SRI - EFI Sector Research

Business as usual A Financial and Extra-financial Analysis of the Aerospace & Defense Industry

Ó A controversial sector by nature

Toute la recherche Ó Changing threats & security needs CM- CIC Securities est aussi disponible sur Bloomberg: ESNR Ó IT, electronics & meta-systems, more than ever Ó National interests reign supreme

Ó State is the omnipresent stakeholder - financial & EFI

Agnès Blazy, Financial Anayst +33 1 45 96 77 61 [email protected] 10 February 2006 Valéry Lucas Leclin, SRI Analyst Sarj Nahal, SRI Analyst Business as usual

This report follows a request from a group of asset managers working with the United Nations to analyse the environmental, social and corporate governance issues that may be material for company performance and to then identify potential impact on company valuations.

The United Nations Environment Programme Finance Initiative (UNEP FI) works closely with 160 financial institutions worldwide, to develop and promote linkages between the environment, sustainability and financial performance.

UNEP FI Asset Management Working Group (AMWG) explores the association between environmental, social, and governance considerations and investment decision-making. Asset Managers that have participated in this project have combined mandates of 1.7 trillion USD.

Asset managers: ABN AMRO Asset Management Brazil Acuity Investment Management BNP Paribas Asset Management BT Financial Group Calvert Group Citigroup Asset Management Groupama Asset Management Hermes Pensions Management HSBC Asset Management Insight Investment Management Morley Fund Management Nikko Asset Management RCM (UK) (Allianz Dresdner) Sanpaolo IMI Asset Management

For more information about UNEP, UNEP FI or the AMWG please contact the project team: Philip Walker, Helen Bloustein or Gordon Hagart email: [email protected]

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Contents

Investment Case...... 5

Threats and needs have changed ...... 9

New threats abound… ...... 9 … and States must tackle these new threats in different ways ...... 10

Trends in global defence spending: a clear horizon ...... 12

The role of NATO ...... 12 Defence spending patterns...... 12 The enlarged EU – a mixed picture...... 13 US – Fiscal 2006 DoD budget is released...... 14 The world’s largest arms exporters ...... 14 Controlling the arms trade – the Wassenaar Arrangement ...... 17

Innovation and IT – the technological shift ...... 18

R&D is rising – but what’s the ultimate aim?...... 18 Innovative financing: a new trend forced upon Europe’s defence sector ...... 20 Network-centric warfare: systems integrators take the lead ...... 22

Governance and shareholding structure: incestuous relations till the end ...... 24

Additional roles: more a consequence than a choice! ...... 24 Government twin roles: client and shareholder ...... 26 Governance: incestuous relations...... 31

How the industry is bearing up in the face of change ...... 39 EADS vs. Boeing: an illustration of the gap between Europe and the US...... 40

Nothing points to a forthcoming major consolidation in Europe ...... 43

Aerospace: already highly concentrated...... 43 Land combat: Europeans gaining the upper hand, but lots still to be done...... 44 Pooling sector skills: the two types of integration ...... 45 Preserving the subcontractor industrial base: how and why? ...... 47 Guidelines for better protecting Europe’s defence industry ...... 49 Are US groups planning to move into other zones? ...... 50

Why Western groups are eyeing markets in non-NATO countries ... 51

Arms flows in other zones...... 51 Emerging of New or Old Powers in search of cash recovery...... 51 How the main European groups are bearing up ...... 52

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Corruption – inevitable or avoidable?...... 58 Vulnerability of defence activities to corruption...... 58 Measuring the extent of corruption in the industry...... 61 International efforts to tackle bribery & corruption ...... 64 Impacts of corruption – a glass half full or half empty...... 72

Conclusion...... 78

Appendix: tax rewards and subsidies, the debate...... 96

Trade and aid – Airbus (EU) vs. Boeing (US)...... 96 EU (Airbus) vs. US (Boeing) – the arguments...... 97 Possible outcomes ...... 100 Hope on the horizon...... 101

Appendix: Aero Defence Sector and employment: chicken and egg ...... 103 European employment profile ...... 103

Appendix ...... 105 Environmental efficiency, another potential source of conflict over the next 15 years ...... 105 AirBus vs. Being: the Hydrogen Divide ...... 105

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Investment Case

Ó Any extra-financial analysis of the aero-defence sector is bound to be controversial. The industry is caught between the logic of war – wholly abhorrent – and the logic of security and defence – wholly and increasingly legitimate. The borderlines are fuzzy to say the least with military intervention becoming the watchword of the era and collateral damage the unfortunate result and (sometime) constraint.

Ó Our reading of the sector’s financial and extra-financial investment perspectives is simple. When investors buy into the aero-defence sector, they are buying into a unique financial story where the State simultaneously plays a multiplicity of roles – customer, supplier, shareholder, regulator, and salesperson vis-à-vis the companies.

Interactions with the State(s) are so predominant that investors are effectively buying a share of the defence and security policy and strategy of the State – with all of its potential strengths and weaknesses – Europe including France, Germany, Italy, Spain and the UK – and the US.

Ó Investors are betting on the state of global geopolitics. Defence procurement and arms sales are to some extent inversely proportional to the state of geopolitical tensions – at local, national, regional and international levels. They are less sensitive to economic realities and variations and more dependent on long-term geo-political trends and the lifespan of equipment and the need for renewal.

Ó Investors are always making a national preference. When a State places orders, its choices are inherently linked to national interests – including economic, social, cultural and employment factors – which are an issue beyond price in its eyes. At times, even the quality of the end product will fall victim to the desire to “buy national” –Buy US (Boeing, General Dynamics, Lockheed, Northrop), UK (BAE), French (Dassault, Safran, Thales), Italian (Finmeccanica) – and increasingly European (Airbus, EADS).

Ó Investors are also buying safeguards and prevention against new threats. If the end of the Cold War convinced many that the risk of threats was on the decline – new and disparate post-Cold War regional conflicts and the ever-present global threat of terrorism have since given way to a rising need for involvement across the world and frequently at great distance from home.

The concept of preventive war requires more local military interventions, with greater costs in terms of logistics and different needs in terms of general-purpose armaments and command centres. This new set of needs will be on the cards for the long-term.

Ó Investors are increasingly buying into “meta-systems” rather than arms or defence equipment. Facing ever more diffuse threats, more underhanded but global threats and the omnipresent threat of terrorism, the traditional logic behind arsenals – more than enough stock to scare the adversary – no longer holds water.

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The new demand for security means an evolution towards the precise identification of diffuse threats and their eradication at the first strike and an ever greater focus on IT & electronics. Most of the biggest players in the sector are better-positioned in this regard (except for EADS and Rolls Royce).

Given this reality as well as budgetary constraints, States are looking for meta-systems - a menu of coordinated and integrated solutions and systems providers rather than equipment for mass mobilisation purposes. The leading systems players are BAE, Boeing, Lockheed, Northrop and Thales whereas the relative weakest are Dassault, Finmeccanica and Rolls Royce.

Ó Investors are increasingly buying dual-technology capacities as the border between civil and military end-use grows ever blurrier. Just as the threats are becoming more diffuse and trans-border, technological usage increasingly passes interchangeably from civil to military domains and vice versa. This new technological duality far surpasses the traditional separation between civil and military activities, which is simply rooted in the type of end customer. Dual use also offers great extra-financial potential such as more environmentally- friendly forms of energy. Today, dual technology is an immense advantage for companies such as Boeing, EADS, Rolls Royce, Safran and Thales – in terms of significant market potential and growth.

Ó Critical size and regional concentration will be an issue for some investors with Dassault, Finmeccanica, Safran and Thales – all possible mid- to long-term M&A targets, in our view.

Ó Investors are looking to secure margins through export volumes (i.e. defence funding). Long-declining defence budgets are on the rise once again even if the relative heydays of the 1960’s and 1970’s are unlikely to be seen again. The biggest winners in terms of increased funding are BAE, Boeing, Dassault, General Dynamics, Lockheed, Northrop and Rolls Royce. The biggest relative losers are Finmeccanica and Safran who have the technology but too specialised and small a range of products to fully benefit from state aid.

Despite increased funding, the prevailing societal demands in terms of security are no longer the same. More than ever, security is linked to controlled exports of arms and defence equipment – which make it possible to make projects conceived and developed on the basis of national priorities profitable.

Ó All companies receive significant state support – direct and indirect for exports. However, an interesting evolution that needs to be taken into account is the progressive reduction of direct and indirect State assistance for exports – a major structural development, in our view. The outcome of the current US vs. Europe trade dispute is only a symptom of this decline.

Ó Investors are buying into a comprehensive political project – including the democratic credentials (or lack thereof) of States as well as the potential instability arising from domestic or regional economic, political, social and cultural conditions. Companies at potential risk through relatively higher dependence on exports to unstable states include BAE and Rolls Royce.

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Bribery and corruption is regardless of the best intentions, something of a given in the sector. Efforts to combat it have had only limited results with the role of States playing an inhibiting rather than facilitative role. Potential risks associated with corruption are potentially significant in our view from a financial perspective and negatively impact all companies in the sector although we believe that relevant legislation and safeguards minimise the risk for US companies when compared to European companies even if this is, perversely, a competitive disadvantage for the former.

Ó Given the omnipresence of States as the all prevalent stakeholder – and without trying to diminish the responsibilities and achievements of companies – it is necessary to recognise that the nature and quality of economic relations in this very particular market is primarily determined by States and their aero-defence priorities and projects. The resulting balance or equilibrium is certainly under-efficient if not inefficient and a regulatory tendency is strongly felt – controls over arms exports, technologies, provisions against bribery and corruption.

Ó Probably more than in any other industry sector – from an extra-financial issue perspective, investors are essentially buying into a State’s positioning on such issues as democracy, economic regulations, and social and environmental legislation – Europe – particularly France, Germany, Italy and Spain – and to a lesser extent, the UK, versus USA.

Ó We have comprehensively evaluated eleven global aero-defence companies on a full range of material financial and extra-financial issues. A summary table of our results – including qualitative scores and overall rankings is below. A full table and company by company breakdown by issue is on the following page. We have also undertaken 11 company evaluations for all of the companies in our panel which can be found at the page numbers listed below.

Overview of CM-CIC Securities / ESN evaluation of aero-defence companies

AERO-DEF CO. HOME COUNTRY SCORE RANK EVALUATION BAE UK 2.43 5 Pg. 79 Boeing US 2.71 1 Pg. 81 Dassault France 1.88 9 Pg. 82 EADS France/Germany/Spain 2.29 7 Pg. 84 Finmeccanica Italy 1.63 11 Pg. 86 General Dynamics US 2.43 5 Pg. Lockheed Martin US 2.57 3 Pg. 88 Northrop Grum. US 2.57 3 Pg. 89 Rolls Royce UK 1.86 10 Pg. 90 Safran France 2.25 8 Pg. 92 Thales France 2.63 2 Pg. 94 Source: CM-CIC Securities / ESN estimates

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Our mid-to long-term assessment of material financial and extra-financial drivers

Low Reputation & National State support Possible Dual Systems IT & Multi Domestic Dependence on Qualitative Company Panel Risk Ranking Defence Budget (Export) M&A Targets Applications Providers Electronics Approach Exports to Risky Scoring Management Countries 1 2 3 4 5 6 7 8 9 BAE ÓÓ ÓÓÓ - ÓÓ ÓÓÓ ÓÓÓ ÓÓÓ Ó ns 2,43 5 Boeing ÓÓÓ ÓÓÓ - ÓÓÓ ÓÓÓ ÓÓÓ ÓÓ ÓÓ ns 2,71 1 Dassault ÓÓ ÓÓÓ ÓÓ ÓÓÓ Ó Ó Ó ÓÓ ns 1,88 9 EADS ÓÓÓ ÓÓ - ÓÓÓ ÓÓ Ó ÓÓ ÓÓÓ ns 2,29 7 Finmeccanica Ó ÓÓ ÓÓ ÓÓ Ó Ó Ó ÓÓÓ ns 1,63 11 General Dynamics ÓÓÓ ÓÓÓ - ÓÓ ÓÓ ÓÓÓ Ó ÓÓÓ ns 2,43 5 Lockheed Martin ÓÓÓ ÓÓÓ - ÓÓ ÓÓÓ ÓÓÓ ÓÓ ÓÓ ns 2,57 3 Northrop Grumman ÓÓÓ ÓÓÓ - ÓÓ ÓÓÓ ÓÓÓ Ó ÓÓÓ ns 2,57 3 Rolls Royce ÓÓ ÓÓÓ - ÓÓÓ Ó Ó ÓÓ Ó ns 1,86 10 Safran Ó ÓÓ ÓÓÓ ÓÓÓ ÓÓ ÓÓÓ ÓÓ ÓÓ ns 2,25 8 Thales ÓÓ ÓÓ ÓÓÓ ÓÓÓ ÓÓÓ ÓÓÓ ÓÓÓ ÓÓ ns 2,63 2 Guide: Rating: 1 Share of national defence budget 3 50%+ 2 Level of State support and/or prevalence of State to Stat contracts 2 20 - 50% 3 Likely targets for M&A 1 Below 20% 4 Capacity or possibility for reusing defence technologies for civil uses & vice versa 5 Share (direct or indirect) of turnover 6 Share (direct or indirect) of turnover 1= -10%, 2=10 - 20%, 3=20%+ 7 Repartition of turnover & sites 8 Share of turnover from regions or zones with current or potential high levels of political instability 9 Too qualitative to be evaluated as a separate factor

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Threats and needs have changed

In today’s tense geopolitical climate, worsening international relations are the primary reason behind increased spending on defence and security. The threats now facing countries are varied and changing, which is why we expect defence spending to continue to grow worldwide for the long-term. Countries are facing an ever more urgent need for diversified and broad response capacity capable of being deployed in network formation. We refer here to heavy defence equipment and to homeland security resources alike. Equipment and material requirements are changing in terms of both quantity and quality as countries strive to meet security targets and to build up security resources.

New threats abound…

ƒ Post-Cold war transition period

Following the end of the Cold War, we have seen a gradual transition towards military intervention rather than war:

• The fall of the Berlin Wall (November 1989) – marked the end of communism in Eastern & Central Europe

• Fall of the Soviet Union (December 1991)

• Military interventions by the US (1991-1995) – in Kuwait (1991), Somalia (1992), Haiti (1994), Bosnia (1995), Kosovo (1999); as well as other conflicts where the US did not intervene: Rwanda (1994); civil wars: Liberia, Sierra Leone, Congo).

• 2nd Military intervention in Iraq (2003)

• Each of these cases characterises an end to the logic of the mass wars of yesteryear and a transition towards military intervention, whether legitimate or not. This new logic of intervention induces 2 consequences – a strong need for projection and a reduction in arsenals and a move towards flexible and adaptable stocks. ƒ Terrorism – a new concept of total war

• The post-Cold War period that began with the collapse of the Soviet Union ended with the 9-11 terrorist attacks on New York and Washington in 2001 which were followed by further attacks internationally every year since. The fall of the Soviet Union had left the US in a position of global economic, military and technological supremacy that also gave rise to extremist reactions on the part of its opponents. Terrorism has since changed the global security environment and brought about the birth of a new global strategy for the NATO countries (see GO-2010 below). The notion that terrorism can be defeated by waging war against terrorists wherever they may be found means that pre-emptive strikes are now seen as legitimate. On these grounds, we expect defence spending to remain high for years to come even though spending will not be focused on the same type of armaments.

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ƒ The EU – Global Objective 2010 (GO-2010)

In 1999, the European Union (EU) set itself the Global Objective of acquiring the capacity to deploy at least 60,000 troops within 60 days for a period of at least one year by 2003. In 2003, the European Council said that Europe was near to achieving this operational capacity target. The objective for 2010 covers “joint disarmament operations, assistance to non-EU countries in fighting against terrorism, and security reforms.”

ƒ Defence at home and abroad – a new urgency

The need to protect civilian populations at home and via preventive action abroad requires governments to acquire equipment for deployment in operations both within the national territory as well as overseas.

ƒ New equipment needs – use in external operations

There is a growing demand for external military operations which may be required for any of a number of reasons:

• Participation in multinational taskforces (Haiti 2004);

• Military intervention further to a UN resolution (Congo 2003);

• Reconstruction and training of Afghanistan’s new armed forces (Afghanistan 2002);

• Fight against Al Qaeda (Afghanistan 2001) etc.

France, for one, has decided to enhance its financing procedures for external operations, raising its budget from EUR100m in 2005 to EUR250m in 2006 and EUR600m in 2007.

Surveillance and intelligence gathering for homeland security

EU countries are also seeking ever closer cooperation in defence and intelligence gathering affairs, even if the process is taking some time to become established. The current lack of momentum may be a consequence of the “no” vote in the referendum on the adoption of the European Constitution seen in several key member states in 2005.

… and States must tackle these new threats in different ways

Maintaining global security means facing a broad range of new threats – terrorism, organised crime, local and regional conflicts, as well as the risk of chemical-biological-radiological- nuclear (CBRN) proliferation. Protecting populations is of paramount importance, but other kinds of non-traditional but equally serious threats are also being taken into consideration – industrial and environmental security threats, natural disaster threats, threats to critical networks and infrastructure, and threats to public health. The cost of addressing these threats will weigh heavily on the budgets of states and industry alike.

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ƒ Increased multi-stakeholder cooperation on R&D

The goal of “making the world a safer place” is leading to greater coordination of security research; the aim is that new technologies should enable states to combat multi-faceted threats. Actions currently being undertaken by governments, the scientific community and industry suggest a number of pathways forward in the area of R&D, with the following areas being prioritised:

• Encouraging research into matters concerning security;

• Mobilising the scientific community in the quest for solutions to the challenges facing Europe; and

• Fostering of partnerships between publicly and privately funded research;

• Prospective approach

• Generally speaking, the prospective approach being taken by many countries and regional defence blocs can be summed up as per the graphic below:

1) Analysis of the global situation and forecasts that can be made;

2) The political ambitions of a country on the international arena; and

3) Technologies that are currently available or in the pipeline.

The logic behind the prospective approach: France’s 30 Year Prospective Plan

Geostrategic Prospective • Geostrategic context • Risks and threats

Operational Prospective Technological Prospective • Mission of the armed forces • Tranversal technologies • Future engagements • Specific technologies • Military capacities

Systems Prospective • Techno-operational responses • Geostrategic context • (Future systems and associated modes of action)

• Determinant technologies • Planning action and research (ETO, R&T, R&D)

• Assumptions re armed forces’ equipment plans

Source: “ SYNTHÈSE DU PLAN PROSPECTIF À 30 ANS”, available at: http://www.defense.gouv.fr

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Trends in global defence spending: a clear horizon

The role of NATO

The figures provided below are for total defence spending by NATO members: i.e. material procurement, payroll, running costs, R&D costs etc. The biggest contributors to NATO’s budget are the US and the five key European countries – France, the UK, Germany, Italy and Spain. The other NATO members are: Belgium, Bulgaria, Canada, the Czech Republic, Denmark, Estonia, Greece, Hungary, Latvia, Lithuania, Luxembourg, the Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, and Turkey. The Czech Republic, Hungary and Poland have been members since 1999. Bulgaria, Estonia, Latvia, Lithuania, Romania, Slovakia and Slovenia joined in 2004. Iceland has no armed forces and Switzerland and Sweden are not members.

Defence spending by NATO countries, 1980-2004, USD

Others Europe Countries Total France+UK+All+Esp+ Italy United States

Source: NATO

All of the NATO countries with defence sectors export arms of all types (except nuclear deterrent material and equipment).

Defence spending patterns

ƒ 1996 – low point in spending

After the fall of the Berlin Wall and the collapse of the Soviet Union, global defence spending fell to a low point in 1996 and has been rising ever since. Developed countries account for 75% of global defence spending but only 16% of the world’s population (source: Sipri – Stockholm International Peace Research Institute). ƒ 2005-9 – rise in defence spending

According to official data, i.e. declarations by political leaders and national budgets for the coming three years (e.g. France and its Loi de Programmation Militaire or Military Planning

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Law 2003/2008), defence spending looks set to rise at a faster pace than inflation and GDP growth worldwide. We anticipate that the rise in defence spending will continue through 2009 at least.

This trend is expected to materialise notwithstanding the budget deficits of the Western countries and the economic challenges facing developing countries. Owing to the absence of reliable data beyond the 2009 horizon, we forecast the trend continuing in line with GDP variations.

ƒ Public acceptance & support

Public opinion supports the fight against terrorism and Western nations need to protect their oil and gas sources. This makes extra spending on defence more politically acceptable, meaning that in the near term, governments are likely to continue spending their defence budgets in full.

Countries that spend more than EUR1bn on defence €m 2004 % of total US 115 018 70% UK 11 176 7% France 11 076 7% Germany 5 612 3% Turkey 3 706 2% Italy 3 364 2% Spain 2 884 2% Russian Federation 2 798 2% Canada 1 942 1% Netherlands 1 576 1% Norway 1 096 1% Other European countries (less than EUR1bn each) 3 398 2% Total NATO materiel spending 163 647 100% Source: CIC Securities, Sweden is not a NATO member.

The enlarged EU – a mixed picture

Only by integrating its national armed forces and increasing its defence budgets can Europe hope to close the spending, procurement and equipment gap with the US. The UK and France are currently the only European countries making the requisite efforts in the area of defence.

France’s LPM 2003-2008, for instance, calls for spending on military materiel to rise from EUR13.56bn in 2003 to EUR15bn in 2008. France plans to acquire new equipment so as to enhance its deployment capacity (a second aircraft carrier) and combat readiness (missiles, Rafale, Tigre helicopter, etc.).

Beyond these countries, the rest of Europe accords scant attention to defence due to budgetary constraints and the desire of most states to limit their capacity to “conflict prevention” and “peace-keeping operations”.

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US – Fiscal 2006 DoD budget is released

On 7 February 2005, President George W. Bush sent Congress his fiscal 2006 defence budget. It requested USD419bn in discretionary budget authority for the Department of Defence, and represents a 5% increase over fiscal 2005 funding levels. Defence spending in fiscal 2006 is 41% above fiscal 2001. This budget represents the latest instalment in the President's strong commitment to transforming this department to face the challenges of the 21st century," said Secretary of Defence Donald Rumsfeld. “We continue our transition to a more agile, deployable, and lethal force”.

The world’s largest arms exporters

Defence industry output worldwide came to around EUR200bn in 2001, 80% of which was destined for domestic consumption and 20% for export (EUR40bn). Over the past decade, the world’s three largest exporters (in descending order: the US, the UK, France) together accounted for some 75% of global arms exports (EUR30bn). Russia and Germany accounted for another 15%. Other major arms exporters alongside the Big Three and Russia and Germany are Israel (electronics, drones, and tactical missiles), China, Italy, Sweden, and South Africa.

ƒ The issue of the arms trade is somewhat delicate

Arms-exporting countries and defence manufacturers are not free to enter new markets at will as in other sectors. While economic analysis is certainly a factor, potential earnings are not the be all and end all when it comes to the political crunch. Potentially lucrative exports to certain countries are often out of the question for political reasons, while less lucrative contracts are often given the go-ahead on other political grounds. Politics are the deciding factor, and economics are the means to achieving a strategic objective.

ƒ Emerging players – 3 major categories

Other current or potentially major players as far as their desire to increase defence spending is concerned are India, China and Japan. Beyond NATO, we detected a number of categories of importing and exporting countries. i) Importing countries with their own defence industries

This category – countries that import arms as well as producing them – is important, in our opinion. The current trend is towards development of local output and the creation of local production capacity can lead to the emergence of a new global player in the long term.

China and India are the world’s top importers of arms with 13% and 4% respectively of the total arms imports for the period 2002-2004 (cumulative total).

In 2005, China and India began the process of resolving their border dispute and issues relating to regional nuclear proliferation. In the long term, China could potentially become a menace for Russia as the Chinese migrate to the mineral rich eastern regions of Siberia.

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Major net importer countries with own defence industries USD m Total 2002-2004 Trade balance India Imports 7 029 7 003 India Exports 26 China Imports 6 862 5 932 China Exports 930 Pakistan Imports 1 520 1 492 Pakistan Exports 28 South Korea Imports 1 407 1 298 South Korea Exports 109 Singapore Imports 744 672 Singapore Exports 72 Israel Imports 1 270 510 Israel Exports 760 Jordan Imports 563 491 Jordan Exports 72 Indonesia Imports 475 365 Indonesia Exports 110 Brazil Imports 274 143 Brazil Exports 131 Source: Data SIRPI, CM-CIC Securities analysis. Countries selected: USD100m+ trade balance

• India: During the period 1994-2004, more than 81% of India’s arms imports came from Russia (and the former Soviet republics). Europe was India’s second largest supplier with more than 13% of total imports (or USD1.85bn). The US is not a major supplier of arms to India (USD40m in ten years). Israel has been a steady supplier since 1997, with exports to India totalling USD259m since then (small and regular annual export contracts).

• China: No European country sells arms to China owing to the arms embargo on China imposed following the Tiananmen Square massacre. China is seeking to enhance and expand its capacities. The country is however seeking access to advanced technologies to develop its electronic communications and command systems, and would be keen to import arms from Europe and Israel. Military spending in China focuses on three main areas: nuclear, space, and deployment capacity.

• Emerging countries such as Brazil also play a key role in the production of low-cost medium-bracket arms for countries with more limited requirements. ii) Importing countries without their own defence industries

The countries listed in the table below all face complex political situations at home. They are situated in regions of the world where arms imports have been rising since 2000.

For the period 2000-2004, the UAE, Saudi Arabia, Egypt, Iran, Yemen and Algeria imported some USD10.4bn worth of arms, or 12% of total world imports. This situation usually reflects local tensions.

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Major non-Western arms importers USD m Total 2002-2004 United Arab Emirates Importer 2 084 Saudi Arabia Importer 1 530 Egypt Importer 1 518 Iran Importer 1 140 Yemen Importer 886 Algeria Importer 702 Malaysia Importer 633 Taiwan Importer 624 Japan Importer 584 Source: SIRPI data, CM-CIC Securities analysis. Countries selected: USD500m+ in total imports for the period

The three East Asian countries listed above are all subject to specific sets of circumstances:

• Japan is a significant case in point as it is a country with its own defence industry. At USD50bn, Japan’s defence budget is reportedly the largest in the region and one of the five largest in the world. Japan’s defence industry is technically advanced, but article 9 of the Japanese constitution stipulates that Japan may only take military action in self- defence. As a result, Japan is not an exporter of arms. In the face of threats emanating from North Korea, Japan is currently reviewing its defence policy put in place in the aftermath of World War II with a view to transforming its self-defence forces into a force capable of taking preventive action. iii) Ex-Soviet countries, with major defence industries.

Major non-Western arms exporters USD m Total 2002-2004 Russia Exporter 17 393 Ukraine Exporter 1 161 Uzbekistan Exporter 595 Belarus Exporter 184 Georgia Exporter 140 Kirghizstan Exporter 92 South Africa Exporter 78 Libya Exporter 50 Source: SIRPI data, CM CIC Securities analysis Countries selected: USD50m+ in exports over the period

• Russia: Between 1994 and 2004, Russia sold 33% of its arms exports to China (USD14.6bn), 14% to India (USD10.5bn), and 7% to Iran (USD2.8bn). A permanent member of the UN Security Council and member of the G8, Russia is seen as a partner of the Western democracies for the promotion of peace and stability in the world. That said, the prospects of military action by the US against Iran are likely to be unsettling for Russia given the trade relations between the two, especially as regards arms exports.

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This could explain Russia’s recent realignment with Europe. High oil prices and the flow of petrodollars into the country allow Russia to maintain a high defence budget. Russia’s military industrial complex has been heavily restructured; weak domestic demand means that exports are a vital life-line for Russia’s arms industry, which is positioning itself as a major player in the global arms market.

Controlling the arms trade – the Wassenaar Arrangement

The Wassenaar Arrangement on export controls for conventional arms and dual use materials was created in July 1996. It is a means for arms suppliers to exchange information on arms and technology transfers. Its goal is to prevent destabilising accumulations of conventional weapons by creating a formal process of transparency and, where applicable, multi-lateral restraint on the part of its members. In practice, the large number of signatory countries (33) and the absence of a strong central authority mean that consensus is hard to achieve.

Although it is a step in the right direction, the Wassenaar Arrangement’s impact so far has been very limited. A number of other initiatives aimed at devising codes of conduct for the arms trade are currently being pursued in the European Union and the US.

An eight-point code of conduct Export licences should be refused if incompatible with a member state’s international obligations: UN embargos, non-proliferation treaties, etc. Export licences should be refused if the articles will be used for repressive purposes: respect for human rights and fundamental freedoms in the destination country. Articles that could prolong or aggravate armed conflicts should not be exported. Export licences should be refused if there is a risk of aggression or a territorial claim. Export licences should not be granted without consideration to a country’s own security and that of its allies. Due consideration should be given to the importing country’s conduct with respect to the international community. Due consideration should be given to the risk of misappropriation or re-exportation of the imported equipment. Due consideration should be given to compatibility between the technologies inherent in the exported arms and the technical and economic capacity of the destination country. Source: NATO Parliamentary Assembly 2004 List of embargos and restrictive measures initiated between 1 January 2002 and 31 December 2004: Afghanistan, West Africa, Angola, Myanmar, Democratic Republic of Congo, Côte d’Ivoire, Iraq, Liberia, Libya, Somalia, Sudan, Zimbabwe

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Innovation and IT – the technological shift

R&D is rising – but what’s the ultimate aim?

R&D takes place upstream of production. In the defence sector, governments both finance R&D and purchase the resulting technologies. This means that manufacturers have a vested interest in having a solid defence background so that R&D financing provided by the government outweighs own R&D financing for civilian projects.

ƒ Europe – Letter of intent on mutual cooperation

Europe’s defence heavyweights (France, Germany, the UK, Spain, Italy, and Sweden) have signed a Letter of Intent (LoI) on mutual cooperation. The Act, which has the status of an international treaty and took effect in October 2003, addresses six distinct issues:

• Harmonisation of operational requirements: identifying capabilities that can be shared;

• Research & Technology (simplification of technology transfer procedures, licensing authorisations aimed at promoting industrial integration);

• Procurement security;

• Export procedures: a list of legitimate export destinations and products, harmonisation of re-exportation management procedures;

• Information security; and

• Lighter restrictions on the disclosure of technical data (a risk factor for defence multinationals). ƒ Research – R&T vs. R&D

In the defence sector, research is divided into R&T and R&D:

• R&T (Research & Technology) takes place upstream and receives direct public financing from the national budget as mandated by public finance laws.

• Prototype development (the D of R&D) takes place downstream once a particular project has been given the go-ahead for development.

Where R&T ends and R&D begins depends on where the limit is placed; it varies from country to country and is not always self-evident (problem of definition). In France, an increasingly large proportion of R&T now takes place in a context of Europe-wide cooperation (more than 20%). This trend will be amplified further with the creation of the European Defence Agency.

Impact of European Defence Agency

The Agency’s role will be to structure R&T in Europe by creating CapTechs (networks of experts drawn from member states, industry and research institutes). The Agency’s current flagship project is the long-range UAV (unmanned aerial vehicle). The Agency is also taking stock of defence projects underway across Europe with a view to harmonising capability requirements.

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ƒ Research trends 2005-2030 – welcome to electronics and dual technologies!

In its broadest sense, research means preparing for the future. The military capabilities that will be needed in the future will of course be human operated, but technology will also have a fundamental role to play. This underlines the importance of anticipating how technology might evolve between now and 2030. The current trends as regards technological advances in defence systems reveal a series of key issues.

• Miniaturisation: micro and nano systems are driving the development of new armament system architectures; this requires collaboration between researchers and industry;

• Meta-systems or “systems of systems”: as systems become interconnected, there will be a need to develop network-centric meta-systems (Network Centric Warfare, Network Enabling Capabilities, Knowledge Centric Warfare…);

• Network-enabling of objects and systems: military systems will be able to freely communicate in the same way that civilian systems do today, meaning implications for radio frequency management and information system security (architecture, information warfare, encryption, etc.);

• System electrification: the current trend is for electricity to become the power-source for all defence system functions (propulsion and armaments in particular). In this light, progress is needed in the areas of energy generation and storage;

• Widespread reliance on digital technologies: automatic reconfigurations and diminishing breakage and outages without human intervention

• Integration of humans with defence systems: the human operator will be an integral part of the systems of the future thanks to integrated sensors and calculators and miniature energy sources (biotechnology-nanotechnology hybrids, sensory prostheses, etc.).

• Robotisation of systems: as human-system integration deepens, the drive towards making systems more autonomous (terrestrial robots, drones, UAVs, etc.) is likely to intensify in the interests of reducing human casualties.

• Enhancement of system reaction speed: defence missions in the future will require faster and more reactive airborne, naval and terrestrial platforms so as to get the most from the advantages of network centric warfare systems.

