What price defence?

New government procurement rules mean that Brit military contractors won't be playing their home games unopposed. Dominic O'Connell reports.

by
Last Updated: 31 Aug 2010

As Tony Blair strode on to the stage in Davos for his headline-grabbing address to the World Economic Forum earlier this year, one of his Cabinet ministers was convening a decidedly less pleasant meeting in his Whitehall office. Geoff Hoon, then Blair's defence secretary, had summoned the three most powerful men in the British defence industry to settle a row that threatened to blight one of the UK's biggest defence projects in decades.

The Royal Navy wanted to buy two new aircraft carriers, ships that would cost more than £3 billion to build and another £6 billion to maintain.

If they were to be in service to replace the current ageing ships as planned in 2012 and 2015, the Ministry of Defence and its contractors needed to crack on. Instead, the procurement process had stalled, beset by wrangles over the budget and which company would be in charge of the ships' construction.

At Hoon's side was Sir Peter Spencer, head of the Defence Procurement Agency and the civil servant responsible for delivering the carriers on time and to budget. Across the table were Dick Olver and Mike Turner, chairman and chief executive respectively of BAE Systems, Britain's biggest defence contractor and the company assumed to be in line not only to win the lion's share of the carrier work but to manage the entire programme.

But Hoon and Spencer had other ideas. Having already snubbed the British company once by appointing Thales, a French defence group, as a one-third partner in the project, they now wanted to appoint a 'programme manager' to run the construction phase, a move that threatened to undermine BAE.

Even worse, the company they wanted to appoint was Kellogg Brown & Root (KBR), an arm of the controversial oil and defence services group Halliburton. KBR was best known in the UK for its expertise in oil and gas services. The closest it had come to building a naval vessel was the construction of offshore oil platforms.

Olver and Turner were not happy that BAE was being passed over for a company that knew nothing about naval contracts.

But Hoon and Spencer did not budge. Little more than a year earlier, there had been the mother of all rows over two multi-billion pound programmes that had gone badly awry - the first the refurbishment of Nimrod maritime surveillance aircraft, the second the construction of a new Astute-class of hunter-killer nuclear submarine (see box, p57). In the event, BAE was forced to take a punishing £750 million write-off against delays and cost overruns.

In Hoon's office, the discussions grew tense. Spencer stressed his intention to appoint professional project managers, while Turner and Olver repeatedly returned to the problems of management by committee, and KBR's lack of shipbuilding expertise. Eventually, Olver had had enough. Such an ill-conceived piece of procurement was a danger to the company's international reputation, he said, and BAE was considering pulling out entirely. It was an extraordinary confrontation. The chairman and CEO of a FTSE-100 company do not often tell their biggest customer that they have got it completely wrong, and even less often when that customer is the Government.

It was perhaps not out of keeping for the defence industry. Dwight Eisenhower, the US world war two general turned peacetime president, coined the phrase 'the military-industrial complex' for the interlocking of interests between the political and business worlds that is unique to the industry. In defence, governments are the big spenders and virtually the only clients. The US will spend £239 billion on defence projects this year, the UK £30 billion. Politicians do not, however, have a free hand in how the money is spent - witness last month's stories detailing how BAE paid more than £1 million to front companies for former Chilean dictator Augusto Pinochet between 1997 and 2004, and the continuing investigation into alleged slush fund payments as part of the £25 billion Al Yamama Saudi Arabian arms deal. Security and national interest considerations dictate that large or strategically important defence contracts go to domestic contractors, and the export of the resulting equipment and technology is strictly regulated.

Shrinking defence budgets mean that large programmes are rare. For a company that wants to keep abreast of the technology and retain the skills needed to complete complicated major projects, each deal becomes a must-win. Fiercely competitive bidding and governments' desire to secure fixed-price contracts can result in financial disasters, as exemplified by BAE's experience with Nimrod and Astute.

