On average, companies in the ESDS Index and the MSCI Europe Industrials had similar CapEx levels as a percentage of sales (figure 5). The comparable performance, regardless of changes in sales or overall economic conditions, suggests ESDS Index and MSCI Europe Industrials compa-nies took similar views on the longer-term prospects of their respective industries.
Internal R&D and capital expenditures could serve as a barometer for the vitality of the defense and security sector. If falling margins and cash flows are complemented by decreasing internal R&D and capital expenditures, it may be that companies are becoming pessimistic about their long-term prospects and potentially are preparing to exit the market. In recent years, defense and security companies have invested at levels comparable to those of industrial companies, and government R&D spending has decreased but not dramatically so. This suggests that firms in the European industrial base supporting defense and security are confident about their medium- to longer-term opportunities, or at any rate are as confident as their industrial counterparts are in their own respective markets.
a healthy, diversified defense industry despite declining european demand | 35
Vulnerabilities
Two indicators could shed some light on companies’ potential vulnerabilities to economic auster-ity: geographic exposure and market exposure (pure defense versus a mix of defense and commer-cial).
CSIS ESDS Index companies’ revenue grew from €63 billion in 2003 to €93 billion in 2009 (in constant 2009 euros), a 49 percent gain, despite flat or declining defense budgets in Europe. One explanation is CSIS ESDS Index companies’ increasing exposure to foreign markets, especially that of the United States. Figure 6 shows the CSIS ESDS Index revenue mix by geographic origin for 2003 and 2009. Revenue originating outside Europe more than doubled and increased from 35 percent of total ESDS Index revenue in 2003 to 55 percent by 2009.6 Revenue from European mar-kets remained virtually unchanged between 2003 and 2009, though its contribution to total ESDS Index revenue fell by 20 percent. This shift in revenue by geographic origin means that European markets are no longer the main revenue source for ESDS Index companies. It also indicates that European defense and security companies are competitive in the global marketplace.
Figure 6. CSIS ESDS Index Revenue Mix by Geographic Origin (2003, 2009 in constant 2009 billion euros)
Note: Excludes European Aeronautics Defense and Space (EADS).
Source: Company filing; analysis by CSIS Defense-Industrial Initiatives Group.
European defense and security companies with a geographically diverse revenue mix will be less vulnerable to European austerity measures. North America will likely remain a key revenue source for European companies in the coming years. However, with U.S. defense budgets facing
6. Excluding European Aeronautics Defense and Space (EADS).
Europe Europe
pressure, it is unclear whether European defense and security companies will be able to maintain growth rates comparable to those of the past decade. Firms have ramped up their business devel-opment efforts in emerging markets such as Latin America, the Middle East, and India, and the competition for business in these markets will be intense. Russia, which signed a deal for four French Mistral-class amphibious assault ships in January 2011, might be another potential cus-tomer for European defense firms, but no additional deals are imminent and it is unclear whether there will be much Russian demand for foreign defense equipment in the coming years. China is an additional potential export market, but given the EU embargo on military sales to the country, the lifting of which requires a consensus of all member states as well as a willingness to accept U.S.
ire, European firms are unlikely to view this as a source of revenue growth in the near future.
Unlike their U.S. counterparts, however, European defense and security firms tend to be more diversified between the commercial and defense sectors. From a top-line corporate perspective, European defense and security firms’ exposure to commercial markets could offset some of the de-cline in defense and security spending, and growth in the commercial business units could make up for losses on the defense and security side. At the same time, the existence of commercial busi-ness units lowers the barrier for exiting the defense market. Put another way, existing commercial segments will make it easier for executives to shift focus—and capital—from defense to com-mercial business (though to date none of the ESDS Index companies have done so to a significant extent). This might lead to fewer players in the European defense industrial base, leading in turn to less competition, potentially less innovation, and a loss in capacities. However, the considerable level of government involvement, including the ownership of golden stocks and other equity in many European defense and security companies, might alter some of these market-driven deci-sions. For example, the announcements in early 2011 by Daimler, the German stakeholder in EADS, that it would off-load 50 percent of its shares prompted the German government to an-nounce it will consider creating a golden share in the company in order to maintain influence on its business decisions.7
Conclusion
The European defense and security industrial base has the capacity to develop and produce a wide range of equipment and services, including transformational and operationally relevant ones such as counter-IED capabilities, deployable logistics, C4ISR, cyber, and missile defense.8 This capacity exists because European companies have recognized that developing such technologies is im-portant to their competitive position in both defense and commercial markets around the world.
Future trends in CapEx and R&D will indicate whether industry’s outlook on these market oppor-tunities has changed, based on whether orders are placed in Europe or elsewhere.
The European defense and security industrial base overall remains capable, competitive, and financially healthy. Companies in the European defense and security sector have performed well in recent years, both in absolute terms and compared to their peers in the commercial sector. Aided by protected defense equipment accounts, higher domestic security spending, and increased
7. Vanessa Fuhrmans, “‘Golden Share’ an Option for EADS,” Wall Street Journal, February 23, 2011, http://online.wsj.com/article/SB10001424052748703775704576162080985105642.html.
8. See, for example, Gordon Adams and Guy Ben-Ari, Transforming European Militaries
(London: Routledge, 2006), pp. 142–143; and Seth Jones, The Rise of European Security Cooperation (Cam-bridge: Cambridge University Press, 2007), pp. 160–176.
a healthy, diversified defense industry despite declining european demand | 37 defense business abroad, their revenues grew steadily despite largely falling or stagnant European defense spending. Operating margins expanded, in line with operating margins of companies from other sectors, and the ESDS Index defense and security companies continued to generate high levels of cash flow.
Concurrently, the European defense and security industrial base is facing the critical challenge of managing the anticipated further declines in European defense spending. A mitigating factor on the defense spending side is the fact that European governments have over the past years managed to maintain their investment accounts in relative terms despite overall budget cuts as well as in-creased spending on homeland security. In addition, many European defense and security compa-nies have significant commercial business units that can potentially be enhanced to offset declines in the defense business units.
However, it is unlikely that these trends will continue at a pace that can offset future reduc-tions in defense spending. Furthermore, U.S. defense modernization accounts are likely to fall in the near future. The growth potential of other regional markets over the next five years might also change. For instance, the revolutionary tendencies in the North African region might shift acquisi-tion priorities and preferences for suppliers.9 Given the constraining budget environment on both side of the Atlantic, and the low barriers for European firms to exit the defense business, it will be critical for European governments to communicate their requirements clearly to European defense and security companies so that these in turn may most effectively align their portfolios with their customers’ priorities.
9. See “Les blues des marchands de canons,” Le Monde, March 5, 2011.