• A greater role for space-based systems: the intrinsic characteristics of space-based systems are what make them so attractive from a defence standpoint (lack of vulnerability, global coverage, their use does not infringe the sovereignty of states).

• Moves towards compliance in a more restrictive legislative environment: there will probably be tougher regulation of matters pertaining to the impact of armaments on the environment.

While these key trends are largely focused on electronics – as the frontiers between civil and military usage seriously starts to blur – they also drive the development of dual technologies. Electronic devices, licenses and technologies can be used in dual applications. It is also a two-way road – some armed forces now rely on civil applications (IP) for their telecommunications systems. The main advantage of this situation is again to reduce and to share R&D cost burdens as well as to capitalise on potential long-term business opportunities.

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ƒ Space: an important new aspect of many a defence programme

The military conquest of space is the key to political clout on Earth.

Importance of satellites

Satellites are the optimal means of observing, eavesdropping upon, transmitting and distributing vast quantities of information over vast distances, including in real time. They are also unbeatable when it comes to identifying enemy positions (communication between forces on the ground and remote command centres). Satellites enable almost immediate access to any point on the globe with discretion and without risk to civilian populations. Satellite telecommunications are used to relay data from surveillance aircraft and drone for the purpose of planning and conducting operations.

Greater compatibility – Alcatel & Thales

As far as a shake-up in the industrial landscape is concerned, a move towards greater compatibility between the space telecommunications technologies of the various players on the European scene would be one way of getting around the problem of tight military space budgets in Europe.

This could explain Alcatel’s interest in Thales: Alcatel is seeking to bolster its “Private Communications” segment (around 30% of 2005 group sales), which comprises a satellite sub-division as well as other sub-divisions that make telecoms systems for non-telecoms industrial clients (e.g. railway operators, oil companies, governments, utilities). It would make sense for Alcatel to acquire Thales given that Thales would give Alcatel substantially greater exposure to markets (especially the military communications market) that are perceived as being more stable that fixed and even mobile telecommunications.

Innovative financing: a new trend forced upon Europe’s defence sector

ƒ Research financing from a major client - always welcome

Boeing is a good example of a manufacturer benefiting from the research endeavours of its key client in the defence sector. Boeing’s situation contrasts to the situation in Europe, where defence budgets are much lower than in the US. Hence the wide variations in R&D carried out internally from one industrial conglomerate to another, as witnessed by the trends seen over the past three years. That said, it would be misleading to rely on ready-made observations without taking a closer look at the full picture.

R&D costs for fighter aircraft – US vs. EU R&D costs for fighter aircraft are much higher in the US than in Europe; in the US, higher R&D costs are theoretically recouped via longer manufacturing series once production begins (e.g. some 3,000 J-35 aircraft will be produced over the life-cycle of the series vs. only 600 Eurofighters and some 300 Rafales).

This should mean that US conglomerates should have an export price advantage (a lower fly- away price than in Europe), but European manufacturers say that this is not the case (based on a 1:1 forex rate). Strange then, that when the Euro was trading at USD1.3, Europe lost out on a contract to supply fighter aircraft to Singapore.

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R&D trends at Boeing and EADS, 2002-2004

R&D/Sales Boeing R&D/Sales EADS

Source: company, CM CIC Securities estimates

Advantages of a strong defence arm

In 2004, Boeing spent USD941m on commercial aircraft R&D (or 4.4% of its total commercial aircraft sales) vs. the EUR1,735m or 8.6% of Airbus sales spent by EADS. This rather sizeable gap illustrates just how useful it is to have a strong defence arm so as to be able to reuse the processes and technologies developed with the help of government clients.

ƒ Client-financed R&D vs. internal financing

In the defence sector, the proportion of R&D financed internally is not always commensurate with the proportion financed by clients. Indeed, client-financed R&D often outweighs internal financing, as is the case in the US:

EADS invested EUR392m in Aerospace & Defence R&D, or 3.4% of its sales in this segment

Boeing invested USD938m in Aerospace & Defence R&D, or 2.9% of its sales in this area. Tight military budgets in Europe mean a trend towards innovative financing. In Europe, each country is responsible for its own defence spending, but it is Europe that sets the rules as contained in the draft European Constitution of 2005. The draft constitution sought to ban the financing of military operations (OPEX excluded) from civil budgets, but left it up to each Member State to decide independently on the funding to be allocated to armed forces operations and hardware procurements. Hence the need for Member States to find innovative solutions for financing the maintenance of up-to-date and properly equipped armed forces while avoiding the temptation of excessive public spending. With these imperatives in mind, the industry has offered an outsourcing-like solution to clients.

ƒ UK – PPPs & PFIs

The UK’s Ministry of Defence was at the forefront of the emergence of innovative financing solutions with its Public Private Partnerships (PPPs) and Private Financing Initiatives (PFIs), whereby all financing is sourced in the private sector. PFI contracts are ultra long-term commitments (25 years) to an initially fixed price for specified services, but these particular clauses can be modified later down the road if the legal or fiscal environment changes.

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ƒ Advantages of new financing solutions

With these new financing solutions, armed forces and government clients no longer purchase a product but rather a “full cost service” supplied by a project manager.

The manufacturer is responsible for the industrial investment and retains proprietary rights with respect to the finished product. The manufacturer receives remuneration from the client (government) in the form of leasing payments or billings for the duration of use of the product. In effect, for the government client this amounts to purchasing a service. The manufacturer borrows to finance the cost of building the materiel (satellite, refuelling plane, etc.) and provides the future earnings as security. The future earnings have only a small impact on the manufacturer’s assets, and the debt is off-balance sheet.

Future earnings from a government contract also depend on how the product can be used in other contexts: for this reason, PFIs tend to be restricted to projects with sufficient civilian use potential to be able to generate civilian sales (which is obviously not possible in the case of an aircraft carrier, missile or tank, for instance). PFI arrangements have been used in training projects, to develop civilian vehicles, and in military communications (e.g. EADS and wholly- owned subsidiary Paradigm Secure Communications carried out a project worth GBP1bn that brought GBP2bn in sales).

(a) The “Standard & Poor’s PPP Credit Survey 2005” explains that the ratings agencies work remains at the centre of capital market transactions. Currently, the PFI market is 70% for banks and 30% for the bond market, but the ratio will change in the short term, with increased bond funding. It also welcomed the development of the secondary equity markets. The number of funds focused on buying second-hand equity investments has grown significantly, which will provide more liquidity in the market and add more certainty to the exit strategy of primary market investors. Furthermore, the prices being paid in secondary market trades are expected to enable primary investors to reduce their initial yield expectations.

Network-centric warfare: systems integrators take the lead

One of the major trends in relations between conglomerates and their government clients concerns the drive towards meta-system integration. In homeland security, for instance, demand for integrated border surveillance systems is rising. Surveillance systems of this type (coastguard, land borders, sensitive sites) usually rely upon entire batteries of equipment: surveillance helicopters, command posts, radar, cameras, communications systems, and, last but not least, the information systems that integrate them.

The defence sector’s needs are now evolving towards network-enablement of equipment. This necessitates network-compatibility at the equipment end and at the system architecture end.

Defence platform makers are looking to optimise their components by integrating them into meta-systems. They are looking at ways of enhancing the command flow so as to ensure rapid reaction and to deliver real time information to the media and general public.

Inter-operability is a concept designed to enhance inter-forces coordination and shared command between countries. Interoperability of military materiel used by friendly countries is a necessity insofar as the resulting standardisation will lead to reduced procurement prices and operating costs.

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The European countries require intelligence gathering resources, communications resources, and battlefield control and command resources similar to those available to the US military so as to secure autonomous decision-making and scope of action.

ƒ The value chain about to be turned on its head

In a world of changing requirements, clients (governments) increasingly prefer to target and procure solutions that correspond to a given situation. Hence the logic of signing a global procurement contract with a “system integrator” rather than a “platform supplier”, as the latter would be unable to provide end-to-end network enablement of systems. This could lead to the value chain being turned on its head, with a “service provider” supplying that portion of the hardware that the service provider specialises in and also assuming the overall risk.

ƒ Two examples of C4ISR

C4ISR: Command, Control, Communications, Computing, Intelligence, Surveillance, Reconnaissance.

Watchkeeper: UK. This surveillance system for the British armed forces will be operable with NATO systems and is due to be launched in 2010. Watchkeeper is to be created under the overall project supervision of Thales. The Watchkeeper contract requires expertise in system integration, project supervision, engineering and manufacturing. Thales UK has created a joint venture aimed at mobilising the requisite skills (manufacturing, tactical drone sub-system support) with Thales Sensors, Elbit Systems, QinetiQ, Aerosystems International, Thales Defence Information Systems, Thales Optronics, LogicaCMG, Vega, Boeing and Qinetiq.

NCW: France. The principle of “Network-Centric Warfare” envisages network-based operations for land forces. France’s armed forces are to be NCW-enabled by 2025. NCW encompasses all players involved in land and airborne combat missions (light armoured divisions with own armaments, radars, intelligence-gathering and combat drones, infantry troops, etc.). Its aim is to ensure faster manoeuvring, enhance the protection of personnel, and enable commanders to keep the upper hand in all circumstances. It meets the need for fast deployment of small rapid-reaction contingents of troops capable of accomplishing a variety of missions, particularly in urban combat zones. France’s main infantry armaments makers, Thales (principle agent), Giat Industries and Sagem, have created a consortium that now has a privileged partnership with MBDA and EADS. This brainchild of the French arms industry will draw on the expertise of manufacturers and research labs, and is open to cooperation on a European and international level.

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Governance and shareholding structure: incestuous relations till the end

The State is a key player – probably the key player - for the aero-defence industry and it has a key role in shaping developments in the sector - much more so than in other sectors. But at the end of the day, relationships with States distort fair competition. Conflicts of interest are nearly everywhere. These conflicts inevitably result in: increasing costs for homeland security; deterioration and destabilisation of regional and global geopolictics, and damage to management models inside the company, with an overwhelming focus on state relationships instead of quality of management, without even taking in account corruption.

Additional roles: more a consequence than a choice!

ƒ Government as oversight authority

Governments also have a role of oversight authority: they monitor and enforce equipment reliability and compliance with standards (see below Corruption).

ƒ Government as economic regulator: protecting jobs

The economic importance of the defence (and aerospace) sector to the countries that signed the Letter of Intent means that governments play a role of “economic regulator and guarantor of employment”. The placement of regular orders and the pursuit of foreign policies aimed at promoting local technologies in export markets are ways for governments to guarantee jobs. The economic and social aspect of the sector’s high potential for job creation, investment and innovation is crucial. The Foundation for Strategic Research (FSR) estimates that the six countries that signed the LOI (Germany, France, Spain, Italy, the UK, and Sweden) account for 90% of arms production in Europe. Of the six countries, France and the UK alone have the industrial capacities needed for the production of the key systems. As far as direct employment is concerned, France leads the way with 166,000 people employed in defence manufacturing, followed by the UK with 155,000, Germany (90,000), Italy (27,000), Sweden (<15,000) and Spain (<15,000). Elsewhere in Europe, other countries are home to niche segments and hubs of excellence: the Netherlands, Portugal, Greece, Denmark, Austria, Belgium, Finland, Norway and Switzerland.

ƒ Government as shareholder: role may be on the wane

Governments also play the role of consolidating the industrial and technological basis of national defence using various legislative and regulatory means such as golden shares and withholding or granting authorisation for company takeovers. The direct and indirect “shareholder role” exists in France and in Italy. The UK privatised British Aerospace, later to become BAE Systems, in the early 1980s, and the UK is no longer a shareholder in its defence enterprises. In the US, defence enterprises are public companies. The French government is currently faced with deciding whether it wants to privatise or to allow monopolies to emerge.

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The French crossholdings in the Aero Defence Sector

DCN GIAT

Lagardère 50% 100% 100% 37% ARMARIS Etat Français 50% BNP PARIBAS SEPI (Etat espagnol) 50% 30% 13% 32% 96% SOGEADE5,52% DASA AG THALES 30,2 30,2 42% AREVA % EADS NV 2,75 8% 20% SAFRAN % 0,34 65,42% SAAB group BAE SYSTEMS 42% % Public EADS 100% 30,7% STN Atlas 10% 5% 37.5 1% % 20% ALCATEL 46% 80% FINMECCANICA

DASSAULT AVIATION 9% 100 % 37.5% 25%

ASTRIUM AIRBUS MBDA Activ. Spatiales

16%

ARIANESPACE

Source: Company Data, CM-CIC Securities

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The question currently being asked is whether the French government is looking at rationalising its holdings? Thales would appear to be the prize morsel given that this group makes the systems that are most in demand on the part of governments (government systems, airport systems, and site, transport and network security systems). The French government is currently a shareholder in many a French defence enterprise, and may decide that its golden shares are sufficient. As soon as an ownership solution for the current industry shareholders is in place, the French government may look at moving on. Privatisation would not necessarily weaken the French government and state’s role because the state is more often than not the number one client of the enterprises that make up the sector.

Summary: French & Italian government stakes in listed defence enterprises Price Total government €m Shareholder 1 Shareholder 2 Shareholder 3 (€) stake EADS 29.0 SOGEADE: 15% (including half - France) DASA AG: 30.1% Free float: 28% 3 960 FINMECCANICA 16 Free float: 67.6% Italian government: 32.4% n.d. 2 202 SAFRAN 18.5 Free float: 40.5% French government: 31.6% Areva: 8.4% 2 437 THALES 38.0 Free float: 42.9% French government: 31.3% Alcatel: 9.5% 2 043 Source: CM-CIC Securities

Other companies Name Shareholder 1 Shareholder 2 Shareholder 3 BAE SYSTEMS PLC Free float: 67.9% Chase Manhattan: 13.0% Templeton: 8.1% BOEING Free float: 68% State Street: 10.8% Capital: 5.1% DASSAULT AVIATION Gr. Industriel M. Dassault: 50.01% EADS: 45.8% Free float: 4.2% ELBIT SYSTEMS Federmann Enterprises : 30.6% Elron Electronic Ind : 19.4% Heris Aktiengesellschaft : 9.5% LATECOERE Free float: 71.2% Employees: 18.0% Latecoere family: 7.0% LOCKEED MARTIN Free float: NA State Street : 19.3% US Trust Co: 16.7% ROLLS ROYCE Free float: 78.0% Franklin Resources Inc.: 12.1% BMW AG: 9.9% SMITHS GROUP Free float: 78.9% Franklin Resources, Inc: 9.0% Capital Group Companies, Inc: 8.7% UNITED TECHNOLOGIES Free float: 92% State Street: 10.85% Capital: 5.3% ZODIAC Free float: 63.6% Families: 30.3% CDC: 6.2% Source: CM CIC Securities

Government twin roles: client and shareholder

In centuries gone by, defence manufacturers were owned and run by ministries of war. They were later separated out into departments of war ministries, and subsequently transformed into stand-alone companies. The defence sector only sells battlefield equipment to governments (of authorised States). Governments tender out contracts for equipment, which is then manufactured and certified and hopefully sold at a margin (conditions are not the same on either side of the Atlantic: in Europe, manufacturers bill a fixed price, while in the US the norm is cost plus fees, meaning that contractors have a guaranteed margin).

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State Cross-Relations: States as shareholders and clients

2005 sales % of govt % state-held Country Comment Market Cap in €m Comment in EURm sales capital

Present in all of the platforms and services (maintaining operating "No foreign person, or foreign persons acting in concert, conditions) of the UK armed forces. Number one armaments company can have an interest in more than 15% of the company's Bae Systems Plc UK 21 625 20% in Europe. Al Yamamah contract (Saudi Arabia) is not included in UK 18 506 0% issued ordinary share capital". Start of January 2006, BAE sales even though it’s a state to state contract, paid by the MOD (to reported 43% foreign shareholders. BAE). Including the Al Yamamah contract: MOD = 27% of sales.

Boeing USA 46 874 33% The state share is smaller given its civil activities. 47 526 0%

The % seems low for the group - 80% of sales are in the civil sector Held indirectly through a 50% stake in Sodéade with Eads France 33 771 8% with Airbus. Almost all of Eads’s defence sales are with France and 26 066 15% Lagardère and Axa BNP Paribas Germany.

Listed only on Nasdaq, no local shareholder among the The order book for USD2.4bn includes Israeli orders worth 35% of the Elbit Systems Israel 882 22% 857 0% first 15: 10 US investment funds, 4 European investment total, i.e. an increase in Israeli orders to local industry. funds and one other fund.

Makes most of its sales in Italy, but is also positioned well in the UK via Finmeccanica SpA ItalY 10 982 29% 7 057 32% Ministry of Finance Agusta Westland, following on from the purchase of assets from BAE.

General Dynamics USA Na 50% 0%

80% of sales are with different US government departments, 16% of Lockheed Martin Corp. USA 31 772 58% 23 259 0% sales outside the US and the remaining 4% are commercial.

Northrop Grumman USA Na 40% 0%

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2005 sales % of govt % state-held Country Comment Market Cap in €m Comment in EURm sales capital

Capital is protected as follows: "requirement that no Engines for fighter planes (e.g. Tonado, Harriers, etc.), helicopters and individual foreign shareholder, or group of foreign Rolls Royce Group UK 9 527 15% 11 309 0% service support contracts. Engines for Royal Navy carriers. shareholders acting in concert, can hold more than 15% of the Company's shares" Saab group has never been held by the local government. Currently, Investors Group holds 20% of capital (35% of Saab AB Sweden 2 051 47% Grippen Fighters programmes and missiles 1 984 0% votes) and BAE holds 20% of capital (same amount of votes). Following on from the distribution of free shares, around 30% (CM-CICS estimate). If the government wanted to Safran SA France 10 758 10% Split into three divisions: defence, propulsion, equipment 8 620 32% reduce its stake, the ‘Commission des Transferts et Participations’ would have to be consulted. A shareholders’ pact concerning half of the French All divisions are involved in Defence and Security. Since 2000, sales with Thales (ex Thomson government’s stake still exists. If the government wanted to France 10 352 22% the French government (+62%) have been growing quicker than 6 675 31% Csf) reduce its stake, the ‘Commission des Transferts et consolidated sales (+28%). Participations’ would have to be consulted. The majority of sales are made via Aftermarket on Pratt & Whitney United Technologies USA 36 044 15% engines and Sikorsky helicopters. Of the 18% of defence-related sales, 47 631 0% 75% are generated on national territory. Source : Company data, CM-CIC Securities

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Existence of Shareholder agreements etc giving special rights or controls in European companies Company Restrictions & Commentary BAE ƒ Special share of £1 is held on behalf of the UK Secretary of State for Trade and Industry (“Special Shareholder”). Certain parts of the Articles of Association cannot be amended without the consent of the Special Shareholder - No foreign person(s) can have an interest of more than 15% of the company - Majority of the directors are British citizens - CEO and any executive chairperson are British citizens · Requirements can be amended by regulations made by the directors and approved by the special shareholders Dassault ƒ None disclosed, although GIMD & EADS are controlling shareholders with 96%+ of the capital. Finmeccanica ƒ Special rights and powers for the Italian Treasury Minister, in consultation with the Industry Minister (Company statutes, law no. 474, 30 July 1994): - Veto power over certain matters - Appointment of directors by decree EADS Analysis: On 31/12/2005, the shareholders’ pact held 65.25% of capital (minimal difference with voting rights so not dealt with here). This ‘contractual partnership’ grouped together three shareholders until 2003; since then, only the pre-emption rights between parties still exist. - Dasa AGM for 29.89% (Daimler subsidiary). Daimler has not held any direct shares since mid-2004 (a stake of 2.7% was sold on the market at that time). - Sogeade for 29.89%: 50% held by Lagardère, and 50% by Sogepa (state-held company); pre-emption rights exist between the two parties. - Sepi (Spanish government holding) for 5.47%. The French government (for a residual stake of 0.06%), a share buy back of 1.3%, and 33.39% held by individuals accounting for the float. On 31/12, EADS’s capital consisted of 817,743,130 shares. 2005 EPS guidance of EUR1.65/share was established based on around 798/799. The reported 2005 net result should be around EUR1.3bn (in line with consensus). Conclusion: There is an element of training in the declarations made by shareholders, since French and Germany shares must remain equal. J. Schremp, who has been replaced by Dieter Zetsche at the head of Daimler, said in December 2005 that a disposal could not be ruled out; this is where yesterday’s press articles covering this topic came from. Rolls Royce ƒ Special share redeemable preference share (special share) held by the UK Government. Certain parts of the Articles of Association cannot be amended without the consent of the Special Shareholder: - Simple majority of the Board should be British - No foreign shareholder(s) can hold more than 15% of the company’s shares · Provisions were amended in 2002 – removal of the foreign shareholding limit of 49.5%, requirement that a simple majority of the Board be British (vs. 75%), and permitting the appointment of a non-British NE Ch Safran ƒ French State has the right to take special measures (Tripartite agreement between Sagem, SNECMA and the French State, 21 Dec. 2004): - Entitled to appoint a non-voting representative to the board(s) of the group and any subsidiaries with assets connected with French military aircraft engines - Prior right to approve or refuse sale of: certain military & aerospace assets identified as strategic, sensitive or defence; transfer of securities in 5 subsidiaries (SPS, Microturbo, Europropulsion, Arianespace & G2P); acquisition of more than 33.3% or 50% of capital of companies in Sagem & SNECMA holding such assets; any projects granting special rights to information over strategic assets or rights to be represented on the management bodies of SPS & Microtubo - If a 3rd party acquires 10%+ of capital or voting rights, failing an agreement, the State is entitled to purchase the securities & assets of SPS & Micrtoturbo at a price to be set by a panel of experts Thales ƒ Golden share held by the French State. • “Any increase in the direct or indirect holding of securities, of whatever nature or legal form, beyond a threshold of one- tenth, or multiple of one-tenth, of the capital or voting rights of the Company, by any natural person or legal entity, whether acting singly or in concert, must be approved in advance by the minister in charge of the economy (...)”. • “At the proposal of the Minister of Defence, a representative of the State sits on the Board as a non-voting director.” • “(...) Decisions to assign or allocate by way of guarantee the assets specified in the annex to this Decree may be opposed.” These assets include majority interests in the capital of eleven Thales direct subsidiaries: Source: Company information and data,

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ƒ THALES: national interest embedded in the shareholding structure

So as to protect the national interest, the French State has agreed to let private industrialists take a share of the capital, provided a kind of shareholding agreement be passed in the long period. The following two agreements were concluded for a ten-year period expiring on 30 June 2008.

THALES: General agreement between the "Industrial Partner" and the "Public Sector"

A shareholders’ agreement exists between Thomson SA (now THALES) on the one hand, and Alcatel and GIMD on the other, as part of the cooperation agreement between the Company, the Public Sector and the Industrial Partner (Alcatel and GIMD). This was initially concluded on 14 April 1998 and was submitted to the French financial markets authority CMF, which publicised the main points of the agreement on 21 April 1998 (Decision n°198C0370). The agreement was revised on 18 November 1999 following Aerospatiale's exit from the arrangement and the raising of Alcatel's stake in Thomson-CSF, now Thales.

The agreement remains valid as long as the Industrial Partner (mainly Alcatel) and the Public Sector hold at least 15% each of Thales capital, and its main provisions relate to:

• Membership of the Board of Directors ;

• A commitment to seek approval by a majority of the directors representing the Industrial Partner for decisions by the Board of Directors of Thales concerning:

- the appointment and dismissal of the Chairman and Chief Executive Officer, - adoption of the annual budget, - significant acquisitions and disposals, or decisions liable to impair cooperation between Thales and the Industrial Partner;

• A commitment by the Public Sector to ensure that the Industrial Partner is in a position to remain Thales' leading private-sector shareholder. The Public Sector has undertaken not to raise its holding above 49.9% of the Company's share capital;

• A recognised right of pre-emption for the Public Sector concerning shares held by Alcatel if the latter loses its leading position within the Industrial Partner agreement, and a mutual right of pre- emption if either the Public Sector or the Industrial Partner falls below a 15% interest in Thales capital, for the party still above that threshold.

Shareholders’ agreement between Alcatel and Groupe Industriel Marcel Dassault (GIMD)

Alcatel and GIMD have signed a shareholders’ agreement whereby they declare themselves to be acting in concert in their capacity as the Industrial Partner, with GIMD acknowledging Alcatel's pre- eminence. In addition, the two parties have undertaken for a five-year period not to transfer shares received in exchange for their contribution of assets.

The main provisions of this agreement were published by the CMF on 21 April 1998, and came into force on 22 June 1998, the date of the extraordinary General Meeting that approved the Company's exit from the Public Sector. The agreement was modified on 24 September 2002, in order to allow Alcatel to divest Thales shares on the market without reducing the Industrial Partner's interest in Thales capital below 15% or modifying the Alcatel's pre-eminence over GIMD within this agreement (CMF decision 02C1306). The Company declares that it is involved in no agreement or pact with a listed company or an unlisted subsidiary likely to have a significant impact on the Thales share price.

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Governance: incestuous relations

Corporate governance encompasses all of the following: different management theories, the balance of power and the balance between generations, group and manager networks and shareholder influence. All of these things together are often complex, so it is better to look at all of the different dimensions (and how they interact) simultaneously rather than individually in order to get a clearer overall picture.

In Europe, boards hold very strong links with the state and have a significant influence on national interests.

Analysing the links between company boards and their trustee states via the direct links of certain directors leaves no doubt whatsoever that national interests play an essential role in the boardroom of the sector’s major players.

Directors with significant links to government COMPANY DIRECTOR STATUS* DIRECT LINKS TO GOVERNMENT(S)** BAE PJ Caroll Jr Independent ƒ US – Oversight of Iraqi Oil Ministry (Committee Chairman) U Cartellieri Independent ƒ DE – Federal Investment & Development Company (Dep. Ch.) Rt Hon M Portillo Independent ƒ UK – MP, ex-Secretary of State (Defense, Employment) Boeing J Bryson Independent ƒ US – ex- Cal. Water Resources Board, Attorney) K Duberstein Independent ƒ US – ex- Chief of Staff for President Reagan) R Ridgway Independent ƒ US – ex- Secretary of State, Ambassador, Counsellor et al. Gen J Shalikashvili Independent ƒ US – ex-Joint Chief of Staff (Dept. of Defence) et al. Dassault S Dassault Honorary Chair. ƒ FR – Senator, Mayor O Dassault Director ƒ FR – ex-MP Y Michot Director ƒ FR – DCN (Director) EADS T Enders Co-CEO ƒ DE – ex-Ministry of Defence (Planning Staff) N Forgeard Co-CEO ƒ FR – ex-Advisor to President, Ministry of Defence (Advisor) F David Independent ƒ FR – ex-DREE (Director), misc. positions JM Eguiagaray Director ƒ ES – ex-MP, PSOE (Spokesman), Minister (Industry) L Gallois Director ƒ FR – ex-Ministry of Defence (Head of Civil & Military Cabinet Office) Finmeccanica F Bonferroni Independent ƒ IT – ex-MP G Castellaneta Vice Ch. ƒ IT – ex-Government representative on the Board, ex-Diplomat D Scanapiecco Government rep. ƒ IT – ex-Minister (Economics & Finance) General Dyn. Adm. J.Johnson Independent ƒ US – ex-Naval Operations (Joint Chief of Staff) et al. Gen. G Joulwan Independent ƒ US – ex-Army (Supreme Allied Commander, Europe) et al. Dr PG Kaminski Independent ƒ US – ex-Department of Defence (Under-Secretary) et al. Gen J. Keane Independent ƒ US – ex-Deputy Chief of Staff et al. DJ Lucas Independent ƒ US – ex-Congressional Budget Office (Chief Economist) et al. Gen L Lyles Independent ƒ US – ex-Air Force (Commander; Vice-Chief of Staff) et al. CE Mundy Jr Independent ƒ US – ex-USO (CEO), Marine Corp (Commander) et al. Sir R Walmsley Independent ƒ UK –ex-Defence Procurement Agency (Div. CEO) et al. Lockheed EC Aldridge Jr Independent ƒ US – ex-Special Assistant to Secretary of Defence et. al. Adm. J Ellis Jr Independent ƒ US – ex-Strategic Command (Commander) et. al. GS King Independent ƒ US – ex-Dept. of Health (Commissioner) et. al. JM Loy Independent ƒ US – ex- Dept of Homeland Security (Dep. Sec.) Coast Guard EF Murphy Independent ƒ US – ex-CIA (Attorney) Gen J Ralston Independent ƒ US – Joint Chiefs of Staff (Vice Ch.), General, NATO et. al. Northrop Gen J. Chain Jr Independent ƒ US – ex. Director (US SAC) V. Fazio Independent ƒ US – ex-MP (House), Democratic Leadership Admiral C Larson Independent ƒ US – ex-US Navy et. al. Ph Odeen Independent ƒ US – ex-Depury NSC et. al. Rolls Royce AL Bondurant Independent ƒ US – OECD (Ambassador), misc. positions as Sr. Counsel et. al.

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COMPANY DIRECTOR STATUS* DIRECT LINKS TO GOVERNMENT(S)** Safran J-P Béchat CEO ƒ FR – General Council for Armaments (Member) G Olivier Exec. ƒ FR – Conseil Scientifique de la Défense (Member), ex-Advisor J-M Forneri Board member ƒ FR – ex-Ministry of Finance Y Guéna Independent ƒ FR – ex-Senator, ex-Constitutional Commission (Pres) et. al. P Jost Government rep. ƒ FR – Ministry of Defence (DGA/DCI, Director) et. al. A Lauvergeon Indep. Vice Ch. ƒ FR – ex-Personal Rep. to the President, Advisor et. al. J-Y Leclercq Government rep. ƒ FR – Various government positions P Morraillon Government rep. ƒ FR – Ministry of Economy (MD, Economic Relations) et. a. J-B Pene Government rep. ƒ FR – Ministry of Defence (Director, Technical Expertise) et. al. J Rannou Board member ƒ FR – Ex-Air Force (Chief of Staff) M Wachenheim Government rep. ƒ FR – Ministry of Infrastructure (CEO, Civil Aviation) et. al. Thales DG Ranque CEO ƒ FR – ex-Ministry for Industry (Energy Sector, various positions) S Dassault Director ƒ FR – Senator, Mayor CF De Croisset Director ƒ FR – ex-Ministry of Industry (Chief of Staff) et. al. FB De l’Estang Director ƒ FR – ex-Ambassador (to US), misc. positions Lord Freeman Director ƒ UK – ex-Minister (Public Service, Defence Procurement) et. al. D Lombard Director ƒ FR – ex-Agency for International Investments (Pres.) et. al. Gen K Naumann Independent ƒ FR – Federal Armed Forces (Chief of Staff) et. al. D Samuel- Director ƒ FR – Ministry of the Economy (Division MD, Shareholding Agency) Lajeunesse United JS Gorelick Independent ƒ US – ex-CIA (Advisor); ex-various government positions Tech. CT Whitman Independent ƒ US – ex-Governor (New Jersey); ex-EPA (Administrator) Source: Boardex data, company documents, CM-CIC Securities / ESN estimates. * Status as defined by the company. ** DE = Germany, ES = Spain, FR = France, IT = Italy, UK = Great Britain, US = USA.

ƒ National interests beyond independence

There are between three and six directors on any given board with a significant influence on national interests. This is understandable when the government is a shareholder. It is understandable to a lesser extent that the government can have a place on the board if it is a customer, even though it is a position that will inevitably lead to a real or imagined conflict of interest.

A more worrying phenomenon is when directors are considered to be independent as long as they have worked in a position of responsibility in, for example, a government ministry, parliament, cabinet or the army.

Overview of board structure and independence in companies in the sector ¨Positions No. of Non- Board Stringent evaluation of Board Independence of Chair No. of Company of Chair/CEO executives Independence independence Size (by CM-CIC/ESN) Executives (NEDs) (by Company) BAE 15 Separate Not independent 6 9 53% 33% Boeing 10 Combined Not independent 1 9 90% 30% Dassault 10 Combined Not independent 2 8 ND 10% EADS 11 Separate (x2) Not independent (x2) 4 7 18% 9% Finmeccanica 12 Combined Not independent 1 11 58% ND* General Dynamics 13 Combined Not independent 1 12 92% 0 Lockheed 15 Separate Not independent 1 14 93% 27% Northrop Gr. 11 Combined Not independent 1 10 90% 27% Rolls Royce 14 Separate Independent 6 8 50% 43% Safran 21 Separate Not independent 3 18 24% 10% Thales 16 Combined Not independent 1 15 13% 7% United Tech 12 Combined Not independent 1 11 92% 58% SECTOR (12) 13 Combined Not independent 2.3 11 61% 23% Source: Company information and data, CM-CIC Securities & ESN evaluations of independence are made as of available information regarding the post 2005 AGM situation at 15/01/2006 (where possible). ND = not disclosed. Calculations of independence for 2-tieerd boards are based on the combined number of Managing & Supervisory Board members. * = Insufficient biographical disclosure.