Defence companies have political levers of their own to pull, and have become past masters at playing the jobs card. American defence groups are experts at ensuring that they have factories in important electoral areas, where the local congressman or senator can be relied on to bring pressure to bear when important contracts are up for grabs.

The same game is played in Britain. In the UK, the MoD was forced to reveal this year that it had provided £87 million in financial assistance to Tyneside shipyard Swan Hunter by underwriting the financial risk on a landing ship contract that had gone wrong. The willingness to help Swan Hunter was perhaps understandable: a clutch of influential politicians, including Tony Blair, Nick Brown, Stephen Byers and David Miliband, have constituencies on the yard's doorstep.

A classic example of the shifting sands that can undermine projects is Eurofighter, a four-nation European programme to build a new combat aircraft (see box, p59). Eurofighter, now better known in Britain under its service name of Typhoon, was originally conceived in the 1970s as a cold-war champion, an aircraft that would blast out of its base to meet the waves of Soviet bombers attacking western Europe in the event of a full-scale confrontation. The British, German, Spanish and Italian governments clubbed together to produce it, and it was to cost about £30 billion.

The concept now looks as dated as an Allegro or Morris Marina. Eurofighter's costs have trebled to nearly £100 billion and the project has been beset by delays. Rather than it being run by a single contractor, with production concentrated at a single factory, each national contractor has demanded, and received, a share of the work. There are four Eurofighter assembly lines and, to make matters worse, the project has been at the mercy of the stop-go rhythm of each country's domestic budget cycle and spending priorities.

While the politicians have dithered, the threat that Eurofighter was meant to counter has disappeared. The collapse of the Soviet Union has lessened the need for a powerful, complicated fighter dedicated to ensuring air superiority. Instead, the partner nations now want an aircraft able to carry heavy weapons and attack ground targets, something more B-52 than dogfighter. The negotiations over the specification and price of the second tranche of aircraft, which were finally completed just before Christmas 2004, took two years.

The scenes played out in Hoon's office earlier this year were not the first clashes between BAE and the Government. There had been tension over what BAE executives saw as the MoD's willingness to undermine its status as the national defence contractor, and the Government's unrealistic expectations on programme cost and risk. Eventually, the regular showdowns with the Ministry made BAE's top managers the object of ridicule, criticised by analysts, fund managers and the media for allowing the company's relationship with its most important client to deteriorate so badly.

Turner, who became chief executive of BAE Systems just seven months before the full extent of the problems with Nimrod and Astute were made public, remembers ruefully the reaction from investors the day after he had to take a large write-down on the contracts in BAE's 2002 results. 'After Nimrod and Astute, all I got from shareholders in this country was: what are you going to do about the Ministry of Defence, about performance and programme management?' he recalls. The City's reaction was clear in the company's share price, which fell 20% to 131p, its lowest level in seven years.

Despite the battering, Turner and Sir Richard Evans, then BAE's chairman, did not back down. Olver, the new chairman, has proved equally staunch.

The firm has clashed publicly with the Government a number of times since.

As well as heated arguments over the future of the carrier programme, there was a major lobbying battle over an £800 million contract for jet training aircraft for the Royal Air Force, with BAE finally securing the deal despite strong opposition from the Treasury.

Turner is unapologetic, saying it was vital that the company changed the terms of trade with the MoD. What BAE wanted was, in its eyes, a return to sanity, with more money spent upfront on taking the risk out of large, technologically challenging programmes. The company would no longer accept contracts that carried what it views as an unacceptable level of risk, says Turner. 'It is not sensible to commit yourself to dates and prices that are very risky, as we have in the past. Everyone - our shareholders, the Ministry of Defence and Britain as a whole - gets shot in the foot.'

Unfortunately for Turner and BAE, some foreign defence contractors are happy to step into the breach. Britain's £33 billion-a-year defence budget makes it a land of milk and honey compared with France, which spends £23 billion, and Germany, with £17 billion. Europe spends 1.5% of its gross domestic product on defence compared with over 3% in the US.

