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British Arms Merchant With Passport to the Pentagon
Published on Wednesday, August 16, 2006 by the New York Times
British Arms Merchant With Passport to the Pentagon
by Leslie Wayne
 

It is hard to tell whether BAE Systems should be flying the Union Jack or waving the Stars and Stripes.

BAE, the British military contractor, manages top-secret programs in England and the United States and makes weapons for military operations in Iraq and Afghanistan. It is the world’s fourth-largest military contractor and the seventh-biggest in the United States, the only foreign Pentagon supplier to crack the top 10.

BAE says it is neither British nor American, but a new breed of military contractor — a trans-Atlantic supplier. Its American subsidiary, based in Arlington, Va., has operations in 36 states as well as England, Sweden, Israel and South Africa. The company is listed on the London Stock Exchange, but nearly 50 percent of its shares are held by American investors.

The chief executive, Mike Turner, has even hinted he might move the company to the United States if he gets more Pentagon business, a goal that is central to his strategy for growth.

“It’s been the absolutely right strategy for BAE to enter the American market,’’ said Alexandra Ashbourne, head of Ashbourne Strategic Consulting, a London research firm. “Although others are trying to do the same, BAE has been more successful. No doubt they will be looking for more in the U.S. It’s where the defense spending is.”

Of course, BAE’s ability to get Pentagon business is, in large part, the result of a special relationship between Britain and the United States that allows BAE to bid more easily on Pentagon business than companies from other foreign companies. BAE has capitalized on that advantage by moving boldly and quickly. It has acquired American businesses worth more than $7 billion since 1999 and wants even more.

But BAE’s ambitious plans hit a stumbling block a few weeks ago. To free up cash for acquisitions, BAE announced in April that it would sell its 20 percent stake in Airbus to its parent, the European Aeronautic Defense and Space Company, or EADS. At the time, financial analysts conservatively valued the Airbus stake at $4 billion to $5 billion.

But in June, Airbus said that technical glitches would delay deliveries of its new commercial plane, the A380, and, last month, it announced a costly redesign of its midsize A350. These twin problems pushed down the value of BAE’s stake in Airbus to $3.5 billion. Once transaction costs and loan repayments are accounted for, BAE said, it expects to net $2.1 billion, at most.

“It’s a challenge,’’ said Alison Wood, a member of the BAE executive committee, in an interview in BAE’s offices here. Ms. Wood is also director of BAE’s strategic development group and oversees the company’s global business strategy, including that in the United States.

Nonetheless, Ms. Wood, British-born and Harvard-educated, said the lower valuation would not crimp the American acquisition plans.

“We have to be realistic, but we will proceed,’’ she said. “The challenge will be to find the right quality of deals. I’m more worried about finding deals to do than having money to do them.”

BAE is conducting an independent audit of Airbus to help the BAE board decide whether to accept the price or keep the shares and hope for better days. A board decision is expected in September. Under terms of the deal, the $3.5 billion price cannot be renegotiated, only accepted or rejected.

The reason BAE is so attracted to the United States, the company says, is obvious. Pentagon spending is reaching $500 billion a year. This is more than twice the $230 billion a year spent by all 25 members of the European Union combined.

Last year, BAE made headlines when it spent $4.1 billion to buy United Defense Industries, makers of the Bradley tanks used in Iraq. It was the largest foreign takeover of an American military company.

But even before that, BAE was acquiring American companies at a steady clip — more than a dozen in the last six years. BAE’s first move was a bold one: the 2000 acquisition of the Sanders unit of Lockheed Martin, which does top-secret electronics work for the Pentagon. Once that barrier was broken, other acquisitions came more easily.

“The BAE Systems strategy was unique,’’ said Suzanne D. Patrick, former deputy under secretary of defense for industrial policy. “BAE set out to buy Lockheed Sanders, a firm providing some of the most sensitive electronic countermeasures. The U.S. government demonstrated its trust in BAE, and BAE was able to acquire other less sensitive defense equities with relative ease.”