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Overview of board structure and independence in companies in the sector Other Company Home Cy Women Age of CEO Av age Exec Av age NED nationalities BAE 10/15 DE, US(4) 1 57 56.5 59.6 Boeing 10/10 0 2 56 56 60.4 Dassault 10/10 0 0 68 66.5 56.5 EADS* 11/11 0 0 53 51.5 59.0 Finmeccanica 13/13 0 0 69 69 61.2 General Dynamics 13/13 0 1 63 63 64.6 Lockheed 15/15 0 2 54 54 64.3 Northrop Gr. 11/11 0 1 57 57 66.3 Rolls Royce 9/14 DE, US(4) 1 53 54.7 57.1 Safran 21/21 0 1 63 54.5 59.5 Thales 14/16 DE, UK 1 53 54 62.7 United Tech. 10/12 FR, UK 2 63 63 61.8 SECTOR (12) 92% 8% 8% 59 58.3 61.1 Source: Company information and data. For age calculations, we have included employee directors among NEDs. * For EADS – CEO age refers to the average of the 2 co- CEOs and home country includes 3 major countries of origin for EADS (France, Germany & Spain).

There is still the eternal debate regarding the balance between board-level independence and experience in the sector, especially given that experience can rarely be acquired outside the sector. It should also be noted that several of the companies examined have a very broad idea of what independence really is (e.g. Lockheed, General Dynamics, Boeing and Safran) - , with a large number of non-executive directors presented as independent even though they have very strong links to the relevant State.

We note that independence is defined as the absence in the (near) past or present of any direct or indirect link, professional or personal, that could cloud a director’s judgement.

What is more worrying at a time when we are trying to develop a culture of responsibility and fight against corruption and conflicts of interest, we can see that on boards today there is a whole generation of directors brought up on the opposite type of culture – with an overwhelming abundance of experience with the cold war, strategic national interests and commissions.

ƒ Priority given to experience!

Experience – Executives Directors BAE BOE DAS EAD FIN GEN LOC NOR ROL SAF THA UNI X12 Years in Role 5.1 0.5 7.9 1.1 0.5 11.8 0.5 2.3 6.0 0.7 8.0 4.0 4.0 Years on Board 7.4 4.1 9.5 2.4 3.8 11.8 5.3 4.3 6.6 2.0 8.0 4.0 5.8 Years in Co. 15.3 4.1 9.5 3.1 3.8 11.8 12.1 4,3 18.1 2.0 8.0 14 8.5 Years in Sector 15.8 4.1 9.5 4.6 3.8 12.9 12.1 4.3 18.1 2.0 8.0 14 9.1 Source: Boardex, Company Data at 17/01/2006.

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Experience – NEDs / SB Members BAE BOE DAS EAD FIN GEN LOC NOR ROL SAF THA UNI X12 Years in Role 2.5 5.8 5.9 3.3 1.8 6.9 5.7 3.8 2.2 2.3 4.7 6.5 4.3 Years on Board 2.6 6.8 7.7 3.3 2.0 8.5 6.0 6.1 3.2 3.9 4.7 6.5 5.1 Years in Co. 2.8 6.8 7.7 3.3 2.0 9.6 6.0 6.5 3.2 4.0 4.8 6.5 5.3 Years in Sector 2.6 6.8 9.4 4.4 2.0 10.6 6.0 6.7 3.2 4.0 5.1 6.5 5.6 Source: Boardex, Company Data at 18/08/2005

ƒ Strong connections between sectors

In both the US and Europe, it is also noteworthy that there is an impressive network of knowledge and contacts between the different boards.

Links between directors* of European aerospace & defence companies BAE Sys. Dassault EADS Finmeccanica Rolls Royce Safran Thales ° of separation 1 2 1 2 1 2 1 2 1 2 1 2 1 2 BAE Systems - - 0 2 0 5 0 2 0 67 0 4 0 4 Dassault 0 2 - - 3 21 0 1 0 4 0 42 3 55 EADS 0 5 3 21 - - 0 0 0 0 0 7 1 26 Finmeccanica 0 2 0 1 0 0 - - 0 0 0 1 0 1 Rolls Royce 0 67 0 4 0 0 0 0 - - 0 1 0 6 Safran 0 4 0 42 0 7 0 1 0 1 - - 0 49 Thales 0 4 3 55 1 26 0 1 0 6 0 49 - - °of separation: 1° means contact direct at present time; 2°means former direct contact or contact indirect via another person at the present time Source: Boardex Data. * Directors = Management Board and Supervisory Board members.

Links between directors* of US aerospace & defence companies Boeing Lockheed General Dynamics Northrop Gr. ° of separation 2° 3° 2° 3° 2° 3° 2° 3° Boeing - - 13 189 4 59 6 108 Lockheed 13 189 - - 0 57 5 91 General Dynamics 4 59 0 57 - - 0 42 Northrop Gr. 6 108 5 91 0 42 - - United Tech. 9 134 6 153 0 54 4 125 Source: Boardex Data.

We have noticed:

• A moderate level of 1° contact, but an abundance of indirect contacts (2° and 3°). This is especially true for US companies. If they are competing in the same technologies and in numerous market segments, they cannot have directors in common (1°), but one level below, there are numerous contacts. The consolidation of the sector that took place in the 1990s definitely encouraged this; Boeing and Lockheed both maintained a network of contacts between themselves and their competitors, although this is not quite so true for General Dynamics and Northrop Grumman;

• strong national links (Bae and RR, but also and more importantly between the French companies EADS, Thalès, Dassault and Safran);

• specific cases, such as the average number of direct and indirect contacts between EADS and Thalès (27) or between Dassault and Thalès (58) or Safran and Thalès (49). Some companies may also find themselves at the head of a more dense network and in a more powerful position when negotiating mergers.

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ƒ Remuneration: a US bonus

In terms of remuneration, the normal types of bias were noticed, i.e. a geographic bias in favour of US and English managers (in absolute direct salary terms), a logical bias in terms of company size, and also an undeniable bias via stock options in the participation of the capital performance, where once again US managers stand out.

The weight of bonuses in direct remuneration is higher in US companies (only around 45% for Boeing) but between 60-80% for the other companies in our panel). Such predominance in terms of direct salary means that there is perhaps a risk of short-termism in the company, whereas the aeronautics defence sector is a long-term sector (life cycle of equipment and contracts varies between 20 and 30 years).

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Detailed Compensation of Executive Directors

Equity Total Total Wealth (B)/ (E )/ Equity EUR 000s Salary (S) Bonus (B) Implied (W) Direct (S)+(B) Direct (D) Total (D)+( E) linked (E) (S)+(B)+(E) (S)+(B)+(E)+(W) [(S)+(B)] [(S)+(B)+(E)] linked (E)

BAE 2004 Total 4 241 4 392 8 471 7 875 8 633 17 104 24 979 50,9% 49,5% 803 0 803 Average 707 732 1 412 1 312 1 439 2 851 4 163 50,9% 49,5% 115 0 115 2003 Total 4 681 2 375 5 938 -228 7 056 12 994 12 766 33,7% 45,7% 377 0 377 Average 669 339 990 -174 1 008 1 998 1 824 33,6% 49,5% 54 0 54 2002 Total 5 202 802 1 756 2 931 6 004 7 760 10 691 13,4% 22,6% 357 0 357 Average 650 100 251 335 750 1 001 1 336 13,3% 25,1% 51 0 51 Boeing 2004 Total 1 103 926 18 063 39 011 2 029 20 092 59 103 45,6% 89,9% 5 556 36 437 41 993 Average 1 103 926 18 063 39 011 2 029 20 092 59 103 45,6% 89,9% 1 111 7 287 8 398 2003 Total 88* 74* 217 42 981 162 379 43 360 45,7% 57,3% 3 210 14 922 18 132 Average 88* 74* 217 42 981 162 379 43 360 45,7% 57,3% 642 2 984 3 626 2002 Total 1 487 944 9 304 5 671 2 431 11 735 17 406 38,8% 79,3% 7 426 18 648 26 074 Average 1 487 944 9 304 5 671 2 431 11 735 17 406 38,8% 79,3% 1 238 3 108 4 346 Dassault Aviation 2004 Total 1 534 22 0 -1 529 1 556 1 556 27 1,4% 0,0% 178 0 178 Average 767 22 0 -775 789 789 14 2,8% 0,0% 22 0 22 2003 Total 1 379 21 0 -1 380 1 400 1 400 20 1,5% 0,0% 145 0 145 Average 690 21 0 -701 711 711 10 3,0% 0,0% 21 0 21 2002 Total 1 325 21 0 -1 329 1 346 1 346 17 1,6% 0,0% 153 0 153 Average 663 21 0 -675 684 684 9 3,1% 0,0% 19 0 19 EADS 2004 Total 3 729 3 795 2 681 3 230 7 524 10 205 13 435 50,4% 26,3% 1 028 0 1 028 Average 932 949 670 808 1 881 2 551 3 359 50,5% 26,3% 206 0 206 2003 Total 3 636 3 223 4 054 2 071 6 859 10 913 12 984 47,0% 37,1% 936 0 936 Average 909 806 1 014 517 1 715 2 729 3 246 47,0% 37,2% 156 0 156 2002 Total 0 0 949 2 648 0 949 3 597 100,0% 0 0 0 Average 0 0 475 724 0 475 1 199 100,0% 0 0 0

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Equity Total Total Wealth (B)/ (E )/ Equity linked EUR 000s Salary (S) Bonus (B) Implied (W) Direct (S)+(B) Direct (D) Total (D)+( E) linked (E) (S)+(B)+(E) (S)+(B)+(E)+(W) [(S)+(B)] [(S)+(B)+(E)] (E) Finmeccanica 2004 Total 77 1 024 0 -1 101 1 101 1 101 0 93,0% 0,0% 874 0 874 Average 77 1 024 0 -1 101 1 101 1 101 0 93,0% 0,0% 73 0 73 2003 Total nd nd nd nd nd nd nd nd nd nd Average nd nd nd nd nd nd nd nd nd nd 2002 Total nd nd nd nd nd nd nd nd nd nd Average nd nd nd nd nd nd nd nd nd nd Lockheed 2004 Total 788 1 691 4 618 519 2 479 7 097 7 616 68,2% 65,1% 6 824 30 830 37 654 Average 788 1 691 4 618 519 2 479 7 097 7 616 68,2% 65,1% 1 365 4 138 5 503 2003 Total 2 077 4 048 19 381 35 902 6 125 25 506 61 408 66,1% 76,0% 9 546 27 005 36 551 Average 1 039 2 024 9 691 17 950 3 063 12 754 30 704 66,1% 76,0% 1 909 5 401 7 310 2002 Total 2 296 3 777 38 855 42 645 6 073 44 928 87 573 62,2% 86,5% 9 572 52 957 62 529 Average 1 148 1 888 19 427 21 324 3 036 22 463 43 787 62,2% 86,5% 1 914 10 591 12 505 Northrop Grumman 2004 Total 713 1 470 7 705 23 191 2 183 9 888 33 079 67,3% 77,9% 5 248 16 602 21 850 Average 713 1 470 7 705 23 191 2 183 9 888 33 079 67,3% 77,9% 1 050 3 320 4 370 2003 Total 689 1 088 5 945 7 691 1 777 7 722 15 413 61,2% 77,0% 6 472 13 216 19 688 Average 689 1 088 5 945 7 691 1 777 7 722 15 413 61,2% 77,0% 925 1 888 2 813 2002 Total 1 024 1 922 5 997 18 927 2 946 8 943 27 870 65,2% 67,1% 7 227 16 663 23 890 Average 1 024 1 922 5 997 18 927 2 946 8 943 27 870 65,2% 67,1% 1 445 3 333 4 778

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Equity Total Total Wealth (B)/ (E )/ Equity linked EUR 000s Salary (S) Bonus (B) Implied (W) Direct (S)+(B) Direct (D) Total (D)+( E) linked (E) (S)+(B)+(E) (S)+(B)+(E)+(W) [(S)+(B)] [(S)+(B)+(E)] (E) Rolls Royce 2004 Total 3 468 1 987 3 577 24 074 5 455 9 032 33 106 36,4% 39,6% 732 0 732 Average 578 331 596 4 013 909 1 505 5 518 36,4% 39,6% 81 0 81 2003 Total 3 419 1 506 6 918 2 927 4 925 11 843 14 770 30,6% 58,4% 679 0 679 Average 570 251 1 153 488 821 1 974 2 462 30,6% 58,4% 75 0 75 2002 Total 4 303 1 379 1 722 2 908 5 682 7 404 10 312 24,3% 23,3% 291 0 291 Average 615 197 246 415 812 1 058 1 473 24,3% 23,3% 48 0 48 Safran 2004 Total 1 202 674 168 -1 876 1 876 2 044 168 35,9% 8,2% 912 62 974 Average 240 135 34 -375 375 409 34 36,0% 8,3% 912 21 933 2003 Total 1 035 583 843 -1 618 1 618 2 461 843 36,0% 34,3% 1 457 202 1 659 Average 259 146 211 -405 405 616 211 36,0% 34,3% 162 101 263 2002 Total 865 253 717 -1 118 1 118 1 835 717 22,6% 39,1% 1 247 125 1 372 Average 288 84 239 -372 372 611 239 22,6% 39,1% 178 63 241 Thales 2004 Total 1 117 0 1 197 1 519 1 117 2 314 3 833 0,0% 51,7% 258 0 258 Average 1 117 0 1 197 1 519 1 117 2 314 3 833 0,0% 51,7% 26 0 26 2003 Total 0 0 664 915 0 664 1 579 100,0% 259 0 259 Average 0 0 664 915 0 664 1 579 100,0% 32 0 32 2002 Total 902 0 877 421 902 1 779 2 200 0,0% 49,3% 253 16 269 Average 902 0 877 421 902 1 779 2 200 0,0% 49,3% 32 16 48 United Tech 2004 Total 882 2 573 8 286 237 776 3 455 11 741 249 517 74,5% 70,6% 6 896 16 112 23 008 Average 882 2 573 8 286 237 776 3 455 11 741 249 517 74,5% 70,6% 1 379 3 222 4 601 2003 Total 1 566 3 253 19 398 7 456 4 819 24 217 31 673 67,5% 80,1% 7 173 29 403 36 576 Average 783 1 627 9 699 146 261 2 410 12 109 158 370 67,5% 80,1% 1 435 5 881 7 316 2002 Total 1 795 3 508 15 867 215 275 5 303 21 170 236 445 66,2% 75,0% 8 181 24 990 33 171 Average 898 1 754 7 933 107 637 2 652 10 585 118 222 66,1% 74,9% 1 636 4 998 6 634 PANEL (x11) 2004 Average 650 687 2 106 11 996 1 290 3 178 15 174 75 525 264 2003 Average 640 578 2 347 12 726 1 198 3 270 15 996 80 106 134 2002 Average 711 504 2 925 9 509 1 178 3 719 13 228 78 112 113 Boeing: remuneration for M. Sonecipher only, end 2003 Source: Boardex data, companies

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How the industry is bearing up in the face of change

Our analysis of companies presented below accounts for 65% of the total sales of the 20 largest global players. (Top 20 (with companies covered in bold): Boeing, United Technologies, Eads, Lockheed Martin, Northrop Grumman, Honeywell Intl, Bae Systems, Raytheon, General Dynamics, Bombardier, Finmeccanica, Safran, Thalès, Textron Inc, Rolls Royce, Goodrich, Dassault Aviation, Embraer, Rockwell Collins).

This study covers the following majors Recurring Published Classification by size Sales 05 (e) Ebit 05 MARGIN MARGIN Net debt 05 business 05 net earn. 05 Bae Systems Plc 26 108 1 813 6,9% 1 180 1 197 4,6% 4 196 Boeing 57 375 3 533 6,2% 2 298 2 279 4,0% 4 472 Dassault Aviation 4 760 568 11,9% 412 429 9,0% -2 768 Eads 40 111 3 169 7,9% 1 546 1 541 3,8% -4 815 Finmeccanica 13 397 852 6,4% 453 417 3,1% 1 279 Lockheed Martin Corp 37 565 2 861 7,6% 1 673 1 698 4,5% 1 739 Rolls Royce Group 11 572 1 140 9,9% 669 681 5,9% 304 Safran 13 084 919 7,0% 542 467 3,6% 724 Thales (Ex Thomson Csf) 12 379 881 7,1% 386 364 2,9% 1 062 Source: CM-CIC Securities, JCF Quant

Sales growth 2000-2005, $m

70 000 sales 00 sales 05 60 000 50 000 40 000

30 000 20 000 10 000 0

a s s f) rp n lc p an ic ds m ie s o tio P ou ab ng fr n a te og C C ia s r a ei Sa ca E ys ol on in v m G S o ec S n s rt t A te ce B m it ch om a ul ys y in lb e h M a S o F E T T ed ss e s R ed x e a a ll it (E kh D B Ro Un s oc ale L Th

Source: CM CIC Securities ƒ Poor performers (2000-2005)

Rolls Royce has been among the three worst performers in terms of business growth over the past five years owing to a downturn in civil aviation. The group’s civilian sales should edge back to the 2000 levels in 2005. Saab Group suffered fallout from an unfavourable local situation and was forced to resort to arbitrage. Boeing saw sales of jet aircraft fall by 32% over the same period.

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EADS vs. Boeing: an illustration of the gap between Europe and the US

Product lines and specific data, financial data

EADS 2004, IFRS BOEING 2004, US GAAP Commercial aircraft, 100+ seaters EUR20,224m USD21,037m Others (military aircraft, space, defence electronics) EUR11,537m USD31,420m Net earnings EUR1,030m USD1,872m MCAP EUR20,522m USD52,551m Equity EUR19,943m USD11,286m Net financial debt EUR1,061m (including refund.) USD12,200m (incl. Boeing Capital Corp.) Enterprise value EV: EUR19,595m EV: USD50,025m ROCE 7% 4% VE/CE 95% 125% VE/Sales 77% 125% Three year organic growth +3% -11% Source: companies, CM-CIC Securities estimates

Sales per zone

Sales EADS: 31,761 €M Sales Boeing: 52, 457$M

Europe North America 9% 27% Asia Asia 46% 15%

North America 71% Other areas 5%

Other areas

11% Eur ope 16%

Source: companies, CM-CIC Securties estimates

While Boeing and EADS are in the same business, their economic and geopolitical environments are very far apart. The US is home to other conglomerates with a greater defence industry presence than Boeing’s (Lockheed Martin). For the purposes of this study however, Boeing offers the advantage of being present in the “defence activities” sector and the “commercial airliners” business. The same cannot be said of the other players.

Boeing and Airbus are the only two makers of 100+ seater commercial airliners left in the Western countries; this explains our focus on these two “trans-Atlantic twins”.

ƒ Defence: advantage to Boeing

Boeing benefits from access to the US’s enormous defence budget. US defence spending is lavish both in absolute terms and relative to Europe.

A quick glance at the country-by-country defence spending statistics provided by NATO reveals that the US has by far the largest domestic market.

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NATO defence spending in all areas USDbn 1980 1985 1990 1995 2000 2003 Europe - 16 member countries 111.9 92. 2 186.2 184.3 164.3 200.0 Europe vs. total 44% 26% 37% 39% 35% 34% US + Canada 143.1 265.7 317.7 287.9 309.9 393.2 North America vs. total 56% 74% 63% 61% 65% 66% Total 255.1 357.9 503.9 472.3 474.3 593.2 Source : OTAN, Estimations CM-CIC Securities

Boeing benefits from a very large and highly protectionist domestic defence market. Boeing captures around 9% of total US materiel and equipment investment, which accounts for 33% of the group’s consolidated sales (55% of defence sales). The remainder of defence sales (USD14bn) stems from exports to Asia and Europe.

The billing practices used on either side of the Atlantic also have an impact on margins. Europe’s defence manufacturers bill a “fixed price”, while US manufacturers are paid “cost+fees”. This has major implications insofar as in the US, the state assumes the industrial risk and guarantees the manufacturer’s margin, while in Europe, industrial error can prove fatal. BAE is a good illustration: in 2002 the group accrued GBP796m in provision for its Astute submarines and Nimrod marine patrol aircraft, which were experiencing production problems. ƒ In civil aviation, Airbus is a victim of its own success

The issue of development assistance for 100+ seater jets continues to pit Europe against the US. The conflict arose as a consequence of Airbus’s commercial success. Airbus’s order book is 15% above Boeing’s, giving Airbus a potentially larger share of the market than its rival. The launch of the Boeing 787 has narrowed the gap between the two from the 40% seen at the beginning of 2005.

Boeing vs. Airbus: commercial aircraft order book volumes

1600 1600 1400 1400 1579 1200 1200 971 1359 1000 1000 800 615 800 600 600 349 400 168 149 400 200 115 80 172 143 49 49 5 200 12 28 20 13 0 0 0 A318 A319 A320 A321 A300 A310 A330 A340 A380 Total July 717 737 747 757 767 777 787 BBJ Total 2005 July 2005

Source: CM-CIC Securities estimates ƒ Dispute between Europe and the US referred to the WTO

EU-US competition being played out in the court-room

Back in 1992, the European and aviation conglomerates struck an agreement whereby the Europeans would enjoy subsidies equivalent to one third of the development costs of 100+ seater aircraft while US players would continue to benefit from the Defence Department subsidies provided to groups making equipment for the Pentagon. The idea was to ensure balanced market shares. The US has since backtracked on its agreement and referred the issue to the WTO.

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Is Boeing raking in subsidies for civil aviation construction?

The cost of developing the Boeing 787 is estimated to have been 50% subsidised (based on fiscal aid granted by the State of Washington and Japan alone).

Airbus says that its A380 received less in the way of subsidies and in a more transparent manner, stating that since the 1992 agreement it has reimbursed USD6.7bn or 40% more than it received in the first place. While the possible outcome to the dispute is unclear, Airbus has gone ahead with the launch of its A350 which cost around EUR4bn to develop. EADS has requested reimbursable advances from the states concerned. These are to be received next year (2006) once all other avenues have been explored.

Are the stakes high for EADS?

Airbus and its shareholders recently issued a joint communiqué stating that without the USD5bn in subsidies that Boeing received for the development of the Boeing 787, the company could never have brought the project to fruition. The communiqué also raises a number of key issues:

• The technologies used in the Boeing 777 and the Boeing 787 were paid for by the US government, specifically the composite wings which were borrowed from the B2 military aircraft (sailwing without tail fin) and the V22 Osprey (a tilting rotor combat helicopter).

• Between 1992 and 2004, Boeing received USD12bn from NASA and USD5.1bn from the FSC (special tax status for “companies selling abroad”), and has yet to reimburse any of it.

Airbus’s shareholders claim that despite Boeing’s less-than-tenable position in the light of the above, the group persistently lobbied the US Congress to step up US protectionism and prevent EADS from competing in the refueller plane segment. Boeing was excluded from this market two years ago owing to fraudulent practices.

Given EADS’s economic and financial success since it was founded in 2000, it seems clear that Boeing is pursuing a strategy of judicial containment in the hope of strangling its competitor. ƒ The US strategy: the DoD has a moral imperative to “buy American”

The Buy American Act (1933) obliges the US government to procure US-produced goods, but exceptions are possible in the following instances: if not buying American would serve the public interest (!); if buying American would be excessively costly; or if adequate quality American goods are not available in sufficient quantity. These considerations make it difficult for non-US groups to win DoD contracts.

In Europe the situation is different: none of the European members of NATO is obliged to favour European industry. The choice made by certain NATO countries to finance and buy US products illustrates this: the Netherlands, Italy and the UK are contributing to the development of Lockheed’s JSF combat plane, and Poland has bought F16s from Boeing. The European market is both smaller and more porous.

That said, we believe that the long-term could see countries favouring European manufacturers, which are increasingly seeking to bid for DoD contracts with attractive price conditions.

For more details on tax impacts, see Appendix below.

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Nothing points to a forthcoming major consolidation in Europe

Aerospace: already highly concentrated

The major restructuring events of the period 1980 to 2000 were the acquisition of GEC Marconi by British Aerospace (renamed BAE Systems) and the alliance between Aerospatiale-Matra, Daimler-Benz and CASA, which gave birth to EADS (which holds 46% of Dassault). Thomson-CSF (Thalès) acquired Racal in 2000 to become the MoD’s second biggest supplier. Other transactions have taken place in Europe since 2000, including the purchase by Finmeccanica of assets in the UK from BAE Systems and from GKN (50% of AgustaWestland helicopters) and in 2005, the acquisition of Snecma by Sagem to form Safran. These mergers and acquisitions were carried out with a view to building capacity at reasonable cost and protecting companies from hostile takeover bids. In our view, economic weight in the sector is synonymous with proportionally higher valuation.

The aerospace industry in the Western countries is now highly concentrated. The number of development programmes underway (combat aircraft, for example) is not very high, and at the end of the day is probably sufficient. As for the naval sector, things are starting to move, and there will probably be concrete developments in the medium-term. For land combat equipment, there are needs stemming from the missions being pursued by governments, and the sector is fairly dispersed.

ƒ Naval: concentration almost underway in Europe

The most recent high profile transaction involved the purchase and resale of HDW (6,300 employees, sales EUR1, 335m): the company was bought by US group One Equity Partner (OEP) and resold to ThyssenKrupp, a long-standing partner of HDW. The HDW acquisition enabled ThyssenKrupp to merge its shipyards with HDW’s. OEP took a 25% stake in the new company, renamed ThyssenKrupp Marine Systems (9,300 employees, sales EUR2.2bn). The transaction means that HDW is now majority German-owned, in keeping with the will of the political leaders in Germany who inspired the acquisition. OEP reportedly wants to pull out, and EADS is said to have been talking about buying the 25% stake in 2004. This would explain the joint bid made for Atlas Electronik (a direct competitor of Thalès), currently being sold by BAE.

In 2003, an alliance between the former HDW and French groups Thalès and DCN was looked at. This option continues to be valid for the medium-term perspective in a broader form. Meanwhile, an alliance is currently being finalised between DCN and Thalès.

In April 2004, BAE let it be known that it was thinking about selling its naval branch, which was experiencing problems at the time (the “Astute” nuclear submarine). BAE said it would look at various options for the division, while stressing that no decision had been made. The future of BAE Systems’ naval division therefore remains an open issue; no possibility can be discounted. It may well be that the decision to pull out of shipbuilding should be looked at in the context of the negotiations for aircraft carrier contracts, in which BAE’s participation as project manager would be compromised. In this case, the decision can be interpreted as a means of exerting pressure. For security reasons, the US would oppose the acquisition of

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BAE’s naval activities by a non-US conglomerate, as Britain’s submarines use US technology (nuclear propulsion). General Dynamics or Northrop Grumman could be potentially interested. This would mean the UK’s defence industry would miss out on the alliances forming in continental Europe (France, Germany, Italy, and Spain).

The naval sector is changing. DCN describes the current challenges using an example: “depending on the nature of the conflict situation, the system needs to determine if the response should be a torpedo or a long/short-range missile”. Players in the sector therefore need to be both “naval architects” and “defence system and equipment architects” at the same time, and the two are by no means synonymous.

Land combat: Europeans gaining the upper hand, but lots still to be done

ƒ The US offensive in Europe’s land combat sector suffered a setback in 2004

In the space of five years, two US groups, General Dynamics and United Defence, took control of five major national suppliers and exporters.

1. In 1999, Mowag (Switzerland) was bought by General Motors in a transaction that was part of the licence agreement for armoured vehicles developed by Mowag and granted to GM. In 2003, GD bought GM’s defence activities, including Mowag (2003 sales EUR100m, 500 employees).

2. In 2003, GD purchased Austrian group Steyr (2003 sales EUR200m, 450 employees, wheel and caterpillar armoured vehicles). Steyr has developed products in collaboration with Santa Barbara via shared subsidiary Austrian-Spanish Cooperative Development, set up around 1980.

3. In 2001, Santa Barbara (2,000 employees) was bought by GD in a wave of privatisations in Spain. GD’s offer was accepted over those of German groups KMW and Rheinmetall, despite the fact that these two were seen as the natural candidates given that Santa Barbara was making tanks under licences granted by the Germans.

4. In 2002, GD bought EWK (Eisenwerke Kaiserslautern: 350 employees, bridges, pontoons, a major exporter) via Santa Barbara. In the wake of these transactions, GD set up an umbrella division for the acquired activities in 2003: European Land Combat Systems is based in Vienna. GD is now a major player in the European land combat systems sector.

5. In 2000, US group United Defence (controlled by Carlyle) bought Bofors Defence (500 employees, artillery, intelligent munitions and naval arms), a subsidiary of SAAB of Sweden. ƒ Trend reversed thanks to BAE

In 2004, a takeover bid launched by GD against Alvis (UK) failed. BAE, which held 29% of Alvis, offered +15% and Alvis remained British. The acquisition of Alvis by GD would have meant excessive Americanisation of Europe’s land combat sector: Alvis is a major player in Europe (2003 sales EUR500m, 2,800 employees), having taken control of Hägglunds (Sweden, 1997), GKN’s armoured vehicles division (UK, 1998), and Vickers’ land combat division (UK), which it bought from Rolls Royce in 2002. In March 2005, BAE took everyone by surprise by announcing the acquisition of US group United Defense for USD4.2bn (United Defense: sales USD2.29bn, 8,000 employees, maker of the Bradley tank). This is a clear

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Business as usual reversal of the trend of successive US takeovers of European groups. The United Defense takeover gave BAE control over Bofors Defence (Sweden), acquired in 2000 by United Defense. ƒ Uncertainty in Germany concerning the ownership of the two major players: Rheinmetall

The Rochling family, core shareholders for the past fifty years, decided to sell in November 2004. There were persistent rumours of a planned pull-out, and the German media had named General Dynamics as a potential buyer as well as several US funds (Carlyle and Blackstone). Nothing came of it however, because Rochling sold its shares to more than 75 institutional investors to ensure the group’s independence. The second player is Krauss- Maffei Wegmann: this company is 51% owned by the Bode family, and its situation looks unstable because Siemens, which holds the rest, also reportedly wants to pull out. ƒ France - GIAT

In France, the French government is the sole shareholder and main client of the Giat (2003 sales EUR 1729m, order book EUR2.2bn, 6,000 employees), a company undermined by low sales and weak competitiveness. The group was loss-making until 2004 inclusive. Restructuring plans are in the works (Projet Giat 2006). Following a recapitalisation, at the beginning of 2005 the group held EUR45m worth of owner’s equity to be used to deal with the drop in business anticipated in 2006 and 2007. Any kind of M&A transaction would be premature at this stage.

Pooling sector skills: the two types of integration

• Horizontal integration: this involves bringing together various types of capacities and technologies so as to build “complete systems” based on multiple platforms. This is a key strategy approach in industries with a global reach, and it seems the most sensible given that clients buy linked-up equipment to carry out their missions. Concentration is already quite advanced however. In the UK and in France, for example, the sector is dominated by oligopolies and the next step forward may not be achieved.

• Vertical integration: this involves making equipment piece by piece. It is not necessary to control the entire value chain of the product, e.g. a combat aircraft. This was incidentally the initial argument used by Thalès to rebuff a possible merger with EADS.

In the light of the latter consideration, we believe that leaving aside financial reasons and balance sheet leverage, there is nothing to suggest that a new round of consolidation in the European market is imminent. ƒ Europe’s majors: little to suggest M&As imminent

• A drop in defence budgets could lead to consolidation among players seeking to deal with a long-term drop in sales (see “last supper” case below). We believe that this is unlikely in the medium-term: defence budgets are rising.

• Capture of military research budgets, if EADS, which is as big, if not bigger than the US heavyweights, wins its struggle with Boeing. The group needs better access to technologies financed by the client (governments) so as to reduce the cost of group R&D. This means that EADS needs to have a more substantial presence in the defence sector.

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• Will structure-creating programmes and the continuation of Europe-wide coordination of defence policy give impetus to a new wave of concentration?

If the aim is to have European defence as unified as possible, it would surely make sense to rationalise equipment design and manufacturing. A redistribution of skills based on a “product by country” matrix would be optimal as far as costs are concerned, but would be too difficult to gain acceptance for and implement in the foreseeable future. Each of Europe’s member states seems set on holding on to its own production capacity.

The industrial organisation of the Eurofighter combat aircraft programme (born before EADS was set up) is not optimal: each of the participating countries is responsible for assembling the planes it will buy (620 planes for the UK, Germany, Spain, and Italy). By way of contrast, the A400M (bulk cargo plane) will not be beset by duplication because the design and prime contracting work will be carried out at EADS.

