Can BAE defend its future?

Britain's defence and avionics giant is a world-beater when it comes to traditional military hardware. But how is it faring in a world where a hacker can do more damage than a missile?

by Matthew Lynn
Last Updated: 11 May 2016

A jeep that jumps up in the air. An aircraft that travels at hypersonic speed. Or a passenger plane that takes off straight upwards.

They may sound like fantasies that didn't quite make the grade for an old episode of Thunderbirds, but in fact they were all projects that the UK's largest engineering and defence conglomerate, BAE Systems, worked on in the 1960s. At the time, they were all taken very seriously.

If you happen to be in Wharton in the coming months, you can see them all in action. In June, the company marked the opening of a new centre to celebrate its heritage.

Based at its military aircraft manufacturing plant in Lancashire, the centre staged an exhibition that raided the archives of the companies that were eventually merged into BAE, and used videos to show some of the products we might have been using by the 1970s if they had ever been anything more than an idea buzzing around the research and development department.

It is, perhaps, a shame that none of them ever made it past the drawing board. After all, a passenger jet that took off vertically would end all those debates about whether Heathrow needed a new runway - they could just get rid of them all. And a hypersonic plane - that's at least five times the speed of sound, in case you were wondering - would have brought some much-needed innovation to an industry which, while it has become cheaper over the past 30 years, is also no faster and a lot less comfortable than it used to be.

But even though they never made it into production, they are a reminder of how BAE has been dreaming up new products for decades - and of a tradition it will need to rediscover if it is to secure itself a future in a tougher world for defence manufacturers.

'BAE Systems stores more than one million historical documents and artefacts and in addition to celebrating our nation's engineering achievements, I believe these examples of forward thinking are still inspiring for young people,' said Howard Mason, heritage manager for the company.

Not many companies have - or indeed really need - a heritage manager. Then again, very few have the heritage that BAE has. The UK has always had a strong tradition in aerospace and defence technology: this was, after all, the country that created radar, bouncing bombs and the first commercial passenger jet, and BAE is the successor to the host of smaller companies that designed many of those products. It has a richer history than almost any other company in Britain.

The issue for BAE now, however, is not where it has come from but where it is going. Even though it is still one of the UK's largest companies, with a market value of £14.8bn, it has arrived at a critical juncture. Last year, it tried to pull off a mega-merger with the Franco-German defence and aerospace giant EADS (now renamed Airbus Group). But the attempt failed.

At the same time, the defence industry is rapidly contracting, as cash-strapped governments look for savings.

And even where money is being spent, it is being spent on new forms of warfare. Cyber attacks are a far more worrying threat to the UK these days than anyone storming the beaches of Kent or Sussex and, as the nature of the threat changes, so does the type of products BAE has to make.

It needs to come up with a new strategy - and one that convinces investors it is as much a part of the UK's industrial future as it is of its past.

'The great thing about BAE is that it has always been very good at adapting to change,' says Howard Wheeldon of Wheeldon Strategic Advisers, who has followed the business for many years. 'It is a very forward-thinking company. Over the next few years, it is likely to need those skills more than ever.'

BAE has a family tree as complex as the cockpit of a Eurofighter. The company was formed through the 1999 merger of British Aerospace and Marconi Electronic Systems, a £7.7bn deal that finally brought the bulk of the British aerospace and defence industries into a single entity.

Those two partners were themselves the product of a string of mergers that date back almost as far as the Wright brothers. Marconi was the defence arm of Lord Weinstock's engineering conglomerate, GEC, and included a vast range of companies with deep roots in electronics, aerospace and naval engineering.

British Aerospace had been formed in 1977 from the nationalisation and merger of the two main UK aerospace manufacturers, the British Aircraft Corporation, one of the partners that built the Concorde, and Hawker Siddeley, the company that made the Trident passenger jet, which was a familiar sight in European skies throughout the 1960s.

At the time the deal was struck, the defence and aerospace industries were going through a round of global consolidation. The two giants of the American industry, Boeing and McDonnell Douglas, had just merged, and two years before that Lockheed Martin had come together to create the world's biggest defence business.

As John Weston, MD of BAE's defence unit, put it at the time: 'Europe is supporting three times the number of contractors on less than half the budget of the US.'

The trouble was, while that deal consolidated much of the UK industry into one company, the European industry remained fragmented. The 1999 merger was just one step in a process that is still going on. In the 14 years since it was formed, BAE Systems has been through enough acquisitions and disposals to keep even the most deal-hungry investment banker happy.