Continental defence contractors, emboldened by the consolidation in their ranks that has given them the size and clout to compete with the big American players, now view a presence in the UK as vital to their future, while the Americans in turn see Britain as a natural export market. In the past decade, foreign defence companies have pushed hard into the British market through acquisitions and aggressive contract bids.

Britain's second-largest defence group is now French: Thales burst on to the UK scene with the purchase of the Racal defence electronics business five years ago, and is now regarded by the MoD as a British prime contractor. It has won such sensitive programmes as FIST (Future Integrated Soldier Technology), a plan to put high technology in the hands of the lowest infantryman, and Watchkeeper, an £800 million programme to provide new reconnaissance drones to the British Army (see box, p59).

Vying for third place are EADS, the Franco-German combine best known as the parent of Airbus, and Italian group Finmeccanica. Both have gained substantial footholds in the UK. EADS has won Britain's biggest-ever private-finance initiative contract, a £14 billion deal to supply new air-to-air refuelling tankers to the Royal Air Force. The Italian group now owns the famous Westland helicopter factory at Yeovil, and recently bought a clutch of sensitive avionics businesses from BAE for £648 million.

The Government has been happy to make the most of this competitive pressure.

The UK, complain British defence executives privately, is the only defence market in the world where the natural preference for awarding contracts to domestic companies has been set aside. This lack of attention to the nationality of a contractor, unthinkable in the US or France, is now a central tenet of the MoD's industrial policy.

In a statement two years ago, the defence procurement minister of the time, Lord Bach, said the Government would 'treat all defence suppliers that create value in the UK fairly, regardless of ownership'. From now on, he said, what was important was who was creating jobs and new technology in the UK, not who owned the shares. In an unguarded moment, Hoon rubbed salt in the wound for BAE, questioning whether it was right to call it British at all, noting that at times American institutional shareholders owned a majority of the company.

This official open-door policy has made Britain a happy hunting ground for foreign defence groups. Alex Dorrian, the affable Scot who runs Thales in the UK, says nationality genuinely appears not to be an issue for the MoD.

'We are a UK company run by Brits, as far as the MoD is concerned. The Government likes competition and it views us as a very important part of the UK defence base.'

Alberto de Benedictis, Finmeccanica's UK boss, makes no secret of the fact that his group has deliberately set out to emulate Thales. 'It has provided us with a clear example,' he says.

Britain also provides a transatlantic stepping stone to the largest defence market of all, the US. 'For us, Britain is important not only because it is the biggest spender on defence in Europe, but also because the Government has a good track record of supporting defence exports,' explains de Benedictis. 'Being a big player in Britain also gives you visibility and credibility in America.'

Finmeccanica's move into the UK has paid off more handsomely. Shortly after taking full control of Westland's Yeovil plant, it won a dream US contract. Its EH101 helicopters (renamed the US101) were chosen by the White House as the new aircraft for Marine Force One. And a few months later, shortly before the general election, the British Government said it had entered an 'industrial partnership' with Westland that could eventually yield contracts worth up to £3 billion.

Even larger American groups have been happy to swarm into the gaps left by BAE. When a troublesome, long-running project to replace the army's obsolete radios ran into problems five years ago, Hoon sacked the contractor, a BAE-led consortium called Archer Communications Systems. General Dynamics, a US corporation with an annual turnover of more than $20 billion and best known for its construction of the US nuclear submarine fleet, stepped into the breach. It signed a £1.7 billion contract to build and instal new Bowman radios, and a £300 million follow-on contract that will create a high-tech information network for the British Army.

The deal has not gone smoothly. The follow-on contract, known as CIP (Combat Infrastructure Platform), is running about a year late and the fitting of Bowman radios to army vehicles is behind schedule. General Dynamics executives admit privately that the firm is unlikely to make much profit from the contract.