The issue of the naval sector was brought up by DCN, which gave a more or less concrete vision of what could happen in terms of integration in the Europe’s naval shipyards. Consolidation would begin, according to the scenario, with the consolidation of engineering functions (R&D). This is the most costly item in the construction of a surface or submarine vessel. Years later, industrial rationalisation of the traditional shipyard activities could follow. Pooled design aimed at ensuring inter-operability and cost savings for clients (upstream integration of manufacturers’ information systems) could justify such unions. ƒ Some major transactions & activity in 2005: convergence still in progress

One of last year’s major transactions saw Safran acquire Snecma to become Safran. Finmeccanica took back control of much of its assets jointly held in the UK (avionics: 50% of Agusta Westland) and EADS saw increased sales both at Airbus (+22%) and elsewhere. They also accelerate their external growth towards dual technologies with Datamat acquisition. This Italian IT services group Datamat serves the defence and aerospace sector (44% of sales), finance (23%), telecom/media/utilities (19%), and healthcare and the public sector (11%). Finmeccanica took a 52.7% stake in Datamat in July 2005 (valuing 100% of the group at EUR285m). ƒ Thales at the heart of future restructuring process in Europe

Alcatel is still supposed to prepare a bid for Thalès. Alcatel currently has a 9.5% stake, Compagnie Industrielle Marcel Dassault 5% and the French state 31%. There has been speculation that Thalès could be the subject of a bid for about a year. EADS is thought to be interested, as it would give it skills in systems integration. This is vital if it is to retain prime contractor status. It would also reinforce its presence in a less cyclical business than Airbus and enable it to offset a cyclical downturn, which could come in 2008 or 2009. It should also be borne in mind that a large slice of Thales’s R&D is financed by its clients. Alcatel’s interest is thought to spring from the fact that it needs to diversify its communications activities. It could hope to generate industrial synergies by moving into military communications, a market that looks like having a very strong outlook in the short and medium terms.

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Preserving the subcontractor industrial base: how and why?

Subcontractors have also been acquired by foreign players, mainly US-based groups. Chinese and Indian groups and investment funds could also be looking in the future at European players, which have advanced technologies and are less hermetically sealed than their US counterparts. Military equipment uses advanced technologies and the companies that make them are often dual-purpose.

Among technologies identified as critical for national security and defence, a close eye needs to be kept on software used to ensure system safety and security, cryptography, composites, and nanotechnologies.

ƒ SMIs & SMEs: may follow the majors down the consolidation road

Subcontractors are looking to gain the critical size needed to dilute unit risks and to assume financial risk exposure in civilian programmes. This could lead to SME-SMIs seeking consolidation with each other. Much of the defence industrial and technological base is not listed. Europe has literally thousands of companies working for defence aerospace. Some are facing or are reported to be facing problems of succession. Consolidation among the majors should therefore have repercussions for second and third-tier suppliers, who are coming under increasing pressure to realise productivity gains. The SMEs in question supply entire sub-systems to the majors, and this involves:

• Dealing with the entire production chain (design, manufacturing, R&D financing).

• Participation as a risk-sharing partner in civilian aerospace projects, which require sufficient financial leverage to be able to raise the funds needed to develop their portion of future commercial contracts.

There seems to be a lack of balance in industry relations and investment between Europe and the US. To make matters worse, US groups enjoy privileged access to the European market, and this is not reciprocated. ƒ Problems and risks inherent in allowing foreign groups in

Some segments of the industry are currently at risk of forfeiting their autonomy. Procurement security and industrial bases can be endangered when a non-European shareholder takes a stake, leading to procurement security problems in areas of strategic importance. Acquisitions targeting sub-contractors can lead to loss of control over the sub- contractor’s strategy: the new owner can decide to discontinue certain activities, to shift the production focus, to reduce R&D and to accord preference to certain clients over others.

Europe’s defence industrial and technological base encompasses all segments of production, and this will have implications for the European tendency towards lack of coordination in military procurement. Certain countries are content to buy “off-the-shelf” equipment from the US, making it difficult to keep skills independent. And yet, Europe’s defence policy is based on its defence industry policy.

Another implication that comes into play when US groups acquire European companies concerns US legal restrictions that may become applicable to those companies by virtue of the extra-territorial principle (restrictions on the export of components manufactured in the

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US and limitations on the utilisation and sale of products developed in Europe by companies under US control)

ƒ Industrial restructuring hampered in Europe

The presence of US shareholders is an obstacle insofar as it engenders disassociation of players (land combat equipment, for instance). In the engines segment, the scope for consolidation was curtailed following the acquisitions of MTU and Fiat Avio: the future of these companies now depends on KKR and Carlyle. There has been a marked downturn in R&D activity at engine-maker MTU (besides the announced job losses), and the fact that cost- cutting is the stated aim suggests that short-term results have taken priority. It looks likely that institutional investors will pull out of Europe’s defence enterprises given the manner in which investment funds operate: the acquisitions were made with a view to realising financial gains, and any sale restricted to European buyers would be less than lucrative for the investors.

ƒ France: needs stronger protection of its defence industry

Although we discern little evidence of a trend towards defence industry consolidation within the EU, we believe that France’s defence majors are not in any real danger of foreign takeover thanks to the strong influence of the state (stakes in Giat, DCN, Thalès, EADS, and Safran).

Although isolated changes are not to be ruled out (the debate surrounding the union of Thalès with EADS), France’s majors are well insulated from hostile takeover. We believe moreover that the takeover of Snecma by Sagem has given a boost to French ownership in the long- term and avoided or postponed the prospects of foreign ownership (e.g. US ownership; reciprocal French ownership of sections of the US defence industry does not easily lend itself to the imagination).

Smaller players, i.e. SMEs and SMIs, are more vulnerable. Indeed, these are at the centre of attention today. The financing difficulties that SMEs and SMIs face today, notably in the defence sector, go some way to explaining their vulnerability to foreign takeover. ƒ Germany: the government reacts

The German government has introduced new legislation capping foreign ownership of German defence groups. The German authorities are not known for being overly- interventionist as far as German industry is concerned, but the acquisition of HDW by OEP and that of MTU by KKR investment fund came as a wake-up call.

In 2003, the German government submitted a draft law aimed at putting in place a mechanism for restricting foreign investment in defence and cryptology enterprises. Because German defence enterprises tended in the past to be family-owned, Germany lacked legislation governing this issue of foreign ownership. The draft law proposed replacing “prior authorisations” with “prior declarations” in instances involving the sale of 25% of the capital of a defence or cryptology enterprise, and was voted into law in 2004. ƒ The UK: privileged relationship with the US, but only up to a certain point

Britain’s defence industry is privately owned: restrictions on foreign ownership of BAE and Rolls Royce were lowered before being abolished entirely in 2002. These companies are now majority owned by foreign shareholders. Nevertheless, no single foreign shareholder may hold more than 15% of either company, and the British government continues to hold a “golden share”, meaning that it can veto any changes to the companies’ by-laws, ensure that the

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While the UK has no legislation per se establishing controls with respect to foreign investment, the 2003 Enterprise Act (strengthens the UK’s competition framework) can be invoked if the sales of an entity are more than GBP70m or if the entity controls more than 25% of the market.

The 2002 Defence Industrial Policy published by the MoD states that increasing internationalisation has made the notion of a British defence industry somewhat vague, and that origin of capital has been supplanted by presence on British soil of technologies, jobs and investments as the determining factor. BAE’s last minute acquisition of Alvis following the receipt of a bid from General Dynamics fits in well with this approach.

The UK is becoming increasingly sensitive to the issue of autonomy, because despite its privileged relationship with the US, it is not being granted automatic access to newly developed technologies. In this context, the UK is turning more to Europe and becoming more heavily involved in collaborative projects by engaging European firms to supply it with aircraft carriers and refuelling planes. The notion of European defence industry and technology base is at the forefront today.

The UK is aware of the importance of procurement security, but does not see the nationality of the capital present in its defence enterprises as particularly significant. For the UK, intellectual property issues and the place of fabrication carry greater weight.

Guidelines for better protecting Europe’s defence industry

In its report No. 2202 of March 2005 “On foreign ownership of European defence enterprises”, the French Parliament proposed a number of solutions aimed at protecting Europe’s defence sector. The conclusions set forth in the report suggest that an end to non- European investment in European defence enterprises is nigh:

• Reinforce national and European oversight and early-warning mechanisms: create a database of strategic enterprises and critical suppliers, enhance economic intelligence training, ramify industry oversight and protective mechanisms, assign oversight functions to the European Defence Agency, encourage cooperation between national intelligence services aimed at protecting the defence sector.

• Expand the financing alternatives available to strategic enterprises: foster the development of investment funds (encourage the emergence of venture capital and development capital institutions). The creation of the investment fund (EUR200m) for support to strategic enterprises announced in March 2005 is a step forward in the right direction; it would make sense to enlarge the circle of eligible investors and increase the fund’s financial capacity beyond the initial EUR200m mark.

• Develop direct and indirect employee shareholding mechanisms (FCPE/SICAV) to stabilise ownership and prevent hostile takeovers and bids. Encourage the creation of a European investment fund to support innovative defence and dual-purpose enterprises.

• Encourage defence industry restructuring with a view to reducing vulnerability: Promote the idea of industrial unions between SMEs, raise awareness in Europe of the importance of preserving Europe’s defence industrial and technological base.

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• Harmonise European regulation and draw lessons from US experience: harmonise legislation on foreign investment oversight. Use the US example as a basis for strengthening European regulations.

Are US groups planning to move into other zones?

Now that there are emerging signs of greater strategic, technological and industrial unity in Europe, US groups could be forgiven for fearing that there is little scope for expansion left in Europe (fewer opportunities for investment, an increasing tendency to favour EU over non-EU suppliers). In ten years time perhaps, Europe’s defence sector may well be fully privatised as is the case in the US. With this in mind, the European market represents a real challenge for US players today.

ƒ America’s “last supper”

The US consolidated its defence industry in the immediate aftermath of the Cold War, following the infamous “Last Supper” of December 1993 where defence secretary William J. Perry gave the industry a year in which to reduce its numbers by half. The result was the emergence of major defence groups controlled by such giants as Lockheed, Boeing and Northrop.

US groups classified by sales to the Department of Defense 2004/19 Total sales Dod awards 1995 2000 2003 2004 DOD Awards ($bn) 1995* 2000 2003 2004 95 2004 to sales 2004 1 1 1 1 LOCKHEED MARTIN CORPORATION 12.0 15.1 21.9 20.7 73% 35.5 58% 2 2 2 2 BOEING COMPANY (*) 9.8 12.0 17.3 17.1 74% 52.5 33% 5 5 3 3 NORTHROP GRUMMAN CORPORATION 2.9 3.1 11.1 11.9 310% 29.9 40% 11 4 4 4 GENERAL DYNAMICS CORPORATION 1.7 4.2 8.2 9.6 465% 19.2 50% 6 3 5 5 RAYTHEON COMPANY 2.9 6.3 7.9 8.5 193% 20.3 42% 7 6 HALLIBURTON COMPANY 3.9 8.0 10 7 6 7 UNITED TECHNOLOGIES CORPORATION 1.8 2.1 4.5 5.1 9 8 SCIENCE APPLICATIONS INTERNATIONAL 2.6 2.5 10 9 COMPUTER SCIENCES CORPORATION 2.5 2.4 11 10 HUMANA, INCORPORATED 2.4 2.4 total top 10 82.3 88.2 DOD total expenses 230.6 % of 10 // total of 350 38% 12 BAE Systems 2.2 22% 2004: 62 Rolls Royce 0.5 5% European groups 74 Thales 0.4 4% 95 Smiths Group 0.3 10% Source: www.defenselink.mil (*)1995: Mc Donnell Douglas No.2 and Boeing No. 9

The top ten suppliers of materiel and services account for 40% of total DoD procurement. The US groups enjoy a certain advantage stemming from their internal market: some 25 groups have annual sales of more than USD1bn to the DoD. The US is also the world’s number one exporter.

Today, the two NATO zones on either side of the Atlantic are vying to prevent each other from encroaching on their respective markets, but tomorrow the battle for market share could shift to other zones where exports or investment could potentially become lucrative.

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Why Western groups are eyeing markets in non- NATO countries

Arms flows in other zones

Arms exports have a triple impact on the economy of a country:

• they enhance defence sector competitiveness

• they reduce unit costs if the manufacturing series is sufficiently large;

• shrinkage of international contract; and

• they improve the balance of trade.

Emerging of New or Old Powers in search of cash recovery

ƒ The Russian Federation offers a number of advantages

Russia’s defence enterprises are currently enjoying a boom in orders. According to the Financial Results of Russian Arms Trade with Foreign States in 2004, Russia achieved record deliveries of arms and military equipment export in 2004. The Federal Service for of the Armed Forces reported that deliveries reached USD5.78bn (+7% year-on-year) with foreign currency earnings reaching USD6bn vs. USD5.6bn in 2003. These record export earnings are only the most recent in a five-year pattern of successively improving results since 2000. The boom of the past five years comes after a crisis in arms exports during the period 1997-1999, when revenues fell below previous years’ levels.

Russia has a number of projects in the pipeline whose aim is to expand and enhance the country’s defence offering. The Russian government is seeking to set up a Unified Aerospace Company (UAC) based around horizontal integration. Russia’s Ukrainian competitors have already regrouped around the Antonov consortium. The UAC project has been postponed until the end of 2006. Russia’s industry ministry is looking at merging Russian aerospace majors Sukhoi, Irkut, MiG, Ilyushin and Tupolev to form the UAC, which, according to the plan, would be 60-70% state-owned. The UAC will also encompass specialised sub-holdings: military aviation, civil aviation, etc. Moves are afoot to remove the cap on foreign investment in aerospace enterprises, currently set at 35%.

Russia has a dense and foreign-investment-hungry defence sector. The industry ministry is looking at ways of encouraging increased foreign investment in the aerospace and automotive industries. Western European groups such as EADS already have their foot in the door: Irkut’s vice-president for corporate finance says that “by the end of 2005, Irkut plans to finalise its financial settlements with EADS. Irkut is expecting to receive around USD70m from EADS for a 10% stake in the company.”

Among the projects already underway in the Russian Federation are the joint development with India of a fifth generation combat aircraft, diversification by Sukhoi into the civil aviation sector (development of a Russian regional jet with the participation of Snecma and consulting support from Boeing). Russia’s aerospace industry will be responsible for 3% of Airbus’s new A350 jet. Boeing invested USD2.3bn in Russia between 1991 and 1995, and said it will invest

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Business as usual another USD3bn in other aerospace projects by 2010. Russian analysts remain sceptical however.

ƒ China is the world’s second largest arms importer (after Russia)

China is currently in talks with Europe and the US on the resumption of arms exports to the country, but there has been little in the way of concrete results. With Chinese orders for commercial jets from the two majors soaring, the Chinese government could be tempted to up the political ante. All the more so given the increasing number of industrial ties between China and Europe: China will be responsible for 5% of the design work on the A350. China’s more substantial involvement in the A350 project probably reflects nothing more than the fact that China’s industrial sector is in better condition than Russia’s.

How the main European groups are bearing up

ƒ EADS: targeting the US and system integration

EADS is looking to increase its defence sales over the coming years so as to reduce the impact of the cyclical nature of its civil aviation business. The group also wants to hold on to its market share in the 100+ seater jets segment. There are two major prongs to its strategy: 1) EADS is seeking to penetrate the US market via an intelligent “small steps” approach (small acquisitions, implantation of a helicopter plant, participation in the Guard Cost programme); EADS also wants to build up its system integration capacity substantially, so as to be able to sell its equipment as part of meta-systems.

ƒ BAE Systems: a three-prong strategy

For BAE, UK defence orders are not a major component in its earnings profile. This company relies upon: 1) sales to the Pentagon, 2) civil aviation sales (BAE holds 20% of Airbus), and 3) its Al Yamamah contract with Saudi Arabia. BAE Systems is one of the Pentagon’s key suppliers; indeed the Pentagon is the group’s number one client, ahead of the British MoD. The United Defence acquisition will only serve to accentuate this situation. The US stance on technology transfer remains a matter of concern for BAE, as it makes technology data fusion (US and non-US) to all intents and purposes impossible. BAE’s chairman recently complained that even a company such as BAE, which is deeply integrated into the US market thanks to numerous acquisitions in the US, is subject to stringent controls and suffers from a total lack of autonomy.

ƒ Finmeccanica: an alliance with Boeing

Finmeccanica is 32% owned by the Italian government. The group is increasing its presence in the aerospace and defence sectors and seeking to penetrate the US market via an alliance with Boeing. A letter of intent on cooperation between the two was signed in 2003, but nothing concrete came of it. Finmeccanica needs to find a solution aimed at moving the group on from its current status of a holding company, which has now well and truly run out of steam: Finmeccanica continues to be present in air defence, where sales account for 20% of the group’s total revenue (cumulative half-year losses came to EUR47m vs. group ebit of EUR251m), and it also holds 6% of STMicroelectronics, which it is liable to offload at any time. Finmeccanica’s structure has changed beyond recognition: between 2004 and 2005, the group consolidated quite significant assets in the UK, including the remaining 50% of Agusta Westland and assets previously held jointly with BAE.

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ƒ Safran:

Safran is clearly looking to focus on the defence and security aerospace sector: the group is currently disposing of non-core assets (examples: cable, mobile telephony). Its aim is to achieve growth in the civilian and military OEM segment and at the same time to increase market share in spare parts and services so as to counter-balance any difficulties in the OEM segment. Safran is sitting on a substantial cash pile, and so acquisitions are a viable way forward for the group. Safran’s chairman recently said that Zodiac and Thalès were of little interest to the group, and indeed these companies would be too hefty a morsel for Safran to swallow. In our view, Safran should consider ramifying its system integration and security systems capacities, which is what the group seems to be doing given the recent acquisition of electronic chip-enabled card maker Orga.

ƒ Thalès:

Thalès is Europe’s top “large systems integrator”. This is borne out by the group’s successful track record in implementing new technologies and its new-found status as prime contractor in multiple high profile contracts: the Watchkeeper tactical intelligence project is a good example. Defence clients today no longer buy platforms; “capacities” is the new buzz-word. This is also the reason why the group is viewed as a prime cut within the industry, with EADS, Alcatel and Finmeccanica all looking at wooing Thalès. In our view, even Safran could find its place in an alliance with the group.

With implants in numerous countries across the globe, Thalès is ideally positioned to meet the challenges of international competition and fluctuating exchange rates (50% of sales outside the eurozone). After a period of several years of decline, Thalès’s order book is growing anew.

The group’s only real handicap is its narrow scope for financial manoeuvring (although things have improved since 2000). Thalès could decide to borrow again as a means to fill in the gaps in its defence, civil aerospace and security businesses (e.g. homeland security, cryptology: transport security, secure payment, etc.) both in Europe and the US.

ƒ Rolls Royce:

Rolls-Royce operates in four global markets: civil aerospace, defence aerospace, marine and energy. It is investing in technology and capability that can be exploited in each of these sectors to create a competitive range of products. Rolls-Royce has a broad customer base comprising more than 500 airlines, 4000 corporate and utility aircraft and helicopter operators, 160 armed forces and more than 2000 marine customers, including 70 navies. The company has energy customers in nearly 120 countries. Rolls-Royce employs around 35,000 people (60% in the UK, 23% in North America). The large installed base of engines generates demand for the provision of services. A key element of the company's strategy is to maximise services revenues (+60%/ 5 years), by the provision of a comprehensive portfolio of services. Services revenues represent 55% of the turnover. We do not envisage any specific risks in aerospace and defence contracts, unless there is a downturn in civil air traffic. Rolls Royce also has the advantage of involvement in all of the most recent long-range civil aviation projects: the A380, Boeing 787, and possibly the A350. Commercial risk exposure is low, therefore. The two other business lines, Marine and Energy (together 24% of sales), are low- margin activities for the group.

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ƒ Dassault Aviation

Dassault Aviation designs and builds combat aircraft (37% of total sales: the Mirage export model and the Rafle for the French government), and is the world’s leading maker of executive jets (the Falcon subsidiary accounts for 63% of Dassault’s sales). The group’s defence export order book is contracting at present, both in absolute and relative terms. The group is consistently losing out to rivals, either because of political factors that systematically ensure victory for its US peers, or because the strong euro is undermining its competitiveness. That said, a variety of long-term factors mean that Dassault is in a position of strength in the executive jets segment.

Dassault Aviation is adept at adapting itself to industry cycles: its manufacturing flexibility is well known, and indeed it was with flexibility in mind that Dassault configured its production arrangements in the first place. Dassault’s R&D bureau and skills base make the group a manufacturer of choice for the French government, to the extent that in 2003 the group was asked to organise the mobilisation of a skills base for the purpose of developing a next generation European combat aircraft (one that may or may not have an on-board human pilot).

Dassault Aviation has never posted a loss since it was set up in 1936, and is not shy about saying so. Indeed, today the group is sitting on one of the largest cash piles in the worldwide aerospace industry, one that would allow it to take a stake in any aerospace or defence group of its choice. This factor could see Dassault chosen by as the French government’s partner to take over the state-owned stake in EADS should the government one day decide to pull out while preserving the current balance between French and German ownership.

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Top 100: ranking Defence News

2004 Defence Rank Company Leaders Country Sales 2004 % Defence Revenue * 1 Lockheed Martin Robert J. Stevens, Chairman & CEO U.S. 35 526 96% 34 050 2 Boeing W. James McNerney, Chairman & CEO U.S. 52 457 58% 30 464 3 Northrop Grumman Ronald D. Sugar, Chairman, CEO, & Pdt U.S. 29 900 74% 22 126 4 BAE Systems Mike Turner, CEO U.K. 25 431 80% 20 344 5 Raytheon William H. Swanson, Chairman & CEO U.S. 20 245 93% 18 771 6 General Dynamics Nicholas D. Chabraja, Chairman & CEO U.S. 19 178 78% 15 000 7 EADS Th. Enders & Noel Forgeard, co-CEOs Netherlands 43 388 24% 10 505 8 Honeywell David M. Cote, Chairman & CEO U.S. 25 601 40% 10 240 9 Thalès Denis Ranque, Chairman & CEO France 14 053 63% 8 868 10 Halliburton (DoD contract only) David J. Lesnar, Chairman & CEO U.S. 20 446 39% 8 000 Pier Fr. 11 Finmeccanica Italy 12 808 60% 7 671 Guarguaglini. Chairman & CEO 12 United Technologies George David, Chairman & CEO U.S. 37 445 18% 6 740 13 L-3 Communications Frank Lanza, Chairman & CEO U.S. 6 897 89% 6 134 14 Science Applications Internat° Ken Dahlberg, CEO & Pdt U.S. 7 187 65% 4 686 15 Computer Sciences Corp. Van B. Honeycutt, Chairman & CEO U.S. 14 768 26% 3 779 16 DCN Jean-Marie Poimbouef, Pdt & CEO France 3 547 100% 3 547 17 General Electric (aircraft engines business) Jeffrey R. Immelt, Chairman & CEO U.S. 15 500 22% 3 400 18 Rolls-Royce Sir John Rose, CEO U.K. 11 367 27% 3 069 19 Misubishi Heavy Industries Kazuo Tsukuda, Pdt Japan 25 324 10% 2 517 20 Alliant Techsystems Daniel J. Murphy Jr., Chairman & CEO U.S. 2 081 90% 2 516 21 ITT Industries Steve R. Loranger, Chairman, Pdt & CEO U.S. 6 740 36% 2 414 22 United Defense (Acquired by BAE in 2005) Thomas W. Rabaut, Pdt & CEO U.S 2 292 100% 2 292 23 Snecma (merged in 2005 > Safran) Jean-Paul Béchat, Chairman & CEO France 9 278 24% 2 183 24 Titan (bought by L3 in 2005) Gene W. Ray, Chairman, Pdt & CEO France 2 047 98% 2 004 25 Saab Åke Svensson, Pdt & CEO Sweden 4 200 64% 1 900 26 Rheinmetall Klaus Eberhardt, Executive Board Chairman Germany 4 653 41% 1 882 27 Dassault Aviation Charles Edelstenne, Chairman & CEO France 4 721 39% 1 828 28 Booz Allen Hamilton Ralph W. Shrader, Chairman & CEO U.S. 3 300 54% 1 767 29 Bechtel Group (DoD contract) Riley Bechtel, Chairman & CEO U.S. 17 400 10% 1 742 30 (SAGEM +Snecma) = Safran Grégoire Olivier, Chairman & CEO France 4 871 33% 1 584 31 Electronic Data Systems (DoD contract) Michael H. Jordan, Chairman & CEO U.S. 20 669 7% 1 538 32 Rockwell Collins Clayton M. Jones, Chairman, Pdt, & CEO U.S. 2 604 59% 1 535 33 Textron Lewis B. Campbell, Chairman, Pdt & CEO U.S. 10 242 15% 1 500 34 Aviation Holding Company Sukhoi Mikhail Pogosyan, Director Russia 1 499 98% 1 469 35 URS Martin M. Koffel, Chairman & CEO U.S. 3 300 44% 1 460 36 Harris Howard L. Lance, Chairman & CEO U.S. 2 517 57% 1 445 37 Goodrich Marshall O. Larsen, Chairman & CEO U.S. 4 700 30% 1 400 38 QinetiQ Sir John Chisolm, CEO U.K. 1 639 85% 1 399 39 Israel Aircraft Industries Moshe Keret, Pdt & CEO Israel 2 056 67% 1 379 40 Kawasaki Heavy Industries Masamoto Tazaki, Pdt & CEO Japan 11 548 12% 1 329 41 DRS Technologies Mark S. Newman, Chairman & CEO U.S. 1 309 96% 1 258 42 Smiths Group Keith Butler-Wheelhouse, CEO U.K. 4 972 25% 1 243 43 Anteon Joseph Kampf, Pdt & CEO U.S. 1 268 89% 1 125 44 Washington Group International Stephen G. Hanks, Pdt & CEO U.S. 2 915 38% 1 110 45 RUAG Konrad Peter, Chairman Switzerland 1 692 64% 1 083

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2004 Defense Revenue Rank Company Leaders Country Sales 2004 % Defence * 46 VT Group Paul Lester, CEO U.K. 1 398 75% 1 048 47 ThyssenKrupp Ekkehard Schulz, CEO Germany 53 621 2% 1 029 48 Mitsubishi Electric Tamotsu Nomakuchi, Pdt & CEO Japan 31 721 3% 960 49 Cobham Allen Cook, CEO U.K. 1 894 50% 947 50 Almaz-Antei Vladislav Menschikov, Director Russia 1 327 70% 929 Ashok K. Baweja, Chairman & Managing 51 Hindustan Aeronautics India 1 020 90% 918 Director 52 OshKosh Truck Robert G. Bohn, Chairman & CEO U.S. 2 700 34% 905 53 Singapore Technologies Engineering Tan Pheng Hock, Pdt & CEO Singapore 1 801 49% 883 54 Elbit Systems Joseph Ackerman, Pdt, CEO & Director Israel 940 93% 876 55 IZAR (now part of Navantia) Juan Pedro Gomez Jaen, Pdt Spain 1 528 56% 851 56 NEC Akinobu Kanasugi, Pdt Japan 45 155 2% 843 57 Engineered Support Systems Gerald A. Potthoff, Vice Chairman & CEO U.S. 884 94% 831 58 Krauss-Maffei Wegmann Manfred Bode, Chairman & CEO Germany 819 100% 819 59 GIAT Industries Luc Vigneron, Chairman & CEO France 805 100% 805 60 Rafael Armament Development Authority Yedidia Yaari, Pdt & General Manager Israel 800 100% 800 61 GKN Group Kevin Smith, CEO U.K. 7 917 10% 792 62 Diehl Stiftung Thomas Diehl, Pdt & CEO Germany 2 169 36% 781 63 ManTech International George J. Pedersen, Chairman & CEO U.S. 842 92% 773 64 CACI (DoD contract only) J.P. London, Chairman & CEO U.S. 1 145 67% 772 65 Babcock International Group Peter Rogers, CEO U.K. 1 428 53% 762 66 Irkut Oleg Demchenko, Director Russia 644 97% 625 67 Fincantieri Giuseppe Bono, CEO Italy 2 970 21% 615 68 Armor Holdings Warren B. Kanders, Chairman & CEO U.S. 980 62% 605 69 Ericsson Carl-Henric Svanberg, Pdt & CEO Sweden 1 650 36% 600 70 MITRE Martin C. Faga, Pdt & CEO U.S. 871 68% 592 71 Battelle Carl F. Kohrt, Pdt & CEO U.S. 2 900 20% 581 72 Korea Aerospace Industries Hae Joo Chung, Pdt & CEO S. Korea 626 89% 558 73 Stewart & Stevenson Services Max L. Lukens, Pdt & CEO U.S. 1 160 47% 549 74 Jacobs Engineering Group Noel G. Watson, Chairman & CEO U.S. 710 77% 544 75 ARINC John M. Belcher, Chairman & CEO U.S. 734 73% 532 76 The Aerospace Corp. William F. Ballhaus Jr., Pdt & CEO U.S. 615 85% 524 Y. Gopala Rao, Chairman & Managing 77 Bharat Electronics India 742 70% 519 Director 78 ADI Lucio Di Bartolomeo, Managing Director Australia 536 95% 512 79 Tenix Defence Robert Salteri, CEO Australia 762 65% 495 80 EDO James M. Smith, Chairman & CEO U.S. 536 91% 489 81 Kongsberg Gruppen Jan Erik Korssjoen, CEO Norway 1 000 48% 478 82 Ultra Electronics Douglas Caster, CEO U.K. 615 77% 473 83 Ishikawajima-Harima Heavy Industries Mototsugu Ito, Pdt & CEO Japan 10 128 5% 459 84 Cubic Walter J. Zable, Chairman & CEO U.S. 722 63% 453 85 Aerospace Equipment Sergei Bodrunov, Director Russia 583 76% 444 86 Teledyne Technologies Robert Mehrabian, Chairman & CEO U.S. 1 017 43% 437 87 Meggitt Terry Twigger, CEO U.K. 923 45% 415 88 RSK MiG Alexei Fyodorov, Director Russia 427 94% 403 89 Israel Military Industries Ltd. Ehud (Udi) Ganani, Pdt & CEO Israel 399 100% 399 90 BearingPoint Harry L. You, CEO U.S. 3 450 12% 399 91 Toshiba Atsutoshi Nishida, Pdt & CEO Japan 54 279 1% 386 92 CAE Robert E. Brown, Pdt & CEO Canada 811 47% 383 93 Embraer Maur’cio Novis Botelho, Pdt & CEO Brazil 3 440 11% 366 94 Orbital Sciences David W. Thompson, Chairman & CEO U.S. 676 54% 365 95 Patria Jorma Wiitakorpi, CEO Finland 400 90% 360 96 AAI Frederick M. Strader, Pdt & CEO U.S. 385 92% 355 97 Admiralteiskiye Verfi Vladimir Alexandrov, Director Russia 405 88% 354 98 Ufa MPO Yuri Puvstogarov, Director Russia 364 95% 346 99 Ball Corp. R. David Hoover, Chairman, Pdt & CEO U.S. 5 440 6% 345 100 Komatsu Masahiro Sakane, Pdt & CEO Japan 9 623 4% 323 101 Indra Sistemas Javier Monzon, CEO Spain 1 474 21% 314 Source: main ranking from Defense News, other information from CM CIC Securities 2004 : Revenue* M$: Currency conversions for non-U.S. firms calculated using prevailing rates at the end of each firm's fiscal year. For Russia: Defence revenue provided by Center for Analysis of Strategies & Techno., Moscow; Japan: Defence revenue reflects Japan Defence Agency contract awards

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Top 100 summary By location Sales 2004 % Defence 2004 Defence Revenue * o/w US 392 254 50% 196 543 66% o/w European countries 229 278 35% 80 199 27% o/w Japan 178 155 4% 6 494 2% o/w Russia 5 249 87% 4 570 2% o/w Israel 4 195 82% 3 454 1% o/w India 1 762 82% 1 437 0% o/w others 19 361 26% 4 957 2% Total 828 492 36% 296 217 100% Source: CM CIC Securities

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Corruption – inevitable or avoidable?

The aero-defence sector and in particular, arms and defence-related procurement activities, are widely perceived as being amongst the most corrupt on the planet. According to Transparency International (TI) – the pre-eminent stakeholder organisation on bribery and corruption – the arms and defence industry was considered the second most likely to be involved in bribery and corruption of all industries ranked in the 1999 and the 2002 TI Bribe Payers Index.

The perceptions of corruption in the industry are further exacerbated by its inextricable ties to States – with TI Indices clearly identifying governments and political bodies as the most corrupted structures (perception-wise). Crossing the two perceptions raises serious issues for investors as to whether corruption is a peripheral, add-on or is central to defence procurement decision-making and whether such corruption has material impacts on companies in the sector.

2002 TI Bribe Payers Index Among the business sectors mentioned previously, which are the two sectors where the biggest bribes are likely to be paid? 2002 Sector Corruption perception Sector Corruption perception Public works/construction 46% IT 6% Arms and defence 38% Forestry 5% Oil and gas 21% Mining 5% Banking and finance 15% Transportation/storage 5% Real estate/property 11% Heavy manufacturing 4% Pharmaceutical/medicare 10% Agriculture 3% Power generation/transm, 10% Fishery 3% Telecoms 9% Civilian aerospace 2% Source: Transparency International. The results reflect the percentage of respondents who mentioned the particular sector.