It bought Alvis Vickers, the main UK manufacturer of armoured vehicles, Tenix Defence, an Australian defence manufacturer, and United Defense Industries, one of the main players in the vast American weapons industry.

And yet despite the reshuffling of its portfolio, the management never seemed to quite settle on a shape and structure for the company that it was happy with.

Perhaps most controversially, it severed its final link with civilian aerospace - an industry that had been the foundation of at least one half of BAE.

The old British Aerospace had been a 20% shareholder in the Airbus consortium, a French-German-British joint-venture that might have started as a political scheme for creating jobs and fostering a vague sense of European unity, but, against the odds, turned into a huge industrial success.

By the 2000s, Airbus was up there with America's Boeing. BAE, as well as owning a fifth of the business, also made the wings for the aircraft. In 2006, however, BAE sold its interest to EADS, which owned France and Germany's stakes in Airbus. It received £1.87bn for it. And although the wings of the Airbus are still made in the UK, the factories are owned by the Airbus Group. British-owned involvement in commercial plane manufacturing had come to an end.

BAE didn't control the Airbus project, and could never hope to. Most management textbooks argue there is little point in owning assets you can't control. The trouble was, selling the stake concentrated BAE even more heavily on the weapons business.

The reason for the constant shuffling of assets is not hard to figure out. BAE is good at what it does, but it is still faced with a fundamentally declining industry. Tony Blair may have been keen on fighting small wars, but since the end of the Cold War, there have been no big ones on the horizon. The result has been a relentless decline in defence spending.

When the Berlin Wall came down in 1989 the UK was spending slightly over 4% of GDP on defence every year. Now it is spending less than 3%. That may seem a modest shift, but it represents a relentless year-on-year decline that is always going to be hard for any company to cope with. It is difficult to do well in a declining market.

True, global spending on defence has been going up slightly year on year. But it has been rising in countries such as China and Russia. And no matter how good BAE might be at making weapons, the reality is that it is never going to be a major supplier to the People's Liberation Army.

Diageo or Land Rover can ride a wave of emerging markets sales even if their home markets are struggling. For BAE, it isn't that easy.

Last year, BAE tried to pull off an audacious mega-deal that would fix many of those strategic issues in a single move. In September, it unveiled a £30bn merger with EADS. Put together in the late 1990s, the European Aeronautic Defence and Space Company - to give it its full title - combined Airbus with a range of French and German defence assets. BAE's shareholders would have owned 40% of the combined company and EADS the rest. The idea was to create a single European defence and aerospace group, combining Airbus with a powerful arms and weapons business.

The industrial logic looked compelling, but the financial and political logic was a lot less sound. Some of BAE's biggest shareholders publicly questioned the move. So did many European politicians.

The British and French governments tried to negotiate a way around that, but nobody thought to make sure it was OK with the continent's most powerful politician, the German Chancellor Angela Merkel. By October, the Germans had decided Berlin was not getting a good enough deal out of the merger. Once the decision not to go ahead was made, there was no way the deal could be completed - and by the end of the month the merger had fallen apart.

It was a serious blow for BAE. When a merger collapses, it raises questions about where the company goes next. After all, if everything was going well, why would it be attempting a merger in the first place?

Ian King, BAE's long-serving chief executive, is not so sure it should be seen that way. 'The merger was the right thing to do,' he says. 'It would have created a global defence and aerospace company that was bigger than Boeing. I have no regrets about the path that we took. But the fact it did not happen does not mean we can't compete. The company is as strong as it has ever been.'

Many of the analysts who follow the company agree: although the shares dropped as low as 300p after the deal was scrapped, they have since recovered to more than 450p.

'To say the merger needed to happen would be wrong. But to say it would have been a strategic solution for the long term would be absolutely right,' argues Wheeldon. 'The merger would have been an ideal solution that would have had a lot of benefits. I wouldn't be surprised if they tried to resurrect the deal at some stage. But it won't happen quickly.'

King, perhaps unsurprisingly, doesn't think that is likely. 'You never say never,' he says of resurrecting the deal. 'The industrial logic is still there. But people and companies move on, and situations change.

' Apart from anything else, he argues, the financial logic does not work for the shareholders the way it did a year ago - and unless they are on board, it is not going to happen.

In the wake of the merger's collapse, BAE has been moving forward purposefully. The deal took up a huge amount of management time, but King sees some upside in it. 'I think the merger debate improved our relationship with the UK government. It made them look at what we represent to the British economy.'