By contrast, other foreign military contractors are more cautious, either selling more basic goods to the Pentagon or, most frequently, working as subcontractors to large American military suppliers.

In recent years, EADS, a French-German company, as well as Finmeccania of Italy and Thales of France, have gained a slice of Pentagon business. But none have made the big-dollar acquisitions that propelled BAE into the top ranks.

Mr. Turner, BAE’s chief executive, emphasized the company’s longstanding American ties in a speech in May in Washington, even noting that the “rockets’ red glare” cited in the national anthem referred to rockets produced by Royal Ordnance, now part of BAE. (Britain and the United States, however, were at war at the time.)

Michael Richter, co-president of Jefferies Quarterdeck, a Los Angeles aerospace investment bank, said, “English companies, above all, are received with open arms by the Pentagon and the U.S. government because of the tight relationship between the countries.”

BAE operates in sensitive national security areas under the terms of a special security agreement that provides that the American business is run under American law and by American citizens. While this permits BAE’s American operations to have the same access to classified Pentagon programs as domestic defense contractors, many areas of sensitive technology are not visible to BAE executives, including Mr. Turner.

Mark Ronald, an American citizen, heads the BAE operations in the United States and is a member of BAE’s executive committee. On top of that, the American subsidiary’s board includes former government intelligence and Pentagon officials, including Anthony C. Zinni, a former Marine general who headed United States Central Command; Kenneth A. Minihan, a retired Air Force general who was director of the National Security Agency; and Lee H. Hamilton, a former representative in Congress who was co-chairman of the 9/11 Commission.

In the same May speech in Washington, Mr. Turner took pains to stress BAE’s dedication to American security: “I really want to reiterate that our record of keeping U.S. secrets is immaculate.”

That still has not silenced some in Congress concerned about foreign purchases of American military companies. After the firestorm over the efforts by DP World, based in Dubai, to take over operations at six American ports, measures have been introduced in Congress to make it harder for foreign companies, BAE included, to buy American military contractors.

And BAE faces some challenges of its own in Washington. It has invested more than $1 billion and is the largest foreign investor in the Joint Strike Fighter program, a $276 billion program to build the next-generation fighter jet. A high-level battle between Britain and America over sharing technologies that go with the planes has opened new trans-Atlantic tensions.

But BAE’s sale of its Airbus shares could help the company in Washington, said Nick Fothergill, a military analyst with Lehman Brothers in London, especially among those who fear that foreign companies might leak Pentagon secrets and technology to China.

“If BAE sells the Airbus shares, it would be dropping its German and French exposure in the event that EADS does something with the Chinese on defense,’’ Mr. Fothergill said. He predicted BAE would sell its Airbus stake because “BAE is angry enough at EADS that they will just want to get rid of the shares.’’

Ms. Ashbourne agreed. ”Even if it is several billion lower, I think BAE will swallow its pride and take it.”

From her office, Ms. Wood is looking for potential takeover candidates — a task made more complicated because many American military companies are selling at a premium.

Ms. Wood said she was not looking for a mega-merger like the United Defense acquisition, but wanted companies in the $400 million to $700 million revenue range. She also said she was “widening the aperture” from military companies to those in commercial aerospace, homeland security and federal information technology.

One much-discussed candidate has been L-3 Communications, based in New York. The L-3 board is assessing the company’s future after the death in June of its chief executive and founder, Frank C. Lanza. Rumors were so strong that BAE even issued a denial.

“People have tried to link L-3 and BAE and I don’t know what will happen,’’ Ms. Wood said. “There are parts of the company that we’ve coveted. But that’s far from saying we will go for it.”

If Ms. Wood’s acquisition binge continues as planned, the bulk of BAE’s revenue might come from the United States, which would raise questions of where the company should be domiciled.

“It’s a tricky issue,’’ Ms. Wood said. “And not to be too Union Jack and British about it, I’d expect our Ministry of Defense would have something to say about it.”

Copyright 2006 The New York Times Company

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