Vulnerability of defence activities to corruption

On many levels, the arms trade shares many of the typical features of international commerce, which is of course vulnerable to a certain degree of corruption.

ƒ Rise of the arms trade

The association of the industry with corruption is inextricably linked with the beginning of the international arms trade in the 1960’s. The period marked a crucial turning point where the governments of western arms producing countries – who then owned and controlled much defence manufacture – adopted pro-active commercial sales to foreign nations. Arms then became a commodity, eventually becoming subject to the vagaries of the market system, including its frequent weaknesses such as corruption.

UK & US adopt used cars sales tactics

In 1961-2, the Kennedy government established the International Logistics Network (ILN) – an organisation within the DoD – responsible for conducting the sale of military items on the international market. Guided by the fertile mind and strong business sense of then Secretary of Defence Robert McNamara, the ILN marked a clear shift towards commercial military sales: “The facts are that he took what was previously a vaguely articulated sales policy (co-

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Business as usual production) and changed it into a dynamic sales effort—an effort that in retrospect has been not too far removed from what the Secretary might have demanded at an earlier time of his Ford Motor Company salesmen.” (Source: Thayer)

The Harold Wilson government in the UK followed suit shortly thereafter, hiring former British Leyland (then a leading automaker) head Sir Donald Stokes, who adopted commercial sales techniques to develop an export strategy for the national arms industry. Stokes – over 40 years ago and before the arms trade had even got off the ground – made some of the clearest statements on corruption in the industry to date, reporting to the government that “a great many arms sales were made not because anyone wants the arms, but because of the commission involved en route." (Source: Roeber)

ƒ Specific corruption risks for the sector

Above and beyond the industry’s exposure to corruption-risks associated with its commercial orientation, arms and defence procurement in particular – is exposed to a much greater degree of corruption risks because of a number of the unique facets of the industry. Many believe that it is an industry “hard-wired” for corruption (Source: Transparency International, TI et al.):

• Necessary & unnecessary secrecy – Many aspects of defence are clearly matters of national and/or regional security, and thus must be dealt with in a highly confidential way. Confidentiality is necessary, but any confidentiality requirement(s) increases the potential risk of corruption. This may be exacerbated by an often exaggerated and unnecessary risk of secrecy, which further reduces transparency and increases corruption risks

• “Security” requirements which are open to manipulation – National security interests mean that importing countries can claim security justification for purchasing almost any item at any price. Similarly, those directing technical specification or technical evaluation teams can make specific requirements on the basis of irrefutable “military needs”;

• Complex web of sub-contractors – Most large defence contracts involve a complex web of subcontractors which has the potential effect of reducing awareness of the underlying agreement (as well as its usual anti-corruption clauses) – and increasing the risk of hiding commissions and/or exchanging of “favours” via subcontractors;

• Complexity of contracts & products – The complexity and long duration of defence contracts makes corrupt payments difficult to detect (at least at an early stage). Such complexity can also be deliberately encouraged, making price comparisons harder to make – increasing the risk of corrupt overcharging;

• Use of agents – The use of agents is all-pervasive in defence contracting and may actually be increasing post-OECD Convention. While using them may be a source of competitive advantage, neither their contracts nor remuneration are disclosed. They also serve as a potential screen against which the principal defence company can hide;

• Nature of military decision making – Defence officials respect hierarchy and in the technical aspects of tenders, lower level officers will usually strictly follow the guidance of their superiors – creating potential risks if the senior officer(s) are in any way implicated in corruption;

• Old boy’s network –.This is a central feature of the aero-defence industry with former government and defence/military officials frequently working for sector players at senior management levels. Whilst this phenomenon has the advantage of promoting sector experience within companies – and is sometimes subject to no-contact periods – it also significantly increases the risk of conflicts of interest and corruption (see also corporate governance – links of directors to government);

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• Promotion of national champions – For countries or regions with aero-defence “champions”, there is a potentially higher risk of corruption depending on how far the respective home government(s) including top-level Ministers and leaders are willing to go to promote their home company for national and overseas contracts – particularly if such “aid” becomes unduly preferential to the home company. This is partly inevitable given that defence contracts are always for governments and often between governments;

• Enormous post-contract support requirements – Such clauses can be as much as 10x the value of capital purchases (using life cycle costing) – meaning that the capital items can be treated as loss leaders. Thus, not only will capital cost evaluation yield the wrong answer, but it offers great scope for corrupt payments for support and maintenance equipment;

• Pressure to land increasingly scarce contracts – Such pressure raises the potential for abuse in middle management ranks across the industry. There is tremendous pressure on 3rd and 4th tier managers to perform well and the all-pervading “must win” philosophy engendered by a paucity of new programmes and contracts can encourage “at any cost” behaviour;

• Lack of disclosure on budget funding – In many arms-buying countries, the defence budget is not disclosed to the national legislature, government or stakeholders. Such secrecy not only significantly increases the potential for corruption in defence procurement in such countries but may have serious negative impacts on already teetering socio- economic equilibriums in such countries;

• Use of offsets – Offsets are additional contracts that the defence contractor enters into on top of the specific bid. They are of two types: direct offsets, in which the contractor agrees to manufacture equipment in the country, or to procure support services in the country; and indirect offsets, in which the manufacturer agrees to establish new businesses in the country. This is the product of a buyers’ market, where the importing country believes it can secure additional jobs as part of the defence purchase. They are very common in large defence deals and can be as large as the main deal itself. The offset terms can make or break a deal and offer multiple opportunities for corruption.

Levelling the playing field with dominant US players

The fact that the US accounts for well over 40% of arms exports to developing countries is a major political advantage for US companies. The fact that US companies have long been more constrained than European companies vis-à-vis corruption – owing to the long-standing criminalisation of bribery of foreign officials in the 1977 Foreign Corrupt Practices Act (FCPA – see below) – may also play a role in facilitating non-US players to try to level the playing field with non-price, non-performance competition - corruption.

Annual US lobbying by sector players (in USD) 1998 1999 2000 2001 2002 2003 2004 ‘98-‘04 Rank (USA) BAE Systems 0.6 0.7 0.6 0.9 1.6 1.6 1.4 7.4 270 Boeing 8.4 8.2 7.8 7.3 8.3 8.0 8.2 57.3 15 Dassault NA NA NA NA NA NA NA NA NA EADS 0 0.1 0.2 0.2 0 0 0 0.4 3,555 Finmeccanica* NA 0.8 1.1 1.5 1.5 1.6 1.2 8.0 NA Lockheed 9.1 8.9 10.6 6.7 6.3 6.6 7.3 55.4 16 Raytheon 1.7 1.8 2.3 2.9 3.4 3.3 4.4 19.7 95 Rolls Royce 0.4 0.4 0.3 0.2 0.4 0.4 0.7 2.8 660 Safran** 0.2 0.2 0.3 0.2 0.2 0.2 0.3 1.5 NA Thales*** 0.2 0.7 1.4 1.5 1.2 1.4 1.1 7.4 NA United Tech. 4.4 4.7 3.0 3.9 3.3 3.5 4.0 26.6 68 Source: The Center for Public Integrity. Figures are based on Senate Office of Public Record Findings. * Data includes Arianespace and Bell/Augusta Aerospace Co. ** Data includes Snecma USA and Sagem Morpho. *** Data includes Arianespace and Thales Inc

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Measuring the extent of corruption in the industry

The industry’s share of corruption is considered far greater than its share of trade. The most relevant publicly disclosed data in this regard come from the compliance department of the US Department of Commerce, which collects reports of corruption as part of its monitoring efforts under the OECD convention. According to its annual report on compliance, more than 50% of the total bribe offers reported to it (294 contracts valued at USD 145 billion) between 1994-9 were for defence contracts. This is despite the fact that such contracts account for only 0.5% to 1% of world trade! Although our focus on corruption is largely on defence-related activities, it is also important to point out that the US State department also regards civil aviation as one of the five “most corrupt” international trades.

ƒ National government reports – too opaque & secret to be useful

One reliable potential indicator of the extent of corruption in defence procurement contracts and defence companies lie in government reports – such as those of national intelligence agencies and audit offices – which are often (conveniently) confidential.

UK National Audit Office (NAO)’s Al Yamamah report

The NAO report, commissioned in 1989, investigated alleged huge commissions paid to Saudis as part of the huge Al Yamamah arms deal with Saudi Arabia, worth over £20 billion. Under the deal, which revived the fortunes of then moribund BAE Systems, the company equips trains and organises the Saudi air force in return for payment in oil. The NAO inquiry was completed in 1992 but has never been published, contrary to common practice, and has been suppressed by both Conservative and Labour governments – many think because of the fact that it reveals commissions which would be embarrassing for the UK, Saudi Royals and BAE.

However, from a strict materiality perspective, the alleged illicit payments of £50 million barely register against a multi-billion pounds sterling contract which also brings in £2 billion in post- contracts servicing – many mainstream financial players would be hard pressed to regard such payments as “working capital.”

ƒ Industry insiders – corruption is all-pervasive & significant

Any attempt to measure the extent of corruption in the industry is largely reliant on unproved allegations made by former government, defence, company and industry outsiders. While companies in the sector will vehemently deny such allegations – and there is always the inherent danger that such allegations are made for personal or destabilisation purposes (especially allegations made by former company insiders) – they remain the closest thing we have to a bottom line estimates of the extent of corruption in the industry:

• Former US Deputy Assistant Secretary of State allegations – Jonathan M Winer, is on record as stating that in the arms trade, “Everybody takes bribes from everybody, and if not bribes, then gratuities, benefits, undue advantage, commissions, contracts for friends and relations, other benefits material or political, and so on."

• Former Russian defence minister – said in 2004 that arms deals in many countries were possible "only when handing over some kind of commission to the buyer"

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• Senior marketing manager of a major defence company allegations – that in 20 years of selling arms, only twice did he not pay a commission to the buyer.

A frequently-cited industry insider rule of thumb is that bribes in the international arms industry account or amount to 10% of total defence procurement – which does not include the cost of the arms that would not have been bought without corruption.

The Serge Dassault affair tells all

In the 1990’s a Groupe Industrielle Marcel Dassault (GIMD) Belgian subsidiary was investigated for paying a bribe to the Socialist party of Belgium to secure a contract for upgrading F-16s. At the judicial investigation of Serge Dassault – then Chairman & CEO and today Honourary Chairman of the company – he stated that "everyone pays commissions" when military contracts are awarded. The French government obviously agreed. When the Belgian courts issued a warrant for Dassault's arrest, the French Minister of Foreign Trade protested that commissions are a normal part of business in the industry – aides naturelles – and had been organised in that manner for decades. Although Dassault was ultimately let off on legal and jurisdictional grounds, Dassault’s admission and the French government’s reaction are revealing as to the pervasiveness of corruption in the sector.

Thales executive’s recent allegations – up to 2% of group revenues

Michel Josserand, a former senior executive of Thales Engineering & Consulting (THEC) recently accused the company of widespread corruption in negotiating domestic and export contracts. His allegations, some of the most potentially damaging in the industry to date, were made in a September 26th 2005 Le Monde interview where he stated that corruption at Thales was equivalent to 1-2% of the group’s total revenues of €10 billion for 2004. Josserand also alleged that Thales was "only following the practices of the major U.S. companies" and would have been excluded from markets if it had not paid out bribes.

We note that Thales has and continues to reiterate its formal denial “to [the] false and damaging allegations” and is currently taking legal action against both Le Monde and Josserand; Josserand was dismissed by Thales for irregularities committed as part of a contract for the Nice tramway (for which the company itself lodged a corruption complaint).

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Some allegations raised over ethical behaviour in the sector COMPANY Allegation(s) Possible Impact(s) / Outcome(s) BAE ƒ Secret payments of £1m to Chile’s General ƒ SFO (Serious Fraud Office) investigation is likely – possible Augusto Pinochet via a British Virgin Islands circumvention of laws on corruption & money-laundering company(1997-2004) ƒ £60m slush fund to members of Saudi Araba’s ƒ Major SFO & Ministry of Defence inquiry is under way at royal family, politicians & officials, to secure BAE and vis-à-vis ex-employees and consultants – money contracts laundering, false accounting ƒ Possible loss of Saudi contracts if members of the very private royal family are directly implicated ƒ Short-term share price impact of -£300M ƒ £16.5m paid to daughter of Indonesia’s former President Suharto to secure a £160m tank contracts (for Alvis) Boeing ƒ Unlawfully took proprietary documents from ƒ 3 Boeing employees investigated – on-going investigation; Lockheed in connection with the EELV Space Boeing suspended from eligibility for future space-related Launch competition contracts; 7 launch awards worth USD 1 billion terminated & unable to compete for future launches (July 2003) Dassault ƒ Bribes paid to Belgian political leaders & then ƒ Serge Dassault found guilty of corruption by Belgium’s NATO Secretary general Willy Claes to secure a highest court & was given a 2-year suspended sentence; contract for upgrading F-16s (1998) ECHR ruled in 2004 that the Belgian court did not have jurisdiction EADS ƒ Alleged bribes of SGD500K paid to a ƒ EADS cleared of any involvement (2005) Singaporean government defence official for information on tender bids in a defence ministry contract for naval helicopters. ƒ Airbus has called for an anti-corruption inquiry ƒ No inquiry launched (to date) into Air India’s Boeing order, citing concerns over the fairness and transparency of the deal Lockheed ƒ Lockheed Corp. paid USD1M bribe to an Egyptian ƒ Export licences for the aircraft were suspended; USD21.9M Parliamentarian to secure military cargo planes sale fine & USD3M in civil penalties imposed; 1 executive fined (mid-1990s) USD20K & given probation while another VP was fined USD125K & sentenced to 18 months in jail ƒ Korean company suing Lockheed for USD30M ƒ Being sued under the FPCA in the US; Korean company lost claiming its client lost USD 225M aircraft radar 1st claim but California Supreme Court said it could claim for contract because a Lockheed trade agent “intentional interference”; related case under way in Canada influenced South Korean government decision (where the client was based) makers with bribes & sexual favours ƒ Exporting controlled materials to South Korea ƒ Fined without valid export licences Raytheon ƒ Attempting to export troposcatter communications ƒ Complaint dismissed after a Settlement Agreement by which equipment to Pakistan (1990 through 1997) in it paid USD20M to the US Customs Service in lieu of forfeiture, violation of export control laws USD3M to the Department of State as a civil penalty and invested USD2M in upgrading export control compliance programmes Rolls ƒ Subsidiary (Parsons Power Generation) accused ƒ Case under way in Indian courts Royce of paying £15m to a Virgin islands based company controlled by the MD of Spectrum Power, the power station company for which they were bidding for a contract in India (mid-1990s) Safran ƒ Nigeria’s President Obasanjo claimed Sagem ƒ Obasanjo has asked French authorities to investigate 2 un- executives paid bribes to win USD314M national named executives; 3 Nigerian ex-ministers indicted identity card contract (2003) Thales ƒ Former head of Thales Engineering & Consulting ƒ Company is planning to sue Le Monde for defamation; accused the company (2005) of widespread Thales says the executive was fired for “irregularities”; the corruption in negotiating domestic & export executive has since joined EADS, which is considering his contracts – equivalent of €10B or 1-2% of annual dismissal. Company is facing two initial inquires by public sales prosecutors into alleged corruption in contract wins in Argentina, Cambodia, France & Greece (to determine the need for formal judicial investigation) ƒ Corrupt dealing in award of 4 corvettes (Rand ƒ South African businessman is suing the government for 1.3B deal) Rand 150M United ƒ Former employee claimed UT subsidiary fired him ƒ Civil case was settled out of court in 1993 Tech. for disclosing bribes to Saudi royals to secure a - No violation of the FCPA was found contract Source: CM-CIC Securities / ESN estimates, Company documents, Government sources, Press sources

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International efforts to tackle bribery & corruption

It has only been over the course of the last decade that we have seen a major concerted effort to clamp down on corruption at the international level. While we have seen a number of international, regional and national initiatives, they are focused on corruption across all sectors, rather then specifically addressing the elevated risks and high levels of corruption in the arms trade.

ƒ OECD Anti-Bribery Convention – an important breakthrough….

The OECD Anti-Bribery Convention (OECD Convention Against Bribery of Foreign Public Officials in International Business Transactions) aims at reducing corruption in developing countries by sanctioning bribery carried out by companies based in OECD member states. Its key impact is to criminalise the bribery of foreign officials to obtain or retain business. It came into effect in February 1999 and has been ratified by 36 states (as at 24 November 2005 – see Annex). Countries that have signed the Convention are required to put in place legislation that criminalises the act of bribing a foreign public official. Most countries – including all EU countries and the US – enacted national laws prohibiting foreign bribery in 1999 and 2000 (see Annex for OECD Convention ratification status).

… But more bark than bite

The convention is undoubtedly one of the greatest international breakthroughs on corruption to date. However, its tangible impact is significantly weakened because it relies on member governments to bring cases to court – inherently difficulty given the web of conflicts of interest with companies. The lack of monitoring mechanisms, independent body to bring cases and tangible cases all point to the lack of political will by OECD countries to give the convention the bite it needs to be effective. In the six to seven years that it has been in effect (nationally), there has been a near absolute paucity of prosecutions. The most common explanation given is that foreign bribery cases are difficult to prepare – bribe payers go to great lengths to cover their tracks; and investigations must be conducted in the home country of the bribe payer, the country whose officials were bribed and third countries where the bribe money may have been deposited, or through whose banks the funds may have been laundered.

ƒ The UN Convention against Convention – big players haven’t ratified

The Convention was adopted by the UN General Assembly by resolution 58/4 of 31 October 2003 as many countries felt the need for a comprehensive international instrument against corruption. It is an important milestone in this regard and includes measures on prevention, criminalisation, international cooperation and asset recovery. While the treaty entered into force on 14 December, 2005, following the 30th ratification – at January 2006, there were only 39 state parties (and 140 signatories). More critically, except for France and to a lesser degree South Africa, none of the world’s major arms exporters are state parties.

ƒ EU Code of Conduct on Arms Exports – strong but not strong enough

The EU Code of Conduct which was adopted in June 1998 can be considered the most sophisticated export control regime currently in existence. The Code sets out a number of conditions under which the denial of a licence is obligatory – including:

• Contradiction of international commitments, (i.e. UN embargo or treaty)

• Existence of “a clear risk that the proposed export might be used for internal repression”

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• Export which would “provoke or prolong armed conflicts or aggravate existing tensions or conflicts in the country of final destination”; and

• Existence of a clear risk that the export would be used “aggressively against another country or to assert by force a territorial claim”.

Corruption – implicit rather explicit

However, efforts to push member states to integrate a dedicated anti-corruption criterion have so far been unsuccessful. Rather, it has been suggested that corruption is one factor to be taken into account in the interpretation of other criteria - notably criterion 8 which states that:

“The compatibility of arms exports with the technical and economic capacity of the recipient country, taking into account the desirability that states should achieve their legitimate needs of security and defence with the least diversion for armaments of human and economic resources. Member States will take into account, in light of information from relevant sources such as the UNDP, World Bank, IMF and OECD reports, whether the proposed export would seriously hamper the sustainable development of the recipient country. They will consider in this context the recipient country’s relative levels of military and social expenditure, taking into account also any EU or bilateral aid”

Practically speaking, the provision is too loosely worded and open to interpretation to make any serious dent into corruption in the arms trade. A number of member states have even declared that they are unsure of how to apply criterion 8. This has prompted the UK government to elaborate a shared understanding on the criterion – a process which is currently underway. While this would be a positive development, it would still far well short of an explicit provision on corruption.

ƒ National laws addressing arms-related consumption – few & far between

Anti-corruption measures targeting the defence industry are few and far between, and where they do exist – tend to be less than comprehensive (ex-the US FCPA – see below):

• Germany – under the 1998 Directive Concerning the Prevention of Corruption in the Federal Administration, certain areas where there is a high risk of corrupt practices occurring, such as in the case of the procuring or the issuing of licences for the export of military equipment, are subject to random internal reviews and secondary checks conducted by anti-corruption units, such as from within the General Audit Office;

• Italy – Article 12 of Presidential decree 454/1987 concerning Provisions on Currency, focuses specifically on “Money transfers to which specific cautionary measures apply” which includes cases where brokering is used to aid the export and import of arms. This law sets out the criteria that would have to be met for a brokerage payment to be valid and legal (Source: Miller & Ibister).

• UK – the new Anti-Terrorism, Crime and Security Act, introduced in order to provide stronger powers to allow the Police to investigate and prevent terrorist activity and other serious crime, strengthens the law relating to international corruption to include bribery of foreign public officials and makes it an offence for any UK national to perform acts abroad which would amount to corruption if committed in England

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ƒ US Foreign Corrupt Practices Act – the most stringent legal provision

The US’ Foreign Corrupt Practices Act (1977) is one of the pioneering regulations in the field and remains the most stringent legal provision in place helping to minimise the risk of bribery and corruption for US companies. In addition to civil penalties, the Act’s anti-bribery provisions criminalise any payment or offer of anything of value to a foreign official, political party official, candidate for public office or any intermediary for the purpose of obtaining or retaining business.

Accounting provisions – a major business difference

The FCPA also bars issuers from misrepresenting payments on their books and records and thus, potentially concealing bribes. The Act imposes a number of requirements vis-à-vis a company's accounting and internal controls system including that they must be able to provide "reasonable assurances" that: transactions are executed in accordance with management's authorisation (i.e. the "level of detail and degree of assurance as would satisfy prudent officials in the conduct of their own affairs"); and that no one shall knowingly circumvent or fail to implement internal accounting controls or falsify any book or record that shows the company's transactions and assets. The FCPA provisions, therefore, clearly indicate that a firm's accounting records must be accurate and that a strong system of internal controls must exist – with the provisions since strengthened by Sarbanes-Oxley.

Without doubt – the biggest anti-corruption success story to date

The Act has been almost alone in successfully deterring corrupt business practices for the very simple reason that it has a very strong “bite.” With penalties of up to USD 2 million for every single instance of bribery – no matter how small – the Act often has the simple effect of ensuring that bribes are not a cost-effective means of doing business, especially given that they are often paid in instalments over time. Additional potential sanctions of imprisonment for bribers and their supervisors also play an important deterrent role. But from a pure business perspective, the ultimate deterrent lies in the potential sanction of debarment from government procurement or export privileges – a huge, direct hit on the bottom line.

The fundamental difference with many other pieces of regulation is that since its passage and particularly in the last 10 years, the US Justice Department has demonstrated its commitment to enforcement time and time again – and the penalties it has imposed (as well as the indirect impacts) have far outweighed the “rewards” involved (see further below – Impacts of Corruption).

Competitive disadvantage for the US & advantage for the Europeans

The tangible impact for US companies has been quite simply – a reduction in bribery and corruption in defence procurement. However, this has had somewhat perverse results vis-à- vis foreign competitors – perverse results being something of a commonplace occurrence in the sector. As the US is the only major aero-defence exporter to ban companies from bribing foreign officials to win business, business has sometimes been lost to foreign competitors who are willing to pay the price of such payments – literally and figuratively. Some argue that the FCPA has made it more difficult for US companies to do business abroad by reducing a potential area of competitive advantage.

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ƒ Export credit agencies & controls – largely unrealised potential

Most major arms exporting countries operate arms export credit agencies (ECAs), which help in arranging finance packages for buyers of domestic goods by guaranteeing bank loans and provide insurance for domestic investors or exporters against non-payment resulting from political risks, instability and contractual problems. As taxpayer funded bodies, there is a strong push from stakeholders to ensure that ECA money is not used to support transactions tainted by bribery and corruption and moreover, than an undue and unnecessary burden is not placed on exporters and banks.

However, at the end of the day – their practical impact in the fight against corruption is limited. This is partly because of the administrative nature of export licensing processes, which typically involves judgements based on a balance of risks – providing ECA’s with an over- generous margin for manoeuvre in terms of interpretation. Moreover, ultimately, ECAs remain inextricably linked to their home State – which as omnipresent stakeholder – means that battling corruption is only one of a number of other priorities, the most fundamental of which remains ensuring lucrative defence procurement contracts.

OECD Action Statement on Bribery & ECAs

The international instrument specifically aimed at ECAs is the OECD Action Statement on Bribery and Officially Supported Export Credits (2003). This requires OECD members to take appropriate measures to deter bribery in officially supported export credits and where bribery is involved in the award of an export contract to take appropriate action including:

• Informing Applicants of the legal consequences of bribery; • Inviting Applicants to provide undertakings or declarations that neither they, nor anyone acting on their behalf has engaged, or will engage, in bribery in relation to the relevant transaction; • Ensuring that the Applicant and other parties receiving ECA support remain fully responsible for the proper description of the supported transaction, the transparency of all payments and complying with all applicable laws; • Refusing to approve credit cover or other support in cases where there is sufficient evidence that bribery has been involved in the award of an export contract if export credit cover or other support has been approved and bribery is subsequently proved to have occurred in relation to the supported contract, the relevant ECA taking appropriate action such as denial of payment under the export credit, refund of any funds provided and/or the referral of evidence to the appropriate national authorities

UK’s Export Credits Guarantee Department (ECGD)

The ECGD’s position on bribery, corruption and money laundering is relatively typical of most ECAs – to do all it reasonably can to avoid taxpayer’s money being used to support transactions tainted with bribery and corruption, and to support wider efforts to deter these practices. Its specific anti-corruption efforts are focused on ensuring that all of its transactions comply with a number of national, regional and international laws and standards – UK law, OECD agreements (Convention on Combating Bribery, Action Statement on Bribery, Guidelines for MNEs), UN agreements (Declaration Against Corruption, Convention Against Corruption) and the Council of Europe Conventions on Corruption.

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Key aspects of ECGD's anti-bribery and corruption procedures - to remind applicants of their legal obligations and that ECGDS will refer all allegation of bribery, corruption or money laundering to the appropriate authorities - to obtain information to ensure that no improper payments involving agents been made - to inspect, if necessary, exporters' documents relating to winning contracts and making payments to agents - to require applicants to provide copies of their codes of conduct and to declare that they have applied them or their equivalents - to require declarations that neither applicants themselves (including directors and employees) nor any subsidiary have been engaged in any form of bribery, corruption or money laundering Source: ECGD

Industry succeeds in watering the rules down

To date, industry has played a major role in the public consultations on proposed amendments to ECAs to ensure that anti-corruption provisions are watered down. A case in point is the ECGD, where the UK government has never fully followed through on proposed changes – widely supported by many politicians, stakeholders and some major institutional investors such as F&C Asset Management amongst others – which would have forced UK exporters to be more transparent about their dealings with controversial contracts and governments. Players such as the Confederation of British Industry (CBI) as well as Airbus (EADS), BAE and Rolls Royce have repeatedly lobbied against certain provisions such as those which would require them to identify agents to whom they make a “secret payments.” Their lobbying efforts are not surprisingly, based on the argument that such changes would hinder companies doing legitimate exports as well as exposing directors to legal action.

Stakeholders continue to push ECAs… with limited results

There has been a continued strong push by organisation such as TI for ECAs – France’s Coface, Germany’s Hermes, the UK’s Export Credits Guarantee Department (ECGD) and the US’s Export-Import Bank (Ex-Im) – to adopt a more pro-active approach to fighting corruption. However, to date such ideas have proved unpopular among those states exporting arms and defence materials:

• Including an examination of the risk that a deal may be corrupt as part of the licensing process, along with procedures to be followed in the event that corruption is exposed after the deal has been agreed;

• the award of a licence should be conditional on the exporter presenting “contract specific no-bribery warranties” and that these should be supported by evidence that the exporters have adequate internal systems to both detect `corruption-risk` and prevent the payment of bribes;

• include a specific written guarantee from the buyer that the deal was “corruption free”, much as many exporters require that the buyer supply some explanation of intended end use (Source: Miller & Ibister).

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ƒ The corporate response – robust but imperfect management systems

The company response to bribery and corruption in the sector has, as is the case with many extra-financial issues – to develop management systems in the forms of codes and policies and compliance programmes. According to Dominique Lamoureux, Secretary General of Thales – one of the European companies who has probably gone the longest way in this regard:

Adopting an ethical approach gives a company a competitive edge by, for example, reducing the risk of sanctions and enhancing a company’s image and reputation. It can also strengthen company identity and staff motivation. Structures and procedures to guarantee strict compliance with the law include effective monitoring, audit mechanisms and sanctions. Structures and procedures to guarantee high standards include a code of ethics or conduct. Explicit commitment from management is essential, with no cosmetic buzz-words, to move from company ethics to an ethical company.

Evaluation of company codes – US over Europe

On the face of it, is very difficult to arrive at any fundamental differentiation between the different management systems. However, the most comprehensive comparison of company codes of conduct to date was undertaken as part of TI’s Preventing Corruption in the Official Arms Trade (PCOAT) project.

Comparison of US and European defence company codes of conduct US Europe Boeing BAE Systems General Dynamics EADS GE Ericsson Lockheed Martin Rolls Royce Northrop Grumman Saab Raytheon Thales United Technologies Dassault NA at time of comparison

The project found that US Codes are somewhat more stringent than European ones – even if they all leave something to be desired:

• US codes are more compliance (rather than value) driven, particularly influenced by the Sarbanes-Oxley Act and the SEC. In the US, codes are taken very seriously and it is possible to have a fine reduced by up to 90% if a company has such guidelines in place;

• US codes are more developed and detailed about anti-bribery practices than European codes (with the notable exception of Thales);

• US codes tend to be couched in legal style (i.e. less user friendly) while European codes concentrate on providing guidance and are written in managerial form;

• The codes were not embedded in the culture of their organisations – this was missing from both US & European codes. Training, feedback and auditing are also conspicuous by their absence. Whistleblowing and disclosure of relevant information is mentioned in almost all codes, but US companies are more rigorous than European ones. All codes fell short on detail.

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Overview of main differences between US and European codes Issue US Codes European codes Bribery/corruption - Refer to legal compliance (FCPA, OECD) - Focus on strong ethical statements (vs. law) - Distinction: bribery & corruption (Nothrop, Raytheon) - Most UK companies have not amended codes post- Anti-Terrorism Act Conflicts of Interest - US codes are more rigorous & detailed - Most codes address the issue Gifts - Specific regulations on level & value of acceptable gifts - Most codes address the issue (Lockheed, UT) Agents/commissions - Most prescribe compliance with company standards or legal - Most do not specifically refer to agent/commission regulations issues - Duty of due diligence (GE)

ƒ Integrity pacts – the new kid on the block

Integrity pacts – a TI-sponsored multi-stakeholder initiative – are project-by-project agreements between governments and the contractors or suppliers of goods and services as well as intermediaries, aimed at excluding corruption in procurement. Under the pact:

• All parties make anti-bribery pledges – an important development, given that most existing initiatives do not put pressure on those soliciting the bribes (i.e. governments of importing companies)

• Bidders commit to enhanced disclosure and independent monitoring with the monitor reviewing all documentation to ensure compliance with the pact

• There is also a threat of sanction – exclusion from the bid – if there is reasonable evidence of non-compliance with the pact.

Integrity pacts have been in use in 14 countries (outside of the aero-defence sector) for close to a decade and the feedback TI has received to date has been extremely positive – including that they stimulate companies to be more pro-active against corruption and that they help to reduce the cost of contracts.

Main elements of an integrity pact i) Pledge and undertakings by the bidders not to offer or accept any bribe or other improper advantage, nor to influence unduly the function of the independent assessor, nor to collude. It commits to applying the pact by its staff, consultants, parent organisation, subcontractors, agents, venture partners and suppliers. It will maintain and enforce a written anti-bribery policy applicable to its business. ii) Bidder will disclose to the government procurement department the details of any agent used, the amount of any payments before and after the award of the contract, and a schedule of the services being provided. iii) Pledge and undertakings by the government, their consultants and advisers (see pledge by bidders (i)) iv) Appointment of a suitably qualified and experienced independent monitor or monitoring team. Access by the monitor to all meetings and unrestricted access to all material documents and records is agreed by all parties. v) Publication of the statement of requirements, the bidding documents, evaluation criteria and all related clarifications; the bidders’ proposals; evaluation criteria and the detailed results of the evaluations vi) Public hearings for discussions of the bid. vii) Arbitration as an enforcement or conflict resolution mechanism (national or international) viii) Sanctions in the case of breach of the pledges (i.e. exclusion from the bidding process, damages and forfeiture of bonds; penalties, debarment, liquidated damages) ix) Applicable law. The IP is a contract which gives rise to enforceable rights and obligations. Source: TI

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Defence integrity pacts – getting off the ground

The pacts hold out great potential for application in the aero-defence sector. Although it is far too early to measure their impact, there has been take-up in Colombia and South Korea with the use of an “ombudsman” as an independent monitor in the latter. The biggest development to date has been the announcement of the Indian Defence Ministry that it plans to use the pacts for major defence procurement. This marks a major breakthrough for India which has long been plagued by arms corruption scandals (i.e. Bofors, Tehelka etc.) and an important precedent for other governments and companies.

