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On first appearances the proposed merger of BAE Systems and EADS looks like a good fit for both companies giving them a balanced civilian and military portfolio across the whole aerospace sector.

Some analysts have spoken of a European version of Boeing with the ability to rebalance between the civilian and defence aerospace sectors depending on the economic cycle and with a significant market share in the US. 

There are two main potential reasons that could still see the merger blocked. First, the US government may veto the merger because of the level of access BAE Systems has to the US defence market and concern about technology being transferred outside the US. Second, the British government requires sufficient assurance over the provision of its strategic nuclear deterrent both in terms of capacity and knowledge protection. 

In both cases analysts have put forward means of placating these concerns. In the case of the former, it has been suggested that resolution will come by ensuring that the US subsidiary element within the new company has sufficient autonomy, including a US Board. In the latter, resolution would revolve around some form of guarantee about information flow and the retention of key skills in the UK. 

However, the British government has further reasons to be concerned. Clearly there are obvious synergies in the whole area of aerospace and missile development. The concern should be where there aren’t synergies. In these areas BAE Systems business has been far less successful. Three areas stand out.

The first area is that of the British Army's armoured vehicle fleet, a lot of which is ageing and which BAE Systems holds design authority. For much of the last decade the British Army embarked on a series of programmes to develop a new generation of armoured vehicles for a medium-weight force. Despite spending over £1bn the army has only received a few prototypes and acquired some vehicles for operations in Iraq and Afghanistan. Now, as a result of the economic downturn and the subsequent drastic cuts in British defence spending that emerged from the Strategic Defence and Security Review (SDSR), the army is confronted with the prospect of making do with updates to its existing vehicle fleet for at least the next decade. As a consequence of this and the competition from the US primes, BAE Systems has already significantly reduced its land systems area and what is left is withering on the vine with little hope of any future orders. A merger looks likely to only hasten BAE Systems withdrawal from this defence sector leaving the UK with little indigenous capacity to design and build armoured vehicles.

It is a similar tale for BAE Systems' warship building yards. The continuing reductions to the Royal Navy and the failure to secure overseas orders for major warships has left BAE Systems with excess capacity. Even before merger talks, BAE Systems was looking to consolidate further with at least one of the shipyards forecast to close in the short term. Since the Barrow yard is the only one capable of constructing nuclear submarines, the former VT yard at Portsmouth was seen as the favourite given the proximity of the other two shipyards to one another. However, if Scotland votes for independence then both the Govan and Scotstoun yards are likely to close, leaving Portsmouth and Barrow left to support construction of the next generation of warship, the Type 26 frigate. The failure of this programme to find an overseas partner and continuing concern that further defence cuts will be made suggest that this may be the last major warship programme built in the UK. 

The same is true for submarine production currently undertaken at BAE Systems' yard in Barrow. The SDSR has already stretched the Astute submarine programme to ensure that there is enough work to keep the yard in being until production starts on the replacement for the Trident ballistic missile submarines. However, once these are complete there is little prospect of further work until the Astute boats need replacing from around 2040 onwards. For the new merged BAE-EADS company the future of British warship building, like land systems, looks like a declining market and the temptation may be to sell the warship building part of the company and instead focus on its core aerospace business. 

The question for the British government will be whether it is prepared to see the withering away of these elements of the UK’s defence sector at a rate far faster than was the case before the proposed merger became known.

Also read:
BAE-EADS Merger: A Tough Call Ahead
Expert Comment
Robin Niblett, September 2012