In the spring, BAE appointed a new chairman, the industrial and City veteran Sir Roger Carr. Although some analysts questioned whether he had the international and defence background to make him a natural choice for the role, he has the experience of handling politicians and shareholders that will be vital as the company moves on from the tie-up with EADS.

The scale of the challenge ahead, however, was laid out clearly in BAE's latest set of results. The total order book was up by 8% to £42bn, suggesting there is still plenty of work for the years ahead, but annual sales fell for the second year in a row to just over £17bn, 7% less than in 2011.

'Our core strategy has not changed,' says King. 'This is a major defence business for the UK and US, and with growing international sales and a fast-growing business in cyber-security. We booked £11bn in new orders last year. And we made absolutely sure that our main businesses were not derailed by the merger discussions.'

King is also confident that its £4.5bn Salam deal with Saudi Arabia to supply 72 Eurofighters, which dates from 2007, will be finalised this year. Twenty-eight planes have already been delivered and BAE hopes the Saudis will extend the deal beyond those 72. But, in truth, unless there is a major war, neither Britain nor the US is likely to be ramping up defence expenditure. The key will be to develop BAE's international sales and find new revenues from civilian work.

'The balance of power is shifting away from the west in defence,' argued Alexandra West of Redburn Partners in an analysis of the company. King believes the company can carve out a role for itself in new markets.

Saudi students undergoing training at RAF Cosford, Shropshire

Saudi students undergoing training at RAF Cosford, Shropshire


 

In the past, a quarter of its sales came from the UK, 40% from the US, and 15% from the hugely lucrative (and controversial) deals it has signed to supply Saudi Arabia over the years. But in the past few years, it has developed significant sales in Australia and India, and in new territories such as Poland.

King believes that this is just the start. 'Our exports are from the UK and US, that is where our intellectual property is, and there will always be restrictions on who we can sell to from those nations,' he says. 'But take the Middle East. As the US depends less on it for energy, it has to become less reliant on it for security and more self-reliant. India is a huge growth market for BAE. Poland is a growing market. The world is not a safer place.'

There is much truth in that. BAE was in many ways a Cold War company, supplying the heavy pieces of kit that would be needed to fend off a Soviet invasion, whether it was tanks, or fighter jets or warships.

In some ways it still is - the Eurofighter, of which it is one of the key manufacturers, is a highly sophisticated plane designed to stop attacks from the air. But the threat of a major war against an enemy with a high-tech airforce has vanished.

Instead, there are small, hot wars, against terrorist, pirates or rebels in failed states. And increasingly the highest defence spending is in new markets - countries that feel menaced by the growing power of China, or Middle Eastern nations that want to reduce their dependence on the US for security. BAE can adjust to supplying those markets - but it is a long, slow process.

And defence is not just changing in terms of who the enemies are. The nature of warfare is changing as well.

Between 2008 and 2011 BAE acquired five cyber-security companies to make itself a world leader in detecting and preventing online attacks. There should be nothing surprising about that. Whereas tanks, ships and fighter jets were once the frontline of any nation's defence, now an assault is as likely to come via a fibre-optic cable as it is from an amphibious landing craft.

Every government is well aware that a first strike is likely to involve taking out electronic systems, and that has to be defended against. BAE has made itself a leader in that part of the industry.

There is a spin-off - and one that might be very helpful for the future. Other defence products don't have civilian uses. Companies don't usually buy tanks, even if they might come in handy on Oxford Street on Christmas Eve.

They are, however, as vulnerable to cyber-attacks as governments, if not more so - and just as keen to protect themselves. The expertise BAE has developed in defence is allowing it muscle its way into that market.

In February, for example, it announced a five-year partnership with Vodafone to provide security systems. 'The big corporations all have to take cyber-security very seriously - it is part of a licence to do business,' says King.

It remains to be seen whether BAE can become a major cyber-security player. It almost certainly has the technical skills, but it may struggle to adjust to the harsher world of private sector contracts. It is used to working for defence ministries, and they are hardly famous for their cost control.

If it can develop that division, and continue to crack open new markets, then it may well have a future as healthy as its past. If not, the future may be more disappointing - a slow, if perhaps dignified decline, as the British and American governments hack away at military spending and the companies that supply their armed forces.

Still, if nothing else works, maybe it should dust off those plans for a vertical take-off passenger jet - and see if they can interest Ryanair in a way of getting away from airports completely. That at least might be a growth market.

BAE - A BRIEF HISTORY


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