ƒ TI – leading the way with companies & governments

Transparency International has been leading the way in the fight against bribery and corruption across a range of industry sectors such as through their multi-stakeholder Business Principles for Countering Bribery (2002). The Principles aim to provide a practical tool to which companies can look for a comprehensive reference to good practice to counter bribery. Although the Principles are ultimately limited by the tangible anti-corruption actions of companies, they serve as a useful starting point for companies and best practice benchmark.

Launch of TI’s defence initiative – a major step forward

In January 2004, TI received funding to launch a series of specific projects targeting corruption in the defence sector which focus on working with: i) Arms purchasing countries by applying Defence Integrity Pacts to defence procurement; ii) International defence companies to strengthen their compliance and tendering practices; and iii) Arms exporting governments so that they support the above initiatives

The projects have received significant support from governments as well as companies (see table below).

Governments & companies engaging in TI programmes to date Exporting Countries Importing Countries US Companies European Companies France Colombia Boeing BAE Systems Germany India General Dynamics Cobham Italy Latvia GE Transportation EADS Sweden Pakistan Honeywell Ericsson UK South Africa ITT Finmeccanica US South Korea Lockheed Martin MBDA Northrop Grumman Rolls Royce Raytheon Saab UTC Thales VT Group Source: Pyman & Wetterwik

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Global consortium for defence companies against corruption – the next big step

TI is hoping to further strengthen defence procurement through the creation of a consortium of international defence companies against corruption. TI’s push is based on a 3-fold argument – that purchasing countries want it; that it will level the playing field across global players and that the US defence market and DoD id very focused on good global behaviour by companies – the last point putting European companies at a disadvantage, even if it is only from a perception perspective. Such a consortium would impose possible minimum requirements such as: clear statements against corruption; standards for compliance programmes, due diligence, partners and training, amongst other issues; annual CEO sign-off; sharing of experiences – incidents, possible losses etc. with other members; and support by assurance mechanisms. Development work is currently under way for a possible launch in 2006.

Rationales for the creation of a global consortium

Purchasing Countries Want It Levelling of global playing field US defence focus / DoD Pressure • Reformist Ministers are asking for it • Level of commitment on entry • US DoD takes great interest in probity of its suppliers, worldwide • Governments are a mix of good & bad •Opportunity to raise standards across the • US perception of European companies and practices industry governments as passive on bribery • The Minister/ Ministry needs tools and levers • Opportunity for mutual understanding among • Perceptions, unfair or otherwise, impact on to assist anti-corruption reform companies that don’t otherwise talk US political process, eg ‘Buy American’ • Companies acting collectively are a powerful • Able to present a common minimum set of • US DoD takes great interest in probity of its force standards to purchaser suppliers, worldwide • Benefits both the companies • Opportunity to integrate new players • US DoD would welcome a global Consortium and government reform as a forum for feedback • Opportunities to develop professionalism • US perception of European companies among compliance officers in all companies

Impacts of corruption – a glass half full or half empty

ƒ Impact on countries – beyond doubt & tragic

We are in full agreement with many stakeholders that the impacts of corruption on countries – importing and exporting – are largely negative in terms of consequences. Moreover, we believe that the impacts of corruption on countries has a negative impact on aero-defence companies as corruption undermines the competitive principles of price, quantity and service on which the market depends – even if it is very “special” market that we are talking about (see also below - direct company impacts).

Importing countries – developing countries hit hardest

The negative impacts on importing countries are particularly acute for developing countries, which today account for upwards of 60% of the global trade in arms. The UK’s DFID (international development ministry) has calculated that 24 of the 40 poorest 40 countries in the world are troubled by armed conflict or have just emerged from it – the arms rarely being home-made. Corruption in defence procurement only hurts such countries by:

• Incentivising purchasers to increase the technical specifications and/or encourage the purchase of unnecessary systems;

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• Diverting valuable and often scant public resources to defence procurement when they could be better allocated for more pressing socio-economic development needs such as housing, education and schooling (i.e. Bangladesh, Pakistan etc.);

• Undermining public confidence in politicians and institutions and destabilising governments and democracy; and

• Exacerbate arms races, destabilise countries and regions, and/or prolong civil conflicts and wars (i.e. the Middle East, India-Pakistan etc.).

Exporting countries – diversion of resources & undermining of policy

For the by-and-large developed exporting countries, corruption is also a poison. Leaving aside moral and legal arguments, corruption:

• Misusing and diverting government funds (i.e. export credit guarantees, R&D tax breaks, direct and indirect subsidies etc) – with, for instance, an estimated €600-700 million p.a. being paid in bribes by the French export credit agency COFACE in the late 1990’s (Source: Le Monde, Amnesty, Transparency International); and

• Undermining good governance by conflicting with the more “ethical aspects” of government policy as well as confidence in public officials, governments and public accountability.

As a number of developing countries ramp up their arms exports – China, India, South Africa et al. – both sets of impacts described above (on importing and exporting countries) will converge.

ƒ Reputational impacts – image counts & costs!

Although, potential reputational damage to companies arising from corruption is often denigrated as being of low impact, an examination of corporate behaviour in the wake of relevant scandals shows that the potential impacts on profitability clearly are a concern (at least from the industry player perspective).

Lockheed Martin’s concerns over image

Lockheed Martin, America's biggest defence company (2nd only to Boeing which has a stronger civil business), is one example of a company that made a concerted effort to fight bribery and corruption and to be seen as squeaky clean after being involved in a string of bribery scandals in the 1970s and 1990s. "Nobody wants a contract that is going to sacrifice the reputation of our company," a Lockheed manager told a recent conference on bribes and the arms trade (see also below – Lockheed & FCPA ban, Lockheed & Titan M&A).

Thomson CSF becomes Thales

The French company Thomson-CSF actually changed its name to Thales after being involved in a 1991 bribery scandal in Taiwan which ended with the French Foreign Minister Roland Dumas being convicted of corruption. The controversy began when Taiwan’s planned purchase of frigates from South Korea was dropped in favour of six larger, costlier gunboats from Thomson CSF – with Dumas stating in a March 2003 interview with Le Figaro that the company secretly paid a half-billion-dollar kickback to a middleman to secure the USD 3 billion deals. While French criminal investigations continue, Taiwan is suing for recovery of that USD 500 million, plus $100 million for damage to its reputation. An ICC arbitral panel

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Thales, in conjunction with its industrial partner, is opposing this request and should lodge its statement of case in defence before the end of the year. The current timetable for the arbitration procedure does not envisage issuance of a judgment before the end of 2007. On the basis of the information at its disposal as of the date of these interim financial statements, Thales is not in a position to evaluate any possible financial effect of this request which constitutes a contingent liability in respect of which no provision has been recognised.

It is important to note that since the affair, Thales’ Chairman and CEO Denis Ranque (who took the helm of then-Thomson-CSF in 1998) has made good corporate ethics a central policy plank for the company. Ranque likes to point out that his message of good corporate behaviour has paid off, and that rules the company put in place have been instrumental in obtaining approval to do business with the U.S. government and to strike partnerships with Raytheon and other leading U.S. defence contractors (see also below Thales executive’s allegations).

The Agusta affair

Finally, the Agusta affair, as it has since become known, arose out of an investigation into the murder of a leading Belgian Socialist Party member, André Cools. He was shot dead in 1991 after hinting that he would expose his party's corrupt activities. As a result of the affair, the former Secretary General of NATO, Willy Claes was given a three-year suspended jail sentence after being found guilty of corruption by Belgium's highest court. Mr Claes was one of 12 defendants standing trial over allegations that two defence firms paid millions of dollars in bribes during the 1980s to secure Belgian Government contracts. He was the Belgian Economy Minister at the time and in 1989 signed the contracts with the Italian helicopter manufacturer, Agusta (owned by Finmeccanica). Several other former Belgian ministers and a French industrialist were also on trial. The former defence minister Guy Coeme, was given a two-year suspended sentence. Former premier Guy Spitaels, and Serge Dassault, head of France's Dassault Aviation were also convicted of corruption.

ƒ Suspension of export licences – largely unrealised impact(s)

By far the most potentially damaging impact of corruption on revenues and profits are the sanctions arising from denial of export licences or exclusion from further contracts and export credits. The threat of large fines and exclusion from contracts acts as an active deterrent to companies with foreign projects, with companies making a concerted push for their legal teams to prepare, implement and monitor compliance with programmes such as the FCPA. However, at the end of the day, unwillingness (conscious or unconscious – you be the judge) on the part of governments to impose biting sanctions diminishes the impacts of such sanctions.

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Lockheed – an important precedent

The biggest case to date occurred in 1994, when the US State Department barred issuance of aircraft export licences to Lockheed’s Aeronautical Systems (aircraft assembly) division because of the parent company and two executives being indicted on FCPA-related charges for having made illicit payments (USD 1 million in “consultancy fees”) in 1987 to an Egyptian politician who aided in the sale of C-130 Hercules transport planes to Egypt. The parent company also ended up paying an FCPA record USD 24.9 million in fines – twice the profits it had made on the planes. Lockheed's former director of Middle East and North African sales, Alan Love, also pleaded guilty to a misdemeanour and Suleiman Nassar, Lockheed’s former director of international marketing, was sentenced to a year-and-a-half in prison and fined USD 125,000.

… But little in the way of material impacts for the company

Without doubt, the FCPA has helped to deter corruption in companies such as Lockheed with the threat of penalties of up to USD 2 million for each instance of bribery – a steep price given that most bribes are paid in instalments over time – as well as the threat of prison. However, materially speaking – these are only minor irritants for the parent company as the most feared consequence of all – debarment from government procurement or export privileges for up to 3 years - a direct hit on a company's ability to survive – has never truly been imposed on a major industry player. Moreover, potential impacts are mitigated through a number of other measures:

• Although the US State Department often reviews a company's proposed export sales (post-indictment), it did not actually delay any deals (in the Lockheed case);

• Bans are only imposed for limited timeframes, rarely lasting longer than six months (and only apply to new export activities – i.e. after the date of indictment);

• Exceptions to the ban are common and are allowed on a case-by-case basis if the company can show that (ever open to interpretation) national security interests” are at stake – most companies, including Lockheed apply for them;

• An effective exception to the ban can be achieved through the marketing of new versions of “banned” equipment – such as Lockheed, which successfully marketed its (then) new C-130J (under a separate export licence) when C-130 sales were banned;

Given these caveats, it comes as little surprise that the markets have justifiably been indifferent in terms of pricing in impacts. In Lockheed’s case, the share price actually jumped USD 1.375 (yes, up!) to USD 64.625 on the day of the announcement of the export ban.

ƒ Impact on M&As – deal-breaking potential

Perhaps the greatest potential impact of corruption on companies is with regard to M&As involving US companies. As a result of the provisions of the US’ Foreign Corrupt Practices Act (FCPA – see further below) – discovery of even non-material corruption by a foreign-based subsidiary (i.e. a local agent paying a bribe to a foreign government official to obtain business) during due diligence on a potential American target – has the potential to delay or derail a proposed deal.

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General Electric’s acquisition of InVision – a spanner in the works

In March 2004, GE agreed to acquire InVision Technologies, a California maker of airport bomb-detection equipment, for approximately USD 900 million in a move to develop its security business. However, in July 2004, InVision voluntarily disclosed to the DOJ and the SEC that possible FCPA violations were discovered during joint pre-merger due diligence. A subsequent joint internal investigation revealed possible violations of the law in connection with possible offers of improper payment by foreign agents and distributors related to InVision's overseas sales.

InVision's potential FCPA exposure, and its failure to expeditiously resolve the issues, delayed the deal closing. The companies had agreed that the acquisition would not be completed until there was a mutually satisfactory resolution with the government of the target's FCPA liabilities. The merger ultimately closed in December 2004 after InVision agreed to pay an USD 800,000 penalty. InVision accepted that through the conduct of certain employees, it was aware of a high probability that its agents or distributors in China, Thailand, and the Philippines had paid or offered to pay money to foreign officials or political parties in the sale of airport security screening machines. InVision also agreed to settle a parallel SEC proceeding by paying a USD 500,000 penalty and disgorging USD 589,000 in profits.

Lockheed Martin’s failed acquisition of Titan – a deal killer

In September 2003, Lockheed announced an agreement to purchase Titan, a military intelligence and technology company, for an estimated USD 1.8 billion. The merger originally was set to close in March 2004. However, in February 2004, Lockheed and Titan jointly disclosed to the DOJ and SEC FCPA-related concerns uncovered during due diligence. They related to payments made by Titan to foreign consultants involved in the sale of the company's radio systems to foreign military and security services. Among other things, they alleged that Titan funnelled USD 2 million via its agent in Benin towards the election campaign of the then incumbent President – to assist the company to develop a telecommunications project in Benin and to obtain governmental consent for an increase in Titan’s management fees for the project.

With regard to the merger, the SEC alleged that Titan's proposed merger agreement with Lockheed Martin was misleading because Titan represented that it had not violated any provisions of the FCPA. The case remains somewhat extraordinary in that at the time, Titan had never adopted policies and procedures to comply with the FCPA. The attention drawn to Titan's potential FCPA liabilities and its failure to expeditiously resolve such issues, caused repeated delays in closing the deal, and Lockheed reduced its offer to USD 1.7 billion. In June 2004, Lockheed dropped its acquisition plan after Titan missed another Lockheed-imposed deadline to secure a plea agreement with the DOJ. The FCPA corruption concerns were a particularly delicate issue for Lockheed Martin as Lockheed Corp., a predecessor company had already paid the largest ever FCPA penalty after having been found to have paid bribes to win an Egyptian contract (see above)

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And what ever became of Titan…

As for Titan, it eventually settled enforcement actions brought by the SEC and DOJ – for violating anti-bribery, internal controls and books and records provisions of the FPCA – by consenting to the entry of a final judgement which imposed new record penalties for a publicly listed company:

• Permanently enjoining it from future violations of the FCPA;

• Obliging it to retain an independent consultant to review the company's FCPA compliance and procedures and to adopt and implement the consultant's recommendations; and

• USD 28.5 million in fines – USD 15.5 million for disgorgement (i.e. vis-à-vis the corrupt payments and related profits and interest) and a USD 13 million criminal penalty.

In a statement issues by Titan, VP David W. Danjcez – who was specifically brought in to oversee FCPA-related systems and compliance – said “We are relieved that this chapter in the company’s history is drawing to a close.” The fiasco went well beyond record fines – killing the acquisition and significantly impacting the company’s profits, share value and reputation. The DoD however waived its right to disbar Titan from future contracts. Titan was eventually acquired by L-3 Communications Holdings Inc. for USD 2 billion in June 2005.

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Conclusion

ƒ The democratic debate continues

On 5 January 2006, the Norwegian reserve fund, Petroleum Fund, which is financed through oil revenues, decided to exclude seven arms companies because of their involvement in specific segments of this industry. The fund accused the companies (BAE Systems, Boeing, Finmeccanica, Honeywell International, Northrop Grumman, United Technologies and Safran) of taking part in “inhuman” arms programmes, namely NBC - nuclear, bacteriology, chemical - programmes. This incident is symbolic not only of the growing commitment on the part of certain investors but also of the democratic debate surrounding defence policies, the use of arms, and acceptance of and tolerance for certain arms. This is a debate that cannot be avoided, but it goes well beyond the domain of finance alone. We should not forget that all five permanent members of the UN Security Council officially hold nuclear arms, and are still the world’s biggest arms dealers.

ƒ Security issues are shaping demand and the sector

• Geopolitics – foreign policy harmonisation in the EU member states should lead to optimisation of resources. Geopolitics also impact global trade flows.

• The need for new equipment, systems and meta-systems (systems of systems) – first and foremost, stemming from new threats on the one hand and technological advances on the other.

• Tighter budgets – which mean that governments need to work together and share their industrial resources and budgets so as to be able to invest appropriately in new systems. ƒ Relations with states, why investors should mind

To many expert observers, corruption is peripheral, an add-on. And so investors are keen on believing them. They share the assumption that bribery does not affect the main procurement decisions, which are taken by professionals in response to strategic need and within budgets determined by cabinet decision. Corruption is not peripheral; it is central to procurement decision-making. Why can we so assertive? First, because according to the US Department of Commerce reported that half of all bribes paid between 1994 and 1999 involved defence contracts, despite the fact that arms constitute only 1% of world trade (Source: The Economist). Second, Because otherwise there will not be so many corporate cases, so many international conventions, so many people jailed or ousted. Corruption deeply threatens business visibility for investors. Management might know about how business is done, but how can investors be aware of the reliability of turnover and long-term contracts? Especially now that more pressure is added by the stakeholders with solid juridical arguments.

There is definitely not such a way to assess the quality risk management of a company in that field. One can expect some indications, but not indicators. First indication, if the investor wants to secure its investment, he should better pick-up some companies with low turnover exposure to areas at risk. Second indication, the more that company deals at the end of the supply chain (e.g. with States representatives, the more risky is the corporate profile.

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UNITED KINGDOM BAE Systems Plc Accumulate

AEROSPACE & DEFENSE

420vvdsvdvsdy 400 Focusing on the US and IT 380 360 340 B USINESS D ESCRIPTION 320

300 280 BAE is Europe’s largest defence company and ranks among the top ten players in the 260 240 US. Since the 1980s, BAE has been part of the state-to-state Al Yamamah contract 220 Dec 04 Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

BAE SYSTEM S PLC DJ Stoxx A erospace & Defense between Saudi Arabia and the UK (roughly 15-20% of sales). In 1999, British Aerospace Source: FactSet JCF plc (now known as BAE Systems plc) agreed with the General Electric Company plc --- BAE Systems Plc, (GEC) the proposed merger of GEC's defence electronics business, Marconi Electronic --- DJ Stoxx Aerospace & Defense rebased Systems, with BAE Systems.

BAE has an international position in all continents as a prime contractor and systems integrator in the air, land, sea, space, and command and control market sectors (world- Reuters: BA.L class capability naval platforms, military aircraft, electronics, systems integration). This Bloomberg BA/ LN enables it to offer complementary capabilities to international customers across the main defence sectors, the commercial world, as well as in the civil aircraft market. The Share price on 10/01/2006 (GBP) 401.25 company employs 90,000 people. Target price(GBP) 385.0 Market capitalisation (GBPm) 12,890.0 INVESTMENT C ASE No. of shares (m) 3,212.5 BAE has done a lot of external growth, including the United Defense company, and has Free float 78.4% to show the gain from this strategy. It has made a lot of acquisitions in the US, most of Daily avg. no. trad. sh. 12 mth 26,794,070 them aimed at increasing the group’s systems integrator capabilities. BAE no longer has Daily avg. trad. vol. 12 mth (m) 8,018,308 its value stock status, which it gained after the difficulties related to the Astute and Price high 12 mth (GBP) 408.50 Nimrod programmes (very high provisions) and due to the financial markets’ wariness of Price low 12 mth (GBP) 232.50 a group that systematically issues last-minute profit warnings. BAE is a play on the Abs. perf. 1 mth 17.2% Abs. perf. 3 mth 18.9% defence sector in the US as well as in Europe, via the 20% stake in Airbus. The Al Abs. perf. 12 mth 71.7% Yamamah contract is expected to make a strong contribution SWOT ANALYSIS Local index FTSE 100 STRENGTHS WEAKNESSES DJ Stoxx 50 No CAGR BPA 02/07 R+ ƒ Key player in the UK, Europe’s ƒ Difficulties in industrialising and biggest market (one-third of making a profit from contracts European arms spending) ƒ Several bad reports leading to nasty

ƒ Present in all platforms (air, sea and surprises for financial markets (and land) heavy provisions) ƒ EFI/CSR disclosure and VOC emissions reduction

OPPORTUNITIES THREATS

ƒ Flow of work from the US, where ƒ Risk of balance sheet deteriorating 40% of BAE’s assets are located due to the booking of pension Agnès Blazy liabilities CM - CIC Securities +33 1 45 96 77 61 [email protected]

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BAE SYSTEMS PLC: summary tables PROFIT & LOSS (M £) 2002 2003 2004 2005e* 2006e* 2007e* CAGR07/02 Sales 12,145.0 12,572.0 13,479.0 14,563.9 15,237.3 15,892.9 5.5% EBITDA 1,214.0 1,202.0 1,215.0 1,426.4 1,489.6 1,569.9 5.3% Depreciatio n & P ro visio ns -212.0 -222.0 -202.0 -220.7 -240.9 -262.1 Goodwill Amortisation -615.0 -518.0 -1,038.0 0.0 0.0 0.0 EBIT 387.0 462.0 -25.0 1,205.7 1,248.7 1,307.8 27.6% Net Financial Interest -206.0 -220.0 -207.0 -120.3 -135.2 -101.5 Other Financials 0.0 0.0 0.0 0.0 0.0 0.0 Associates 0.0 0.0 0.0 0.0 0.0 0.0 Extraordinary Items -797.0 -9.0 0.0 -99.0 -103.5 -108.0 Earnings Before Tax (EBT) -616.0 233.0 -232.0 986.5 1,010.0 1,098.3 R+ Tax -70.0 -225.0 -234.0 -325.5 -333.3 -362.4 Tax rate 30.0% 29.0% 33.0% 33.0% 33.0% Minorities 0.0-2.0-1.0-1.2-1.4-1.7 Net Profit (reported) -686.0 6.0 -467.0 659.7 675.2 734.1 R+ Net P ro fit (adj.) -71.0 524.0 571.0 659.7 675.2 734.1 CASH FLOW (GBPm) Net profit (reported) + Minorities -686.0 8.0 -466.0 660.9 676.7 735.9 Non cash items 533.0 653.0 1,357.0 3,739.7 240.9 262.1 Cash Flow -153.0 661.0 891.0 4,400.7 917.6 998.0 R+ Change in Net Working Capital -290.0 -346.0 -1,213.0 -933.1 -434.5 -223.1 Capex 183.0 248.0 256.0 337.0 364.1 380.9 Operating Free Cash Flow (OpFCF) -46.0 759.0 1,848.0 4,996.8 988.1 840.2 R+ Net Financial Investments 41.0 -62.0 -550.0 2,091.7 0.0 0.0 Dividends 274.7 281.2 281.5 290.7 296.8 306.0 Other (incl. Capital Increase) -196.0 -4.0 -217.0 -4,320.0 -137.0 -137.0 Net Free Cash Flow 73.7 974.2 1,362.5 3,059.2 1,147.9 1,009.2 68.8% NOPLAT 651.3 637.0 658.5 783.7 811.7 850.1 BALANCE SHEET & OTHER ITEMS (GBPm) Net Tangible Assets 1,709.0 1,699.0 1,751.0 1,888.3 2,011.4 2,130.2 Net Intangible Assets (ex Goodwill) 0.0 0.0 0.0 0.0 0.0 0.0 Goodwill 6,417.0 6,000.0 5,647.0 8,318.0 8,318.0 8,318.0 Net Financial Assets & Other 1,526.0 1,710.0 1,674.0 3,350.0 3,485.6 3,621.3 Total Fixed Assets 9,652.0 9,409.0 9,072.0 13,556.3 13,815.0 14,069.5 7.8% Net Working Capital -1,692.0 -2,038.0 -3,251.0 -4,184.1 -4,618.6 -4,841.8 Total capital invested/employed 6,434.0 5,661.0 4,147.0 6,022.2 5,710.8 5,606.5 Shareholders Equity 5,676.0 5,591.0 4,724.0 3,050.2 3,428.6 3,856.7 -7.4% M ino rities Equity 20.0 15.0 14.0 14.0 14.0 14.0 Net Debt 1,277.0 865.0 66.0 1,772.0 1,217.8 821.0 -8.5% Provisions 987.0 900.0 1,017.0 4,536.0 4,536.0 4,536.0 Total M arket Cap 8,686.3 4,487.1 6,417.9 9,034.0 12,278.2 12,278.2 Entreprise Value (EV adj.) 9,511.3 4,729.8 5,879.2 12,918.6 15,537.7 15,067.5 MARGINS AND RATIOS Sales gro wth -7.6% 3.5% 7.2% 8.0% 4.6% 4.3% EBITDA growth -19.0% -1.0% 1.1% 17.4% 4.4% 5.4% EB IT gro wth -49.4% 19.4% -chg +chg 3.6% 4.7% EBITDA margin 10.0% 9.6% 9.0% 9.8% 9.8% 9.9% EBITA margin 8.3% 7.8% 7.5% 8.3% 8.2% 8.2% EBIT margin 3.2% 3.7% ns 8.3% 8.2% 8.2% Debt/Equity (gearing) 22.4% 15.4% 1.4% 57.8% 35.4% 21.2% Debt/EB ITDA 1.1 0.7 0.1 1.2 0.8 0.5 Interest co ver (EB ITDA /Fin.interest) 5.9 5.5 5.9 11.9 11.0 15.5 ROCE 8.5% 8.8% 9.9% 9.2% 9.9% 10.5% WACC 10.4% 11.0% 9.8% 9.6% 9.7% 9.8% ROCE/WACC 0.8 0.8 1.0 1.0 1.0 1.1 EV/CE 1.2 0.7 0.9 1.5 1.9 1.9 OpFCF/CE -0.6% 10.5% 27.9% 58.8% 12.1% 10.4% EV/Sales 0.8 0.4 0.4 0.9 1.0 0.9 EV/EBITDA 7.8 3.9 4.8 9.1 10.4 9.6 EV/EB ITA 9.5 4.8 5.8 10.7 12.4 11.5 EV/EB IT 24.6 10.2 ns 10.7 12.4 11.5 P/E (adj.) ns 8.6 11.2 13.7 18.2 16.7 P/CF ns 6.8 7.2 2.1 13.4 12.3 P/BV 1.50.81.43.03.63.2 OpFCF yield -0.5% 16.9% 28.8% 55.3% 8.0% 6.8% Payout ratio -40.9% ns -62.2% 45.0% 45.3% 41.7% Dividend yield (gross) 3.2% 6.3% 4.5% 3.3% 2.5% 2.5% PER SHARE DATA (GBp) EPS (reported) -22.473 0.196 -15.261 21.560 22.067 23.991 R+ EPS (adj.) -2.326 17.141 18.660 21.560 22.067 23.991 R+ CFPS -5.012 21.623 29.118 143.812 29.988 32.613 R+ BVPS 185.945 182.892 154.379 99.679 112.045 126.037 -7.5% DPS 9.200 9.200 9.500 9.700 10.000 10.000 1. 7 % Source: Company, CM - CIC Securities estimates * Data in IFRS

Source: Company, CM - CIC Securities estimates

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BOEING

AUTOMOBILE

Sales 2004 $52.4bn Double advantage in civil and defence Backlog (30 September 2005) $134bn Boeing is America’s leading maker of large aircraft, and the Ebit 2004 $2.3bn Pentagon’s second-biggest supplier after Lockheed. Boeing Net result $1.8bn acquired MacDonnell Douglas en 1994. Boeing makes sales in 145 Chicago, Headquartered countries around the world, and is the biggest US exporter in terms Illinois of sales.

Main shareholder Boeing has about 153,800 employees in 48 American states and 67 Free float 91.9% countries. The group’s overall European strategy is to continue to retain a significant Stock price 06/01/2006 $70.3 share of the market and to find new opportunities where it is cost-effective Market Cap. $56.7bn to do business in Europe. Underlying this strategy is the principle that Net debt 2004 $5.2bn being more effective globally means being more effective and present Bloomberg BA locally. Local Index NYSE SWOT A NALYSIS STRENGTHS WEAKNESSES ƒ Sales underpinned by defence ƒ Defence programmes can be delayed or scaled back contracts ƒ Lagging behind Airbus, and is ƒ Relatively strong licence to operate actively seeking to fill the gap on jumbo jets on community issues ƒ Poor track record in managing human ƒ R&D expense growth (2004: 3.6% of resources in the long-term (training sales against 3.0% in 2002) and stop&go policies)

OPPORTUNITIES THREATS

ƒ In the past, Boeing has managed ƒ Cuts to US budgets

non-core businesses during ƒ Health of client airlines aerospace recessions ƒ High-level of toxic releases (US): 4th ƒ Good fuel efficiency for the new 787, largest toxic emissions (source: Pert), a key issue for new generation of Maximum potential loss for the airplanes company: 1 3% of revenue Agnès BLAZY CM - CIC Securities N INE- MONTH 2005 SALES BY SECTOR +33 1 45 96 77 61 41% commercial aircraft (737, 747, 767, 777 and 787) [email protected] 21% network systems: defence and space systems products and services,

US government programmes 21% aircraft and weapon systems

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FRANCE Dassault Aviation Hold

AEROSPACE & DEFENSE

750vvdsvdvsdy Leader in business jets, but loosing market 700 share in fighter aircraft over the world 650

600 B USINESS D ESCRIPTION 550

500 Dassault Aviation is one of the major players in the global aviation industry, with a

450 presence in more than 70 countries. It has been profitable since its creation in 1936. Dec 04 Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

DASSAULT AVIATION DJ Stoxx Aerospace & Defense Dassault Aviation is a systems integrator. It manufactures two types of products: 1) Source: FactSet JCF fighter aircraft (Rafale and Mirage 2000) integrating many functions (propulsion, flight --- Dassault Aviation, control systems, communications, cockpit environment, fire control, etc.), manufactured --- DJ Stoxx Aerospace & Defense rebased by about 70 French OEMs; and 2) Falcon business jets resulting from the integration of more than 30 systems and functions manufactured by around 50 major French and foreign, mostly US OEMs. Reuters: AVMD.PA INVESTMENT C ASE Bloomberg AM FP Falcon has a major slice of the business jet market, and its sales forecasts are very good for the coming years. We have recently seen a slowdown in foreign defence Share price on 10/01/2006 (EUR) 578.50 sales, namely deliveries of new and retrofitted fighters to the United Arab Emirates, Target price(EUR) 602.0 Greece and India. In mid-April 2005, a major Rafale sale to Saudi Arabia was Market capitalisation (EURm) 5,858.0 envisaged, which would have prompted us to upgrade, but it did not go through. The No. of shares (m) 10.1 Americans won the tender in Singapore, undercutting Dassault by 20%. There are Free float 4.2% currently no more orders pending in foreign countries, and Dassault’s survival on the military side is dependent on work done for the French state. The next programme, Daily avg. no. trad. sh. 12 mth 443 Neuron, is a combat UCAV, and will keep the group going for the coming decades. In Daily avg. trad. vol. 12 mth (m) 238 financial terms, Dassault has the sector’s biggest cash pile. If it opts for a payout of Price high 12 mth (EUR) 588.00 33%, each shareholder would receive EUR99 per share (yield of 17%). This would also Price low 12 mth (EUR) 447.10 remove the possibility of a change in capital (withdrawal of EADS). The second Abs. perf. 1 mth 2.2% possibility would be to buy Daimler’s or Lagardère’s stake in the EADS stake if Abs. perf. 3 mth 0.0% necessary. Abs. perf. 12 mth 26.8% SWOT ANALYSIS

Local index SBF 250 STRENGTHS WEAKNESSES DJ Stoxx 50 No ƒ Strong order book (294 Rafales to be ƒ Military programmes are not very CAGR BPA 02/07 0 delivered by 2020) diversified. No new exports

ƒ Structural cash generation ƒ The Rafale order mix is up in the air, ƒ Environmental policy implemented with two-seater models now with robust performance regarding preponderant water consumption, CO2 and VOC ƒ Few known projects for the group’s emissions cash ƒ Good level of employee motivation ƒ Worrying safety performance (2004: (absenteeism rate of 2.91% vs. 5% frequency rate: 13.36) for CAC40 companies) ƒ High level of enviro.expenditure - 6.6% of total capital expenditure. Agnès Blazy CM - CIC Securities OPPORTUNITIES THREATS +33 1 45 96 77 61 ƒ France’s aviation authority has ƒ The longer it takes for export orders [email protected] awarded Dassault the contract to for Rafale to arrive, the harder it will develop a combat drone and is be to get any financing it (Neuron programme)

