but it is firmly ring-fenced and some of its Pentagon projects are so sensitive that their secrets cannot be divulged to the company's main board. BAE also has roughly one-tenth of the work share in the Lockheed Martin Joint Strike Fighter F-35 Lightning II, mostly building fuselage and tail components. This, too, had been guaranteed from the US, and agreed in the merger talks.
 
But there have been continuing problems about sharing US technology, including some crucial key codes with the JSF. With a cut of half a trillion dollars from US defence in the next decade, and 100,000 jobs about to disappear from the US defence sector in the next three months, Washington is not going to hand out candy to trusted allies, not even an old friend like Britain.
 
It is now quite likely that a US corporation will try to absorb the most promising parts of BAE US, if not the whole division. The most likely buyer is thought to be Raytheon.
 
This adds to the woes of BAE in UK and its European counterparts. They need to develop new technologies – in particularly with drones – and to cope with the new spectrum of security threats including cyber warfare. Governments, especially the UK, are not providing enough research and development funding for such projects. It is clear now that BAE will have to develop its new drones, the Mantis and Tiranis, with European partners.
 
The US has been generous in providing second-hand drones, like Predator, but will not share cutting-edge technology. It's reported that screens blank out on US instruments in UK and foreign Predators when they enter territory deemed too sensitive for foreign eyes according to the US.
 
In one way or another, parts of BAE will have to cooperate further with European partners, especially EADS, in the near future. But what kind of company, and of what size, it will be by then, is anyone's guess.
 
Far from avoiding a train crash for BAE by abandoning the merger, we may be risking a mid-air break-up of Britain's biggest defence contractor. ·