But Sandy Wilson, former Thales executive and now managing director of General Dynamics UK, says Bowman has transformed the company's fortunes in Britain, taking its turnover from £50 million to £500 million a year, and, more importantly, catapulting it into an exclusive club of prime contractors that the MoD will trust to tackle large, complicated projects.

General Dyamics is now bidding to manage the construction of a fleet of auxiliary ships for the Royal Navy.

As the Europeans have expanded in the UK, BAE has built up its presence in America, making a steady stream of acquisitions to increase its exposure to Pentagon contracts, the latest of which is a £1.9 billion deal to refit armoured patrol vehicles returning from arduous service in Iraq. The reverse has been true in Europe, where it has made a series of disposals.

The reason for the sell-offs became clear in March. In its biggest-ever US deal, BAE bought United Defence Industries, a tank maker, for £2.15 billion. The deal made BAE the sixth-largest defence group in America.

Why is the company building up its presence in the US? 'It's where the action is,' says Turner.

Industry analysts now say the big question is how far BAE will go, and whether it might eventually quit Europe altogether. Olver and Turner have repeatedly stressed that their strategy is to exploit BAE's unique status as a contractor trusted in both Whitehall and the Pentagon to win big deals on both sides of the Atlantic. But neither man completely rules out any course of action, saying they will do what is in the best interests of their shareholders.

There is evidence that the UK government's polyglot industrial policy may be reconsidered. A key test has come with the Joint Strike Fighter (JSF), the $200 billion programme considered the biggest single defence project in history. The JSF will be a versatile, low-cost aircraft able to replace a variety of combat aircraft currently in service, and sales of 3,000 to 4,000 aircraft are forecast. Although it's a US-led programme, the Pentagon has enlisted nine nations to take part, foremost of which is Britain, which has paid £2 billion in order to become the only 'Tier One' partner.

The programme is coming under strain. Pentagon restrictions on technology exports have led to the partner nations protesting that they are being squeezed out and will not receive the vital software codes and other technology they need. The issue is likely to come to a head next year, when a decision must be made as to whether to build another assembly line for the aircraft outside America. Britain wants one, but so does Italy.

America's reluctance to share has made Britain think twice about what it needs to keep close to home. At the Paris Air Show this year, BAE's Turner stunned the defence world by revealing that his company had secretly been building and flying unmanned aircraft in the north-west of England - and that the work had now been picked up by the Government and was being funded as a 'black' - ie, secret - programme. Unmanned aircraft are regarded as the next big thing, and the US is pouring billions into their development.

The MoD's change in sentiment had come, Turner hinted, because the JSF experience had taught defence planners that perhaps they could not rely on other countries to provide the right level of technology to ensure the UK's security. Industry veterans regard this as a sign that the British defence market may be returning to the international norm.

NIMROD AND ASTUTE

Budget: c£3.5bn each

Lead contractor: BAE Systems

With the first modernised aircraft due to enter service in 2009, the Nimrod maritime surveillance upgrade programme is running six years late and £800m over budget. The construction of the new Astute class nuclear hunter-killer submarines - also due in 2009 - is similarly over-budget and three and a half years late. BAE was forced to take a £750m write-off against delays and overruns.

EUROFIGHTER

Budget: c£100bn

Lead contractors: BAE, EADS, Finmeccanica

Conceived in the 1970s as a four-nation European programme to combat a Russian aerial menace that no longer exists, the Eurofighter - better known in Britain as Typhoon - was originally budgeted at £30bn and should by now have been in service for several years. More delays have been caused as the aircraft is modified for a new ground-attack role.

FIST AND WATCHKEEPER

Budget: £2bn and £800m respectively

Lead contractor: Thales

Thales burst onto the UK market five years ago and, thanks to deals like these, the French defence group is now the second-largest in Britain.

FIST (Future Integrated Soldier Technology) aims to give the ordinary infantryman hi-tech thermal imaging and targeting systems. Watchkeeper will provide a remotely piloted drone aircraft for army battlefield surveillance.

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