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DASSAULT AVIATION: summary tables PROFIT & LOSS (M €) 2002 2003 2004 2005e* 2006e* 2007e* CAGR07/02 Sales 3,436.7 3,298.5 3,459.1 3,240.4 4,147.3 4,284.6 4.5% EBITDA 629.8 548.3 520.1 559.7 722.4 746.3 3.5% Depreciation & Provisions -577.3 -577.8 -563.9 -71.6 -80.1 -88.6 Goodwill Amortisation -25.1 -2.9 -2.9 0.0 0.0 0.0 EBIT 447.4 403.0 461.6 488.1 642.3 657.7 8.0% Net Financial Interest 2.9 35.8 4.7 -29.6 -12.1 -10.3 Other Financials -9.6 -1.7 -2.9 -3.0 -3.0 -3.0 Associates 0.1 0.1 0.1 0.0 0.0 0.0 Extraordinary Items 46.0 -2.0 0.7 0.0 0.0 0.0 Earnings Before Tax (EBT) 486.7 435.2 464.2 455.5 627.2 644.4 5.8% Tax -174.4 -139.7 -155.4 -159.4 -219.5 -225.5 Tax rate 34.1% 31.9% 33.3% 35.0% 35.0% 35.0% M inorities 0.0 0.0 0.0 0.0 0.0 0.0 Net Profit (reported) 312.4 295.5 308.8 296.1 407.7 418.9 6.0% Net Profit (adj.) 337.4 298.4 311.7 296.1 407.7 418.9 CASH FLOW (EURm) Net profit (reported) + Minorities 312.4 295.5 308.8 296.1 407.7 418.9 Non cash items 101.2 95.0 41.6 349.3 80.1 88.6 Cash Flow 413.6 390.5 350.4 645.4 487.8 507.5 4.2% Change in Net Working Capital -576.1 -305.9 256.8 -534.4 -25.7 -55.4 Capex -148.2 -96.6 -89.0 -170.0 -170.0 -170.0 Operating Free Cash Flow (OpFCF) -310.7 -11.9 518.3 -59.1 292.1 282.1 R+ Net Financial Investments -2.0 -11.2 -51.4 0.0 0.0 0.0 Dividends -65.8 -84.0 -78.0 -78.0 -74.8 -102.9 Other (incl. Capital Increase) 30.8 -44.0 66.0 -1,090.0 86.0 141.0 Net Free Cash Flow -347.7 -151.2 454.9 -1,227.0 303.4 320.2 R+ NOPLAT 307.1 263.8 301.9 317.3 417.5 427.5 BALANCE SHEET & OTHER ITEMS (EURm) Net Tangible Assets 343.9 340.2 311.7 404.0 493.9 575.2 Net Intangible Assets (ex Goodwill) 4.0 3.5 6.4 50.0 50.0 50.0 G o o d w i l l 17 . 2 14 . 4 11. 5 11. 5 11. 5 11. 5 Net Financial Assets & Other 127.6 146.7 157.0 2,089.0 2,152.6 2,217.1 Total Fixed Assets 492.7 504.8 486.5 2,554.5 2,708.0 2,853.8 42.1% Net Working Capital 20.8 326.7 69.9 604.3 630.0 685.4 Total capital invested/employed 385.9 684.8 399.4 1,069.8 1,185.4 1,322.1 Shareholders Equity 1,762.5 1,902.9 2,104.7 3,202.1 3,684.5 4,206.3 19 . 0 % M ino rities Equity 0.1 0.1 0.1 0.1 0.1 0.1 Net Debt -1,732.2 -1,580.6 -2,035.9 -808.5 -1,111.8 -1,432.4 R+ Provisions 483.1 509.0 487.5 765.2 765.2 765.2 Total M arket Cap 3,372.8 2,735.2 4,134.5 5,408.1 5,857.8 5,857.8 Entreprise Value (EV adj.) 1,649.4 1,160.0 2,098.1 2,671.3 2,755.3 2,370.5 MARGINS AND RATIOS Sales growth -1.0% -4.0% 4.9% -6.3% 28.0% 3.3% EBITDA growth 5.9% -12.9% -5.2% 7.6% 29.1% 3.3% EBIT growth 1.7% -9.9% 14.5% 5.7% 31.6% 2.4% EBITDA margin 18.3% 16.6% 15.0% 17.3% 17.4% 17.4% EB ITA margin 13.7% 12.3% 13.4% 15.1% 15.5% 15.4% EB IT margin 13.0% 12.2% 13.3% 15.1% 15.5% 15.4% Debt/Equity (gearing) -98.3% -83.1% -96.7% -25.2% -30.2% -34.1% Debt/EBITDA -2.8 -2.9 -3.9 -1.4 -1.5 -1.9 Interest cover (EBITDA/Fin.interest) ns ns ns 18.9 59.5 72.4 ROCE 71.6% 36.1% 69.3% 28.7% 34.2% 31.5% WACC 11.2% 9.0% 10.2% 9.8% 9.8% 9.8% ROCE/WACC 6.4 4.0 6.8 2.9 3.5 3.2 EV/CE 3.8 1.6 4.8 2.4 2.3 1.7 OpFCF/CE -72.4% -1.6% 118.9% -5.3% 23.9% 20.8% EV/Sales 0.5 0.4 0.6 0.8 0.7 0.6 EV/EBITDA 2.6 2.1 4.0 4.8 3.8 3.2 EV/EBITA 3.5 2.9 4.5 5.5 4.3 3.6 EV/EBIT 3.72.94.55.54.33.6 P/E (adj.) 10.09.213.318.314.414.0 P /CF 8.2 7.0 11.8 8.4 12.0 11.5 P/BV 1.91.42.01.71.61.4 OpFCF yield -9.2% -0.4% 12.5% -1.1% 5.0% 4.8% Payout ratio 21.1% 28.4% 25.2% 25.2% 25.2% 25.2% Dividend yield (gross) 2.0% 3.1% 1.9% 1.4% 1.8% 1.8% PER SHARE DATA (EUR) EPS (reported) 30.847 29.186 30.497 29.238 40.259 41.365 6.0% EPS (adj.) 33.324 29.469 30.780 29.238 40.259 41.365 4.4% CFPS 40.841 38.569 34.608 63.735 48.173 50.119 4.2% BVPS 174.060 187.927 207.855 316.225 363.866 415.396 19 . 0 % DPS 6.500 8.300 7.700 7.382 10.165 10.444 9.9% Source: Company, CM - CIC Securities estimates * Data in IFRS

Source: Company, CM - CIC Securities estimates

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FRANCE EADS Hold

AEROSPACE & DEFENSE

38vvdsvdvsdy 36 The new world leader 34

32

30 B USINESS D ESCRIPTION

28

26

24 EADS includes aircraft manufacturer Airbus, helicopter supplier Eurocopter, and

22

20 MBDA, a joint venture in missile systems. EADS is the major partner in the Eurofighter Dec 04 Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

EADS DJ Stoxx Aerospace & Defense consortium and the prime contractor for the Ariane launcher. It develops military Source: FactSet JCF transport aircraft and is the largest partner for the European satellite navigation system --- EADS, --- DJ Stoxx Aerospace & Defense rebased Galileo. Corresponding to the product range, the company is divided into five divisions: Airbus, Military Transport Aircraft, Eurocopter, Defence and Security Systems and Space. EADS employs about 110,000 people at more than 70 production sites in France, Germany, Great Britain and Spain as well as in the US and Australia. It has a Reuters: EAD.PA global network of 29 offices to maintain contact with customers. Bloomberg EAD FP INVESTMENT C ASE

Share price on 11/01/2006 (EUR) 31.63 EADS makes 8% of its sales with the French state. At first sight, this does not look like Target price(EUR) 31.0 much, but it must be remembered that Airbus accounts for 80% of the group’s sales. Market capitalisation (EURm) 25,740.0 Nearly all the group’s defence sales (20% of consolidated sales) are made with France No. of shares (m) 813.8 and Germany. EADS is growing in all segments and is aiming to match the organic Free float 28.0% growth on the order book (EUR210bn) with external growth. The challenge will be to Daily avg. no. trad. sh. 12 mth 1,820,616 align the split between the civil and defence businesses with that of the benchmark Daily avg. trad. vol. 12 mth (m) 48,178 Boeing. In this respect, an acquisition of Thales (which has a large amount of its R&D Price high 12 mth (EUR) 33.26 financed by government clients) would provide a welcome boost. Price low 12 mth (EUR) 21.76

Abs. perf. 1 mth -3.5% The other issue that could take centre stage again before long is BAE’s stake in Airbus, Abs. perf. 3 mth 5.8% which could be sold. In this case, EADS would have to find a large amount of money, Abs. perf. 12 mth 41.1% without any strategic benefit accruing from the investment.

Local index CAC 40 SWOT ANALYSIS

DJ Stoxx 50 No STRENGTHS WEAKNESSES CAGR BPA 02/07 R+ ƒ Sound balance sheet during cycle ƒ Low dollar never good in aerospace trough for euro producers (but no risk on translation of assets into dollars) ƒ Wide product range at Airbus, explaining the swift increase in market share ƒ Robust stakeholder management systems

OPPORTUNITIES THREATS

ƒ Strong order book ƒ Trade negotiations on launch aid and risk of US reaction ƒ Higher margins on defence sales ƒ Prolonged dollar weakness Agnès Blazy ƒ Gradual expansion outside Europe CM - CIC Securities (EADS North America, regular visits ƒ Client airlines could come under +33 1 45 96 77 61 to Asia) pressure from high oil prices [email protected] conditions

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EADS: summary tables PROFIT & LOSS (M €) 2002* 2003* 2004* 2005e* 2006e* 2007e* CAGR07/02 Sales 29,901.0 30,133.0 31,761.0 33,175.5 36,342.3 38,503.7 5.2% EBITDA 3,049.0 2,740.0 3,450.0 4,202.4 4,657.3 5,222.4 11. 4 % Depreciatio n & P ro visio ns -2,201.0 -1,808.0 -1,621.0 -1,787.8 -1,934.1 -2,068.0 Go o dwill A mo rtisatio n -936.0 -567.0 0.0 0.0 0.0 0.0 EBIT 160.0 561.0 2,143.0 2,414.7 2,905.0 3,346.9 83.7% Net Financial Interest -60.0 -55.0 -330.0 -50.0 -272.8 -267.8 Other Financials 0.0 0.0 0.0 0.0 0.0 0.0 Associates 87.0 186.0 84.0 96.6 106.3 116.9 Extraordinary Items 0.0 0.0 0.0 0.0 0.0 0.0 Earnings Before Tax (EBT) 187.0 692.0 1,897.0 2,461.3 2,738.5 3,196.0 76.4% Tax -453.0 -474.0 -664.0 -827.6 -919.5 -1,074.2 Tax rate 43.7% 44.2% 36.6% 35.0% 34.9% 34.9% M inorities -33.0 -66.0 -203.0 -345.1 -384.1 -449.3 Net Profit (reported) -299.0 152.0 1,030.0 1,288.6 1,434.8 1,672.5 R+ Net P ro fit (adj.) 637.0 719.0 1,030.0 1,288.6 1,434.8 1,672.5 CASH FLOW (EURm) Net profit (reported) + Minorities -266.0 218.0 1,233.0 1,633.6 1,819.0 2,121.8 No n cash items -660.0 2,815.0 1,404.0 2,188.8 1,870.1 2,004.0 Cash Flow -926.0 3,033.0 2,637.0 3,822.4 3,689.0 4,125.8 R+ Change in Net Working Capital 804.0 2,019.0 2,155.0 11,487.8 561.6 289.7 Capex -2,314.0 -2,951.0 -3,672.6 -3,335.4 -2,925.7 -2,678.3 Operating Free Cash Flow (OpFCF) -2,436.0 2,101.0 1,119.4 11,974.8 1,324.8 1,737.2 R+ Net Financial Investments -45.0 -349.0 -100.0 0.0 0.0 0.0 Dividends -403.0 -240.0 -320.0 -400.0 -432.0 -466.6 Other (incl. Capital Increase) 2,575.0 369.0 254.0 -10,918.0 -1,671.0 -874.0 Net Free Cash Flow -309.0 1,881.0 953.4 656.8 -778.2 396.7 R+ NOPLAT 712.4 733.2 1,393.0 1,569.5 1,888.2 2,175.5 BALANCE SHEET & OTHER ITEMS (EURm) Net Tangible A ssets 10,509.0 11,448.0 12,905.0 14,452.6 15,444.3 16,054.6 Net Intangible Assets (ex Goodwill) 203.0 322.0 548.0 814.8 1,034.3 1,235.1 Goodwill 9,586.0 9,372.0 9,460.0 9,460.0 9,460.0 9,460.0 Net Financial Assets & Other 4,875.0 4,129.0 4,090.0 11,356.0 12,488.1 12,775.4 Total Fixed Assets 25,173.0 25,271.0 27,003.0 36,083.4 38,426.7 39,525.1 9.4% Net Working Capital -4,023.0 -1,322.0 -3,145.0 -14,632.8 -15,194.3 -15,484.1 Total capital invested/employed 16,275.0 19,820.0 19,768.0 10,094.7 10,744.2 11,265.7 Shareholders Equity 12,765.0 16,149.0 16,973.0 15,153.0 15,771.7 16,528.3 5.3% M inorities Equity 1,361.0 2,179.0 2,370.0 1,975.0 2,359.1 2,808.4 Net Debt -1,224.0 -3,105.0 -4,058.0 -4,715.0 -3,937.0 -4,334.0 R- Provisions 8,248.0 8,726.0 8,573.0 9,038.0 9,038.0 9,038.0 Total M arket Cap 11,460.2 10,013.3 16,766.6 20,936.6 25,303.9 25,303.9 Entreprise Value (EV adj.) 20,334.1 17,613.9 25,788.2 35,596.4 40,955.5 40,796.5 MARGINS AND RATIOS Sales gro wth -2.9% 0.8% 5.4% 4.5% 9.5% 5.9% EBITDA growth 0.0% -10.1% 25.9% 21.8% 10.8% 12.1% EBIT growth -93.6% 250.6% 282.0% 12.7% 20.3% 15.2% EBITDA margin 10.2% 9.1% 10.9% 12.7% 12.8% 13.6% EBITA margin 3.7% 3.7% 6.7% 7.3% 8.0% 8.7% EBIT margin 0.5% 1.9% 6.7% 7.3% 8.0% 8.7% Debt/Equity (gearing) -8.7% -16.9% -21.0% -27.5% -21.7% -22.4% Debt/EBITDA -0.4-1.1-1.2-1.1-0.8-0.8 Interest cover (EBITDA/Fin.interest) 50.8 49.8 10.5 84.0 17.1 19.5 ROCE 3.7% 3.2% 6.7% 14.0% 15.9% 17.5% W A C C 13 . 1% 17 . 1% 16 . 4 % 11. 5 % 11. 1% 11. 3 % ROCE/WACC 0.3 0.2 0.4 1.2 1.4 1.6 EV/CE 1.1 0.8 1.2 3.2 3.4 3.3 OpFCF/CE -12.8% 9.1% 5.4% 106.5% 11.1% 14.0% EV/Sales 0.7 0.6 0.8 1.1 1.1 1.1 EV/EBITDA 6.7 6.4 7.5 8.5 8.8 7.8 EV/EBITA 18.6 15.6 12.0 14.7 14.1 12.2 EV/EB IT ns 31.4 12.0 14.7 14.1 12.2 P /E (adj.) 18.0 13.9 16.3 16.2 17.6 15.1 P/CF ns 3.3 6.4 5.5 6.9 6.1 P /B V 0.9 0.6 1.0 1.4 1.6 1.5 OpFCF yield -21.3% 21.0% 6.7% 57.2% 5.2% 6.9% Payout ratio -81.4% ns 39.3% 33.5% 32.5% 30.1% Dividend yield (gross) 2.1% 3.2% 2.4% 2.1% 1.8% 2.0% PER SHARE DATA (EUR) EPS (reported) -0.369 0.187 1.272 1.611 1.794 2.091 R+ EPS (adj.) 0.785 0.885 1.272 1.611 1.794 2.091 21.6% CFPS -1.142 3.731 3.257 4.778 4.611 5.157 R+ B VP S 15.736 19.866 20.962 18.941 19.715 20.660 5.6% DPS 0.300 0.400 0.500 0.540 0.583 0.630 16 . 0 % Source: Company, CM - CIC Securities estimates * Data in IFRS

Source: Company, CM - CIC Securities estimates

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ITALY Finmeccanica Accumulate

AEROSPACE & DEFENSE

22vvdsvdvsdy 21 The big comeback of 2000-05 20

19

18 B USINESS D ESCRIPTION

17

16

15 Aerospace and defence account for 70% of sales (30% from IT, energy,

14

13 transport). Finmeccanica manufacture military and tactical transport aircraft, Dec 04 Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

FINMECCANICA DJ Stoxx Aerospace & Defense training aircraft and unmanned civil and military aircraft. It also carries out Source: FactSet JCF aircraft overhaul and conversion for leading manufacturers. AgustaWestland, --- Finmeccanica, --- DJ Stoxx Aerospace & Defense rebased now wholly owned, makes helicopters, rotor blades, composite structures and avionics systems. Finmeccanica is also a satellite maker and manager (navigation, connectivity services). An agreement with Alcatel Space was concluded in 2005, making it one of the top operators worldwide. In defence Reuters: SIFI.MI electronics, the joint venture with BAE has been wound down, and Bloomberg FNC IM Finmeccanica has bought back some avionics and communication activities. The group has strong positions in sensors for land, sea, air defence, air traffic

Share price on 11/01/2006 (EUR) 16.64 control, avionics and military and secure communications. Finmeccanica Target price(EUR) 18.0 owns 25% of MBDA, and subsidiaries Oto Melara; WASS. Market capitalisation (EURm) 7,010.0 INVESTMENT C ASE No. of shares (m) 421.3 Finmeccanica makes most of its sales in Italy, and is well placed in the UK Free float 67.6% following the purchase of assets from BAE. It is expected to present a new Daily avg. no. trad. sh. 12 mth Daily avg. trad. vol. 12 mth (m) industrial plan (2006-08) early in 2006. The next steps will be to integrate/ Price high 12 mth (EUR) 16.86 rationalise recent acquisitions and to get value out of the civil businesses. Price low 12 mth (EUR) 13.56 Elsag will be focused on security systems, Ansaldo Signal and Ansaldo Abs. perf. 1 mth 3.4% Trasporti will be merged and listed, Ansaldo Energia will be transformed into Abs. perf. 3 mth 2.3% an independent service provider. Other civil activities belonging to Elsag and Abs. perf. 12 mth 20.6% Datamat will be sold. Finmeccanica has never had such a rich industrial product portfolio, as shown by the big orders recently taken in many Local index S&PMIB businesses. Further orders could be collected over the coming months in the DJ Stoxx 50 No US, UK and Russia. Finmeccanica is now in a position to play a leading role CAGR BPA 02/07 0 in the next round of European defence industry consolidation, which should

help narrow the conglomerate discount. New orders and improved visibility on the exit from civil activities could help improve the share’s performance.

SWOT ANALYSIS STRENGTHS WEAKNESSES ƒ Italy’s biggest defence contractor ƒ Uncertainties about the future of the non-core assets and the ƒ The shareholding in STM (6.6%) degree of diversification of the represents €0.7bn and provides Group significant financial flexibility

OPPORTUNITIES THREATS

Pietro Gasparri ƒ Alliances with a view ƒ Risks to Italian defence budget Banca Akros consolidating its position +39 02 4344 4238 ƒ Penetration of markets in the UK [email protected] and the US

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FINMECCANICA: summary tables PROFIT & LOSS (M €) 2002 2003 2004 2005e* 2006e* 2007e* CAGR07/02 Sales 7,757.9 8,646.2 9,386.9 11,372.0 12,556.5 13,862.4 12 . 3 % EBITDA 698.4 790.1 878.1 1,091.7 1,202.9 1,451.4 15 . 8 % Depreciation & Provisions -196.7 -241.1 -263.7 -369.9 -374.9 -415.9 Go o dwill A mo rtisatio n -61.2 -82.0 -96.5 0.0 0.0 0.0 EBIT 440.5 467.0 518.0 721.8 828.0 1,035.5 18 . 6 % Net Financial Interest -18.0 -45.3 -47.6 -90.0 -70.0 -67.0 Other Financials 0.0 0.0 0.0 0.0 0.0 0.0 Associates 103.0 162.1 461.3 -16.4 5.0 5.0 Extraordinary Items -119.6 -173.1 -209.8 0.0 0.0 0.0 Earnings Before Tax (EBT) 406.0 410.7 721.9 615.4 763.0 973.5 19 . 1% Tax -203.3 -211.4 -173.9 -258.5 -320.5 -408.9 Tax rate 50.1% 51.5% 24.1% 42.0% 42.0% 42.0% M inorities -3.3 -10.6 -22.4 -18.0 -22.0 -25.0 Net Profit (reported) 199.4 188.7 525.6 338.9 420.5 539.6 22.0% Net P ro fit (adj.) 289.6 312.4 758.1 338.9 420.5 539.6 CASH FLOW (EURm) Net profit (reported) + Minorities 202.7 199.3 548.0 356.9 442.5 564.6 Non cash items 257.8 323.1 360.1 369.9 374.9 415.9 Cash Flow 460.5 522.3 908.1 726.8 817.4 980.5 16 . 3 % Change in Net Working Capital -298.6 96.7 -269.6 -1,104.4 -237.6 -266.8 Capex -621.9 -625.5 -1,328.7 -1,405.0 -580.0 -520.0 Operating Free Cash Flow (OpFCF) -460.0 -6.4 -690.2 -1,782.6 -0.1 193.7 R+ Net Financial Investments 54.1 -148.3 1,489.1 -625.0 0.0 0.0 Dividends -84.2 -84.3 -84.3 -109.7 -109.7 -118.1 Other (incl. Capital Increase) -208.2 61.8 -803.4 433.8 249.6 263.7 Net Free Cash Flow -698.3 -177.3 -88.8 -2,083.4 139.8 339.2 R+ NOPLAT 250.5 266.4 466.4 418.7 480.2 600.6 BALANCE SHEET & OTHER ITEMS (EURm) Net Tangible Assets 1,564.8 1,692.4 1,925.5 2,960.6 3,165.7 3,269.9 Net Intangible A ssets (ex Go o dwill) 1,219.6 1,198.2 2,247.5 2,247.5 2,247.5 2,247.5 Go o dwill 0.0 0.0 0.0 0.0 0.0 0.0 Net Financial Assets & Other 1,447.7 1,419.0 758.5 758.5 758.5 758.5 Total Fixed Assets 4,232.1 4,309.6 4,931.5 5,966.6 6,171.7 6,275.9 8.2% Net Working Capital 1,167.5 1,070.8 1,340.4 2,444.8 2,682.3 2,949.2 Total capital invested/employed 3,951.9 3,961.4 5,513.4 7,652.9 8,095.6 8,466.5 Shareholders Equity 3,304.5 3,294.6 3,703.2 3,932.4 4,243.3 4,664.8 7.1% M ino rities Equity 1.1 7.5 21.3 27.1 33.3 38.8 Net Debt 248.5 256.5 371.0 1,829.4 1,689.7 1,350.4 40.3% Provisions 664.1 714.1 777.8 928.0 1,016.9 1,105.6 Total M arket Cap 6,385.0 4,794.0 5,309.5 6,443.9 7,020.3 7,020.3 Entreprise Value (EV adj.) 5,851.9 4,356.5 5,730.4 8,488.9 9,020.8 8,773.3 MARGINS AND RATIOS S a l e s g r o w t h 14 . 5 % 11. 5 % 8 . 6 % 2 1. 1% 10 . 4 % 10 . 4 % EBITDA growth 9.0% 13.1% 11.1% 24.3% 10.2% 20.7% EBIT growth 7.2% 6.0% 10.9% 39.3% 14.7% 25.1% EBITDA margin 9.0% 9.1% 9.4% 9.6% 9.6% 10.5% EBITA margin 6.5% 6.4% 6.5% 6.3% 6.6% 7.5% EBIT margin 5.7% 5.4% 5.5% 6.3% 6.6% 7.5% Debt/Equity (gearing) 7.5% 7.8% 10.0% 46.2% 39.5% 28.7% Debt/EB ITDA 0.4 0.3 0.4 1.7 1.4 0.9 Interest cover (EBITDA/Fin.interest) 38.8 17.4 18.5 12.1 17.2 21.7 ROCE 6.3% 6.7% 8.5% 5.5% 5.9% 7.1% WACC 9.8% 9.3% 8.4% 8.0% 8.0% 8.5% ROCE/WACC 0.6 0.7 1.0 0.7 0.7 0.8 EV/CE 1.5 1.1 1.0 1.1 1.1 1.0 OpFCF/CE -11.6% -0.2% -12.5% -23.3% 0.0% 2.3% EV/Sales 0.8 0.5 0.6 0.7 0.7 0.6 EV/EBITDA 8.4 5.5 6.5 7.8 7.5 6.0 EV/EB ITA 11.7 7.9 9.3 11.8 10.9 8.5 EV/EB IT 13.3 9.3 11.1 11.8 10.9 8.5 P /E (adj.) 22.0 15.3 7.0 19.0 16.7 13.0 P/CF 14.0 9.4 6.0 9.1 8.8 7.3 P /B V 1.9 1.5 1.4 1.6 1.7 1.5 OpFCF yield -7.2% -0.1% -13.0% -27.7% 0.0% 2.8% Payout ratio 42.3% 44.7% 20.9% 32.4% 28.1% 21.9% Dividend yield (gross) 1.3% 1.8% 2.1% 1.7% 1.7% 1.7% PER SHARE DATA (EUR) EPS (reported) 0.473 0.447 1.246 0.803 0.997 1.279 22.0% EPS (adj.) 0.687 0.741 1.797 0.803 0.997 1.279 13 . 2 % CFPS 1.085 1.214 2.100 1.680 1.885 2.265 15 . 9 % BVPS 7.840 7.812 8.777 9.321 10.058 11.057 7.1% DPS 0.200 0.200 0.260 0.260 0.280 0.280 7.0% Source: Company, Banca Akros estimates * Data in IFRS

Source: Company, Banca Akros estimates

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USA LOCKHEED MARTIN CORP

AUTOMOBILE

Sales 2004 $35.5bn The Pentagon’s top supplier Backlog (30 September 2005) $69.1bn Lockheed Martin makes most of its sales with the Pentagon. LMT was born of the Ebit $2.2bn merger in 1995 between Lockheed Corp. and Martin Marietta. Lockheed subsequently acquired Loral’s defence electronics and systems integration Net result $1.3bn businesses in 1996. Bethesda, LM has 939 sites in 450 American cities, and employs a total of 130,000 people. Of Headquartered Maryland late, it has actively sought to reinforce its positions, selling property assets and making acquisitions in areas such as IT. LMT does not appear to need allies, but has nevertheless acquired Computer Science, the DoD’s ninth-biggest supplier. Main shareholder Building on previous years, LMT reinforced its position in Europe in early 2006, buying a submarine hatch business in Spain and finalising a sale of F-16 fighters to Free float 85.3% Greece. LMT is prime contractor of the Joint Strike Fighter programme. JSF is the next Share price 06/01/2006 $64.5 generation US fighter aircraft. Valued at $100bn, it will create three versions of a fighter aircraft intended to replace thousands of F-16, F/A-18, A-10 and Harrier jets Market Cap. $28.1bn worldwide. Net debt 2004 $5.2bn SWOT ANALYSIS Bloomberg LMT STRENGTHS WEAKNESSES Local Index NYSE ƒ Key supplier to the DoD ƒ Shortage of young engineers, ageing workforce ƒ History of managing client contracts ƒ Improved track record regarding ƒ LMT is not looking to divest lower- HSE performing units ƒ Air logistics unit strategic to the aerospace sector ƒ Total amount of liabilities recorded for environmental matters was approximately $420 million (2% of market cap, end 2004), mainly for remediation of soil and groundwater contamination

OPPORTUNITIES THREATS

ƒ JSF deliveries ƒ Cancellations or delays are possible in defence programmes

N INE- MONTH 2005 SALES BY SECTOR Agnès BLAZY 32% aerospace: tactical aircraft, airlift and aerospace CM - CIC Securities 28% electronic systems: missiles, naval systems, platform integration and C4I +33 1 45 96 77 61 18% space systems: space launch, commercial satellites, government satellites [email protected] and strategic missiles 11% integrated systems and solutions 11% IT services: federal services, energy programmes, government and commercial IT and aeronautical/aerospace services 2004 customers: DoD/Intelligence 58%; civil government/homeland security 22%; international 17%; commercial domestic 3% 2006 GUIDANCE The order book slipped by 7% in the first nine months of 2005. 2006 sales set to increase to approximately $38.8bn vs. $37.3bn in 2005 (+4%) according to consensus estimates.

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NORTHROP GRUMMAN CORPORATION

AUTOMOBILE

Sales 2004 $29.8bn Third-largest but most diversified supplier Backlog (30 sept 05) $56.2bn Ebit $2.0bn Northrop Grumman provides a broad range of technologically advanced, innovative Net result $1.1bn products, services and solutions in systems integration, defence electronics, Los Angeles, information technology, advanced aircraft, shipbuilding, and space technology. The Headquartered California group was very active in the acquisition market in 2000-02 (Litton, Newport News Shipbuilding, TRW), taking it up from number five to number three ranking among Main shareholder top contractors between 2000 and 2003. Free float 90.4% Northrop Grumman has 125,000 employees and operates in all 50 US states and Stock price 06/01/2006 60.2 $ 25 foreign countries, serving US and international military, government and Market Cap. 21.4 bn$ commercial customers. Northrop needs to expand its margins and drive cash Net debt 2004 3.9 bn$ generation Bloomberg NOC SWOT A NALYSIS Local Index NYSE STRENGTHS WEAKNESSES

ƒ The diversified portfolio should ƒ Defence programmes can be ensure future cash flows cancelled or delayed

ƒ Impact of Hurricane Katrina could force the company to review its shipbuilding capacity

ƒ High level of toxic releases

OPPORTUNITIES THREATS

ƒ Success of air combat drones ƒ Cuts to US budgets

ƒ Potential acquisitions

N INE- MONTH 2005 SALES BY SECTOR

21% electronic systems: airborne radar, navigation systems, electronic countermeasures, precision weapons

18% ship systems: design, engineering, construction, and life cycle support of Agnès BLAZY major surface ships CM - CIC Securities 17% integrated systems: network-enabled integrated systems and sub-systems +33 1 45 96 77 61 17% mission systems: missile systems and technical and management services [email protected] 16% information technology: full life-cycle solutions

11% space technology.

2004 customers: US Navy 35%; US Air Force 20%; US Army 5%; domestic commercial customers 5%, international 5%, other DoD and government 30%

2006 GUIDANCE

The order book shed 3% in the first nine months of 2005. 2006 sales set to increase to approximately $32bn vs. $30.7bn in 2005 (+4.2%).

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UNITED KINGDOM Rolls Royce Hold

AEROSPACE & DEFENSE

450vvdsvdvsdy The only listed engine pure play 400

350 B USINESS D ESCRIPTION

300 Rolls-Royce operates in four global markets: civil aerospace, defence aerospace, 250

200 marine and energy. It has a total of 54,000 gas turbines in service worldwide. The Dec 04 Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

ROLLS ROYCE DJ Stoxx Aerospace & Defense investments in product, capability and infrastructure needed to build up this market Source: FactSet JCF position create high barriers to entry. Rolls-Royce has a broad customer base --- Rolls Royce, --- DJ Stoxx Aerospace & Defence rebased comprising more than 500 airlines, 4,000 corporate and utility aircraft and helicopter operators, 160 armed forces and more than 2,000 marine customers, including 70 navies. It has energy customers in nearly 120 countries.

Reuters: RR.L Rolls-Royce employs around 35,000 people, of which 21,000 in the UK. Forty percent Bloomberg RR/ LN of its employees are based outside the UK, including 5,000 in the rest of Europe and 8,000 in North America.

Share price on 10/01/2006 (GBP) 426.00 INVESTMENT C ASE Target price(GBP) 411.0 Market capitalisation (GBPm) 6,867.0 The main question, given the group’s proven capacity to generate high levels of cash No. of shares (m) 1,612.0 flow, even ahead of the cyclical upturn, is how it plans to spend its cash. We have Free float 66.1% difficulty seeing external growth targets worth the GBP300m the group is expected to Daily avg. no. trad. sh. 12 mth 18,749,268 have at its disposal in 2007. Does this mean that an increase in the payout – and the Daily avg. trad. vol. 12 mth (m) 5,888,231 yield – could be on the cards? Price high 12 mth (GBP) 443.00 Price low 12 mth (GBP) 233.90 SWOT A NALYSIS

Abs. perf. 1 mth 7.4% STRENGTHS WEAKNESSES

Abs. perf. 3 mth 15.5% ƒ The size of the existing fleet helps ƒ Cash payments to reimburse risk- Abs. perf. 12 mth 67.1% boost sales during cycle troughs sharing partners are higher than receipts, which can be expected ƒ Presence in all segments of the civil weigh on future margins Local index FTSE 100 aerospace market and 26% market share in military engines DJ Stoxx 50 No ƒ Good EFI/CSR disclosure and efforts CAGR BPA 02/07 1 regarding HSE

OPPORTUNITIES THREATS ƒ JSF partnership ensures defence ƒ Terrorist action could endanger the sales growth, 25% of planned DoD recovery in air traffic, on which the motor orders group’s health depends ƒ World networks Agnès Blazy ƒ B787 engines: orders are increasing CM - CIC Securities ƒ Soaring oil prices driving fleet +33 1 45 96 77 61 renewal

[email protected]

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ROLLS ROYCE: summary tables PROFIT & LOSS (M £) 2002 2003 2004 2005e* 2006e* 2007e* CAGR07/02 Sales 5,788.0 5,645.0 5,939.0 6,422.1 6,753.9 7,080.0 4.1% EBITDA 544.0 564.0 661.0 890.6 1,018.4 1,073.9 14 . 6 % Depreciatio n & P ro visio ns -258.0 -241.0 -245.0 -263.2 -279.5 -297.0 Goodwill Amortisation -52.0 -48.0 -47.0 0.0 0.0 0.0 EBIT 234.0 275.0 369.0 627.4 739.0 776.9 27.1% Net Financial Interest -72.0 -66.0 -48.0 -25.2 -13.5 10.8 Other Financials -35.0 -24.0 -22.0 -150.0 0.0 0.0 Associates 0.00.00.00.00.00.0 Extraordinary Items -22.0 -5.0 7.0 0.0 0.0 0.0 Earnings Before Tax (EBT) 105.0 180.0 306.0 452.2 725.5 787.7 49.6% T a x - 5 2 . 0 - 6 4 . 0 - 10 1. 0 - 12 9 . 4 - 2 3 9 . 4 - 2 6 0 . 0 Tax rate 33.1% 28.1% 28.6% 28.6% 33.0% 33.0% M inorities 0.0 0.0 -1.0 -2.0 -2.0 -2.0 Net Profit (reported) 53.0 116.0 204.0 320.8 484.1 525.8 58.2% Net P ro fit (adj.) 105.0 164.0 251.0 320.8 484.1 525.8 CASH FLOW (GBPm) Net profit (reported) + Minorities 53.0 116.0 205.0 322.8 486.1 527.8 Non cash items 212.0 323.0 299.0 1,280.7 376.0 397.7 Cash Flow 265.0 439.0 504.0 1,603.5 862.1 925.5 28.4% Change in Net Working Capital 270.0 11.0 2.0 78.3 -62.9 -67.8 Capex -381.0 -196.0 -219.0 -272.3 -293.6 -315.4 Operating Free Cash Flow (OpFCF) 154.0 254.0 287.0 1,409.5 505.6 542.2 28.6% Net Financial Investments -20.0 -16.0 14.0 0.0 0.0 0.0 Dividends -130.0 -88.0 -33.0 -138.2 -145.0 -148.6 Other (incl. Capital Increase) -138.0 90.0 3.0 -1,246.0 -143.0 -150.0 Net Free Cash Flow -134.0 240.0 271.0 25.3 217.7 243.7 R+ NOPLAT 185.9 210.0 270.4 407.8 480.3 505.0 BALANCE SHEET & OTHER ITEMS (GBPm) Net Tangible A ssets 1,876.0 1,750.0 1,626.0 1,327.8 1,341.9 1,360.4 Net Intangible Assets (ex Goodwill) 82.0 104.0 199.0 496.0 605.3 722.3 Goodwill 786.0 759.0 712.0 753.0 753.0 753.0 Net Financial Assets & Other 266.0 266.0 256.0 588.0 603.1 617.9 Total Fixed Assets 3,010.0 2,879.0 2,793.0 3,164.8 3,303.4 3,453.6 2.8% Net Working Capital 394.0 383.0 381.0 302.7 365.6 433.4 Total capital invested/employed 3,138.0 2,996.0 2,918.0 2,879.5 3,065.9 3,269.2 Shareholders Equity 2,035.0 2,141.0 2,303.0 1,617.6 1,956.7 2,333.9 2.8% M ino rities Equity 2.0 3.0 4.0 6.0 6.0 6.0 Net Debt 595.0 323.0 80.0 54.9 -163.2 -406.4 R- P ro visio ns 772.0 795.0 787.0 1,789.0 1,869.5 1,953.6 Total M arket Cap 2,351.7 2,133.9 3,849.5 5,350.1 7,365.5 7,365.5 Entreprise Value (EV adj.) 3,954.7 3,205.9 4,704.7 7,420.2 9,291.3 9,130.0 MARGINS AND RATIOS Sales growth -8.5% -2.5% 5.2% 8.1% 5.2% 4.8% EBITDA growth -4.7% 3.7% 17.2% 34.7% 14.4% 5.4% EBIT growth -25.9% 17.5% 34.2% 70.0% 17.8% 5.1% EBITDA margin 9.4% 10.0% 11.1% 13.9% 15.1% 15.2% EBITA margin 4.9% 5.7% 7.0% 9.8% 10.9% 11.0% EBIT margin 4.0% 4.9% 6.2% 9.8% 10.9% 11.0% Debt/Equity (gearing) 29.2% 15.1% 3.5% 3.4% -8.3% -17.4% Debt/EBITDA 1.1 0.6 0.1 0.1 -0.2 -0.4 Interest cover (EBITDA/Fin.interest) 7.6 8.5 13.8 35.3 75.5 ns ROCE 5.7% 6.6% 8.5% 13.0% 14.5% 14.4% WACC 7.8% 6.9% 7.8% 7.0% 9.3% 9.3% ROCE/WACC 0.7 0.9 1.1 1.9 1.6 1.5 EV/CE 1.2 1.0 1.5 2.4 2.8 2.6 OpFCF/CE 4.7% 7.9% 9.1% 45.1% 15.3% 15.4% EV/Sales 0.7 0.6 0.8 1.2 1.4 1.3 EV/EBITDA 7.3 5.7 7.1 8.3 9.1 8.5 EV/EBITA 13.8 9.9 11.3 11.8 12.6 11.8 EV/EB IT 16.9 11.7 12.7 11.8 12.6 11.8 P /E (adj.) 22.4 13.2 15.9 17.3 15.8 14.5 P/CF 8.94.97.93.58.98.2 P /B V 1.2 1.0 1.7 3.3 3.8 3.2 OpFCF yield 6.5% 11.9% 7.5% 26.3% 6.9% 7.4% Payout ratio ns 116.1% 67.8% 45.2% 30.7% 29.0% Dividend yield (gross) 5.6% 6.3% 3.6% 2.7% 2.0% 2.1% PER SHARE DATA (GBp) EPS (reported) 3.288 6.942 11.644 17.914 27.027 29.357 56.0% EP S (adj.) 6.514 9.814 14.326 17.914 27.027 29.357 35.1% CFPS 16.439 26.272 28.767 89.533 48.135 51.677 25.7% B V P S 12 6 . 2 4 1 12 9 . 9 9 4 13 6 . 2 7 2 9 3 . 5 5 7 113 . 16 9 13 4 . 9 8 5 1. 3 % DPS 8.180 8.180 8.180 8.385 8.594 8.809 1. 5 % Source: Company, CM - CIC Securities estimates * Data in IFRS

Source: Company, CM - CIC Securities estimates

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FRANCE Safran Accumulate (vs Hold)

AEROSPACE & DEFENSE

22vvdsvdvsdy Back in the market: who will the next target 21 20 be? 19

18

17 B USINESS D ESCRIPTION

16

15 Safran is an international high-technology group with four core businesses: Dec 04 Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06 SAFRAN SBF 120 propulsion (engines for aircraft, helicopters, missiles, launch vehicles in civil Source: FactSet JCF --- Safran, and military markets, and support), equipment, defence and security --- DJ Stoxx Aerospace & Defence rebased (navigation, aircraft systems; optronics, air-land systems; security), communications (mobile handsets, printing terminals, residential terminals, digital TV, broadband networks and optics). The group was born of the merger between Sagem and Snecma, which was prompted by the desire to Reuters: SAF.PA embed more electronic components in the whole Snecma product family. It Bloomberg SAF FP was also a real opportunity for Sagem to get out of its strategic corner in which it was languishing (lot of cash, no projects). Safran has 58,000 Share price on 11/01/2006 (EUR) 21.05 employees in 30 countries. Sales are growing in all segments, and growing Target price(EUR) 23.5 sales in the aftermarket (services on the existing fleet) should translate into Market capitalisation (EURm) 8,778.0 better margins and more cash. No. of shares (m) 417.0 Free float 40.5% INVESTMENT C ASE Daily avg. no. trad. sh. 12 mth 78,826 Safran makes 10% of its sales with the French state, in three areas: defence, Daily avg. trad. vol. 12 mth (m) 1,357 propulsion, equipments. Safran is good at managing its industrial activities over Price high 12 mth (EUR) 21.05 its four divisions; it is also good at managing its assets. In 2005, the first year Price low 12 mth (EUR) 15.00 after the merger, Safran bought and sold around ten subsidiaries. We do not Abs. perf. 1 mth 6.6% expect the group to make a decision on any major acquisitions until Thales’s Abs. perf. 3 mth 11.4% future has been decided. Safran has the capacity to raise as much money to Abs. perf. 12 mth 37.1% make a new acquisition as Sagem did to acquire Snecma.

Local index SBF 120 SWOT ANALYSIS DJ Stoxx 50 No STRENGTHS WEAKNESSES CAGR BPA 02/07 0 ƒ Electronics company with ƒ Big dollar impact multiple markets, international client presence in OEM and ƒ The possible replacement of the MRO segments B787 may not use Snecma engines exclusively ƒ Sound finances, making new acquisitions likely in the very near future OPPORTUNITIES THREATS ƒ Possible orders in biometrics ƒ Permanence of the telecom from G8 countries: the group is a business: if a disposal comes too key player in Europe soon, the group could be classed as a holding ƒ More market share with aircraft Agnès Blazy manufacturers; overall, Safran ƒ Ambitious cost saving plans CM - CIC Securities has good presence in arms (includes savings necessary to +33 1 45 96 77 61 programmes in France and cope with currency risks and [email protected] abroad savings stemming from the merger)

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SAFRAN: summary tables PROFIT & LOSS (M €) 2002 2003 2004 2005e* 2006e* 2007e* CAGR07/02 Sales 2,763.3 3,180.4 3,570.2 10,560.0 11,207.6 11,627.1 33.3% EBITDA 329.0 367.3 411.3 1,296.5 1,410.6 1,492.2 35.3% Depreciatio n & P ro visio ns -241.2 -276.2 -257.7 -609.4 -637.6 -671.2 Goodwill Amortisation -6.1 -7.5 -8.1 0.0 0.0 0.0 EBIT 123.9 161.0 197.7 740.5 826.6 879.1 48.0% Net Financial Interest 23.3 8.8 4.5 -30.0 -29.0 -15.3 Other Financials -21.3 -5.6 1.2 -10.0 0.0 0.0 A sso ciates 0.0 0.0 0.0 0.0 0.0 0.0 Extrao rdinary Items -14.4 16.9 -11.5 -80.0 -80.0 -58.1 Earnings Before Tax (EBT) 111.5 181.1 191.9 620.5 717.6 805.7 48.5% Tax -34.6 -61.8 -57.7 -198.6 -229.6 -257.8 Tax rate 29.4% 32.8% 28.9% 32.0% 32.0% 32.0% M ino rities -0.1 -0.4 0.0 -12.0 -13.9 -15.6 Net Profit (reported) 76.8 118.9 134.2 409.9 474.1 532.3 47.3% Net P ro fit (adj.) 82.9 126.3 142.2 409.9 474.1 532.3 CASH FLOW (EURm) Net profit (reported) + Minorities 76.9 119.3 134.2 421.9 488.0 547.9 Non cash items 87.6 -2.0 95.8 1,974.4 584.0 613.1 Cash Flow 164.5 117.3 229.9 2,396.4 1,072.0 1,161.0 47.8% Change in Net Working Capital 90.9 40.3 -40.3 164.3 -41.0 22.6 Capex -61.0 -92.6 -120.0 -316.8 -448.3 -465.1 Operating Free Cash Flow (OpFCF) 194.3 65.1 69.6 2,243.9 582.7 718.5 29.9% Net Financial Investments -43.2 13.0 -1,242.0 0.0 0.0 Dividends -21.8 -28.9 -32.8 -300.8 -78.5 -98.1 Other (incl. Capital Increase) -184.4 -9.1 -91.5 -2,027.7 -413.4 -227.7 Net Free Cash Flow -16.1 -41.7 -1,326.7 90.8 392.7 NOPLAT 84.5 109.5 133.7 481.3 537.3 571.4 BALANCE SHEET & OTHER ITEMS (EURm) Net Tangible A ssets 223.6 246.2 279.2 1,713.0 1,734.8 1,800.3 Net Intangible Assets (ex Goodwill) 13.3 13.5 16.5 3,475.0 3,492.7 3,509.6 Go o dwill 69.5 86.9 88.7 1,279.0 1,279.0 1,279.0 Net Financial Assets & Other 189.3 20.4 19.0 457.0 459.0 460.2 Total Fixed Assets 495.7 367.0 403.3 6,924.0 6,965.5 7,049.2 70.1% Net Working Capital 671.3 631.0 671.3 507.0 548.0 525.4 Total capital invested/employed 977.8 977.5 1,055.7 6,974.0 7,054.5 7,114.3 Shareholders Equity 1,277.1 1,177.7 1,208.2 4,654.0 4,826.2 5,279.1 32.8% M inorities Equity 0.7 1.0 1.5 167.0 168.0 169.0 Net Debt -464.4 -448.4 -406.6 920.0 829.2 436.5 R+ Provisions 353.7 267.6 271.6 1,690.0 1,690.0 1,690.0 Total M arket Cap 2,263.5 2,389.2 2,984.9 7,123.0 8,787.6 8,787.6 Entreprise Value (EV adj.) 1,742.7 2,038.1 2,667.7 8,607.7 10,157.2 9,764.5 MARGINS AND RATIOS Sales gro wth -9.0% 15.1% 12.3% 195.8% 6.1% 3.7% EB ITDA gro wth 194.2% 11.6% 12.0% 215.2% 8.8% 5.8% EBIT growth +chg 29.9% 22.7% 274.6% 11.6% 6.4% EBITDA margin 11.9% 11.5% 11.5% 12.3% 12.6% 12.8% EBITA margin 4.7% 5.3% 5.8% 7.0% 7.4% 7.6% EBIT margin 4.5% 5.1% 5.5% 7.0% 7.4% 7.6% Debt/Equity (gearing) -36.3% -38.0% -33.6% 19.1% 16.6% 8.0% Debt/EBITDA -1.4 -1.2 -1.0 0.7 0.6 0.3 Interest cover (EBITDA/Fin.interest) ns ns ns 43.2 48.6 97.7 ROCE 6.8% 10.2% 11.5% 6.5% 7.2% 7.5% WACC 9.5% 10.3% 10.2% 9.3% 9.3% 9.3% ROCE/WACC 0.7 1.0 1.1 0.7 0.8 0.8 EV/CE 1.4 1.9 2.3 1.2 1.4 1.3 OpFCF/CE 15.7% 6.0% 6.0% 30.2% 7.8% 9.5% EV/Sales 0.6 0.6 0.7 0.8 0.9 0.8 EV/EBITDA 5.3 5.5 6.5 6.6 7.2 6.5 EV/EBITA 13.4 12.1 13.0 11.6 12.3 11.1 E V / E B I T 14 . 1 12 . 7 13 . 5 11. 6 12 . 3 11. 1 P/E (adj.) 27.3 18.9 21.0 17.4 18.5 16.5 P /CF 13.8 20.4 13.0 3.0 8.2 7.6 P /B V 1.8 2.0 2.5 1.5 1.8 1.7 OpFCF yield 8.6% 2.7% 2.3% 31.5% 6.6% 8.2% Payout ratio 46.2% 28.8% 29.1% 19.1% 20.7% 25.0% Dividend yield (gross) 1.6% 1.4% 1.3% 1.1% 1.1% 1.5% PER SHARE DATA (EUR) EPS (reported) 0.390 0.653 0.756 0.982 1.136 1.275 26.7% EPS (adj.) 0.421 0.694 0.801 0.982 1.136 1.275 24.8% CFPS 0.835 0.645 1.295 5.740 2.568 2.781 27.2% BVPS 6.482 6.470 6.807 11.148 11.561 12.645 14 . 3 % DPS 0.180 0.188 0.220 0.188 0.235 0.319 12 . 1% Source: Company, CM - CIC Securities estimates * Data in IFRS

Source: Company, CM - CIC Securities estimates

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FRANCE Thales Buy

AEROSPACE & DEFENSE

60vvdsvdvsdy Too many assets to remain single 55

50 B USINESS D ESCRIPTION 45

40 Established in France more than a century ago, Thales is a global electronics company 35

30 working in aerospace, defence, security and services markets using a common core of Dec 04 Jan 05 Feb 05 Mar 05 Apr 05 May 05 Jun 05 Jul 05 Aug 05 Sep 05 Oct 05 Nov 05 Dec 05 Jan 06

THALES DJ Stoxx Aerospace & Defense technologies. The group has operations in 30 countries, and employs 60,000 persons. Source: FactSet JCF --- Thalcs, INVESTMENT C ASE --- DJ Stoxx Aerospace & Defence rebased Military affairs are multi-domestic, Thales has the capacity to develop complex systems and manage them as prime contractor. Thales is present on all types of air, sea and ground military platforms. Thales has just finalised a partial bid for DCN, and is now the

main focus of the industry. Reuters: TCFP.PA Bloomberg HO FP A lot of players could be interested in acquiring Thales. They include Alcatel, EADS and Safran to name only a few. Foreign players could also be interested, although the Share price on 11/01/2006 (EUR) 39.20 group’s presence in defence businesses could make this problematical. All the group’s Target price(EUR) 40.0 divisions are active in defence and security. Since 2000, sales with the French sate Market capitalisation (EURm) 6,737.0 have grown at a faster pace than consolidated sales overall (+62% vs. +28% No. of shares (m) 171.9 respectively). Free float 42.9% Daily avg. no. trad. sh. 12 mth 714,451 SWOT ANALYSIS Daily avg. trad. vol. 12 mth (m) 25,062 STRENGTHS WEAKNESSES Price high 12 mth (EUR) 39.32 ƒ Multi-country presence facilitates ƒ Little financial leeway future growth in defence sales Price low 12 mth (EUR) 31.20 ƒ Increased competition from the US Abs. perf. 1 mth 4.0% ƒ 60% of sales denominated in the due to the currency (see comments same currency as costs. The on Dassault, and the loss of Rafale Abs. perf. 3 mth 3.1% remaining 40% are naturally hedged contract to Singapore) Abs. perf. 12 mth 12.0% through purchasing in the relevant currency. The group does not suffer much from currencies due to its Local index CAC 40 multi-location strategy DJ Stoxx 50 No ƒ 50 sites ISO14000 certified and low CAGR BPA 02/07 0 environmental provisions standing at only €8.9 million.

OPPORTUNITIES THREATS

ƒ Huge needs for C4ISR systems ƒ Poor visibility on orders from the (inter-army and inter-nation Middle East (15% of sales on coordination), the group’s speciality average) Agnès Blazy ƒ General acquisition interest from ƒ Real or disturbing scandals: press CM - CIC Securities sector players reports on suspected corruption are very common +33 1 45 96 77 61 [email protected]

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THALCS: summary tables PROFIT & LOSS (M €) 2002 2003 2004 2005e* 2006e* 2007e* CAGR07/02 Sales 11,105.1 10,569.4 10,288.4 10,131.0 10,698.4 11,278.0 0.3% EBITDA 1,004.3 1,163.8 1,175.0 1,226.2 1,329.4 1,238.1 4.3% Depreciation & Provisions -307.4 -281.8 -271.9 -289.6 -308.3 -328.1 Go o dwill A mo rtisatio n -193.5 -174.2 -169.5 0.0 0.0 0.0 EBIT 403.4 523.7 559.8 765.5 840.4 910.0 17 . 7 % Net Financial Interest -113.9 -99.2 -84.0 -91.8 -68.6 -61.6 Other Financials -49.0 -10.0 -11.3 0.0 0.0 0.0 A s s o c i a t e s 2 9 . 2 18 . 2 18 . 0 13 . 7 11. 0 10 . 8 Extraordinary Items -72.2 -277.6 -216.9 -224.7 -232.2 -128.4 Earnings Before Tax (EBT) 197.5 155.1 265.6 462.6 550.7 730.8 29.9% Tax -83.3 -30.3 -58.3 -202.1 -231.6 -254.5 Tax rate 23.0% 9.7% 14.0% 45.0% 42.9% 35.4% M inorities -3.1 -12.4 -8.8 -15.0 -17.2 -18.9 Net Profit (reported) 111.1 112.4 198.5 245.5 301.9 457.4 32.7% Net Profit (adj.) 304.6 286.6 368.0 245.5 301.9 457.4 CASH FLOW (EURm) Net profit (reported) + Minorities 114.2 124.8 207.3 260.5 319.1 476.3 Non cash items 557.8 284.2 400.1 1,391.4 471.8 309.2 Cash Flow 672.0 409.0 607.4 1,651.9 790.9 785.5 3.2% Change in Net Working Capital -328.1 290.0 -450.0 -1,180.1 -87.8 -89.5 Capex -356.7 -350.0 -321.0 -354.4 -374.3 -394.7 Operating Free Cash Flow (OpFCF) -12.8 349.0 -163.6 117.5 328.8 301.3 R+ Net Financial Investments 195.9 291.5 98.6 0.0 0.0 0.0 Dividends -120.3 -175.0 -162.0 -137.5 -143.0 -148.7 Other (incl. Capital Increase) 98.3 -41.0 303.4 -579.8 -32.6 -28.3 Net Free Cash Flow 161.1 424.5 76.4 -599.8 153.2 124.3 -5.1% NOPLAT 399.9 467.6 488.6 512.9 563.1 609.7 BALANCE SHEET & OTHER ITEMS (EURm) Net Tangible A ssets 1,385.6 1,272.7 1,213.9 1,161.9 1,177.9 1,194.5 Net Intangible Assets (ex Goodwill) 173.6 206.3 234.5 286.0 336.0 386.0 Goodwill 2,336.1 2,146.2 1,955.2 1,951.0 1,955.2 1,955.2 Net Financial Assets & Other 784.4 650.8 629.2 949.7 978.1 1,006.4 Total Fixed Assets 4,679.7 4,276.0 4,032.8 4,348.6 4,447.2 4,542.1 -0.6% Net Working Capital 412.6 122.6 345.7 1,525.8 1,613.6 1,703.1 Total capital invested/employed 4,307.9 3,747.8 3,749.3 4,924.7 5,082.7 5,238.8 Shareholders Equity 2,138.9 2,014.4 2,097.0 1,885.8 2,044.7 2,353.4 1. 9 % M ino rities Equity 29.0 43.4 49.5 39.9 39.9 39.9 Net Debt 1,348.5 924.3 848.0 1,447.9 1,294.7 1,170.4 -2.8% P ro visio ns 1,575.9 1,416.5 1,384.0 2,500.8 2,681.5 2,681.5 Total M arket Cap 6,284.9 4,286.2 5,116.8 6,010.1 6,737.3 6,737.3 Entreprise Value (EV adj.) 8,843.7 6,479.0 7,196.1 9,492.0 10,157.9 9,961.5 MARGINS AND RATIOS Sales gro wth 8.2% -4.8% -2.7% -1.5% 5.6% 5.4% EBITDA growth -0.9% 15.9% 1.0% 4.4% 8.4% -6.9% EBIT growth +chg 29.8% 6.9% 36.7% 9.8% 8.3% EBITDA margin 9.0% 11.0% 11.4% 12.1% 12.4% 11.0% EBITA margin 5.4% 6.6% 7.1% 7.6% 7.9% 8.1% EBIT margin 3.6% 5.0% 5.4% 7.6% 7.9% 8.1% Debt/Equity (gearing) 62.2% 44.9% 39.5% 75.2% 62.1% 48.9% Debt/EB ITDA 1.3 0.8 0.7 1.2 1.0 0.9 Interest co ver (EB ITDA /Fin.interest) 8.8 11.7 14.0 13.4 19.4 20.1 ROCE 6.6% 8.5% 8.7% 7.5% 8.1% 8.6% WACC 8.8% 9.2% 9.2% 7.9% 8.3% 8.4% ROCE/WACC 0.7 0.9 0.9 1.0 1.0 1.0 EV/CE 1.5 1.2 1.3 1.4 1.5 1.4 OpFCF/CE -0.2% 6.4% -2.9% 1.7% 4.7% 4.2% EV/Sales 0.8 0.6 0.7 0.9 0.9 0.9 EV/EBITDA 8.8 5.6 6.1 7.7 7.6 8.0 EV/EBITA 14.8 9.3 9.9 12.4 12.1 10.9 EV/EB IT 21.9 12.4 12.9 12.4 12.1 10.9 P/E (adj.) 20.6 15.0 13.9 24.5 22.3 14.7 P/CF 9.4 10.5 8.4 3.6 8.5 8.6 P /B V 2.9 2.1 2.4 3.2 3.3 2.9 OpFCF yield -0.2% 8.1% -3.2% 2.0% 4.9% 4.5% Payout ratio 108.3% 114.7% 69.3% 58.2% 49.3% 33.8% Dividend yield (gross) 1.9% 3.0% 2.7% 2.4% 2.2% 2.3% PER SHARE DATA (EUR) EPS (reported) 0.646 0.654 1.155 1.429 1.757 2.661 32.7% EPS (adj.) 1.772 1.668 2.141 1.429 1.757 2.661 8.5% CFPS 3.910 2.380 3.534 9.612 4.602 4.570 3.2% B VP S 12.445 11.721 12.201 10.972 11.897 13.693 1. 9 % DPS 0.700 0.750 0.800 0.832 0.865 0.900 5.2% Source: Company, CM - CIC Securities estimates * Data in IFRS

Source: Company, CM - CIC Securities estimates

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Appendix: tax rewards and subsidies, the debate

Trade and aid – Airbus (EU) vs. Boeing (US)

Trade disputes between European and the US governments have a long history, running for over close to forty years. At issue is a fight over tax breaks and government aid for the makers of large commercial/civil aircraft (i.e. jet aircraft with 100+ seats). The market and dispute is essentially between a duopoly consisting of two manufacturers, Boeing (US) and Airbus (EU), with potential knock-on impacts for players such as BAE and Rolls Royce as well as smaller, regional and specialist players.

ƒ Use of trade policy in the sector

Governments use trade policy to give domestic players a strategic competitive advantage (i.e. market share and profits) over foreign rivals – corporate and governmental. Both Boeing and Airbus have undoubtedly received significant government support whether directly or indirectly.

Two different aid models

The nature and scope of each company’s aid is largely premised on conflicting views as to the limits of state influence – the EU vs. US – as well as the different webs of links between the respective governments and their aero-defence players. The EU, in particular has taken a much more pro-active approach to state intervention in the sector, notably through direct support such as repayable launch aid for commercial aircraft. The US on the other hand has adopted a more indirect approach to funding. Both sides – the US and the EU governments – are united on one argument – that government aid accorded by the other has provided unfair advantages in the civil aircraft market.

ƒ Airbus’ emergence stokes the fires

In recent years, the dispute has largely centred on Airbus, which since the 1970s, has gained significant market share, and significant amounts of governmental subsidy and assistance – which facilitated its entry and participation in the market. The entry of Airbus has undoubtedly fostered international competition and reduced aircraft prices significantly. The emergence of Airbus – steadily increasing market share and gaining of ground over Boeing in terms of deliveries, value of deliveries and order backlog – has led the US to argue that Airbus is no longer an infant industry in need of protection but rather that EU governments are providing a well-developed company with unjust and predatory aid with the goal of out-competing Boeing. Airbus counters that Boeing receives aid in the form of indirect subsidies.

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ƒ 1992 EU-US agreement – a temporary truce

In 1992, after years of extensive dispute, the US and EU agreed a bilateral Civil Aircraft Agreement covering the development of large aircraft (i.e. 100+ seats). The agreement marked a notable precedent for the EU – which acted collectively on behalf of all Airbus- implicated governments, thus increasing bargaining power – something it has continued to do to date. The agreement resolved a number of outstanding EU vs. US issues and resulted in a recently ended twelve year truce – albeit a highly tumultuous one:

• Prohibition of production subsidies and limitation of direct government support to 33% of development costs for a new aircraft programme;

• Support could only be given to development projects likely to repay the support within 17 years;

• Repayments on a per-plane basis (vs. at the end of the loan); and

• Indirect supports limited to a maximum of 4% of annual commercial sales of a company or 3% of industry-wide annual commercial sales in each country.

In order to reduce the risk of trade conflicts, the two sides agreed to monitor implementation and to resolve disputes through consultation. Either side could also abrogate the agreement for non-compliance by the other.

ƒ Deal was a small victory for the US

In retrospect, the deal although far from perfect (from either side’s view) was a victory for the US in that the EU abandoned production subsidies, accepted constraints on launch investments and limited Airbus to 33% repayable investment funding – a marked improvement on EU government loans of 60-100% for earlier development programmes (i.e. A330-340). For the EU, the victories were more symbolic – tacit recognition that the US industry benefited from NASA and Pentagon support and US acceptance of limits on indirect supports.

ƒ Economics brought about a temporary truce

Neither side formally challenged the other over the agreement from 1992-2004 (i.e. through the WTO or retaliatory measures) – and the US actually took the view that the GATT/WTO Agreement on Subsidies and Countervailing Measures (1994) took precedence. The truce may be explained by the fact that most players (governmental and corporate) were dealing with the salient reality of a significant downturn in both the civil and defence markets and ensuing corporate restructuring. An upturn in both markets in the early 1990s marked a formal declaration of trade war with the US abrogating the agreement in 2004 (see below).

EU (Airbus) vs. US (Boeing) – the arguments

From 1992 to 2004, the truce held but both sides collected evidence and built their respective arguments for the case on civil aircraft subsidies. The emergence and development of Airbus over this period as well as the increasing difficulty of either actor to penetrate the others’ market (including vis-à-vis the supply chain) were major drivers in increasing tensions.

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The tensions rose to a crescendo over subsidisation of the next generation of – directly competing – aircraft, the Boeing 787 and the Airbus A380. On 6 October 2004, the US withdrew from the 1992 treaty with the EU and took their first steps towards formal legal proceedings at the WTO – and their goal of an end to repayable launch aid. The EU retaliated on the same day by launching counter-proceedings against the US, arguing that Boeing had “illegally” been given as much as USD 23 billion.

ƒ Unfair US tax breaks – a string of victories for the EU

One of the central arguments of the EU is that Boeing and other exporters have and continue to receive billions of dollars in illegal export tax exemptions from the US government. According to the EU, the tax breaks for Boeing have added up to close to USD 200 million p.a. – USD 1.6B from 1995-2005 and an estimated further USD750M benefit over the next ten years. The EU has successfully challenged the way that the US grants these tax breaks in a series of cases over the last decade – with its latest victory coming in September 2005. These decisions mark the largest ever retaliatory trade measures approved by the WTO – USD 4 billion – and add weight to the EU’s arguments over the larger issue of trans-Atlantic government funding for Airbus and Boeing. i) Foreign Sales Corporation (FSC)

The EU’s original compliant related to the granting of Foreign Sales Corporation (FSC) status to thousands of companies. While FSC status was ostensibly intended to promote the export of a US parent company’s products or services, in practice it allowed companies to set up - shell companies – “offshore subsidiaries” in official parlance – to book profits from overseas sales in jurisdictions without income taxes. The WTO ruled the FSC illegal in 1999 and again in 2000 following an US appeal. ii) Extra-Territorial Income (ETI)

The US repealed the FSC in 2000 and simply replaced it with the Extra-Territorial Income (ETI) system, which allows certain US exporters to exclude a portion of earnings made abroad from their overall income – thus lowering their tax bill. The WTO ruled against the ETI in 2001 stating that US exporters were involved in a “foregoing of revenue which is otherwise due”. The WTO permitted the EU to impose retaliatory duties of up to USD 4 billion on US exports unless the US repealed the measures. iii) American Jobs Creation Act (AJCA)

After the 2001 WTO ruling, the US embarked on a comprehensive overhaul of its corporate tax laws, burying the FSC & ETI – but passed the AJCA in their place. As a result, the EU temporarily suspended the duties that it has been levying since 2004 following the ETI decision. However, soon thereafter, the EU asked the WTO to review certain clauses of the Act as the law extended eligibility for FSC/ETI tax breaks for a further two year transition period and allowed companies that had previously benefited (all contracts in place on September 17, 2003) to continue to do so under a grandfather clause. In September 2005, the WTO ruled against the US law stating that the US has continued to fail to “withdraw the prohibited subsidies and bring its measures into conformity” with earlier rulings. This latest decision renews the prospect of trade retaliation of up to USD4 billion on US imports into the EU although the US is likely to buy time through an inevitable but probably doomed appeal.

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ƒ R&D tax credits

Tax incentives for research are a clear stimulus for long-term innovation and development, particularly in the aero-defence sector which is characterised by and dependent upon high research technology investments. Such tax incentives can have a significant impact on industry players’ decisions on where and how much to invest. European and US aero-defence players are pushing for them to develop their long-term manufacturing plans in light of tight budgetary constraints.

An increasing focus on new high technologies (i.e. modernised equipment, new problems plaguing troops such as roadside bombs and the next generation of technologies (military satellites, precision-guided instruments and technologies that contribute to manoeuvrability, mobility and navigation), will force all companies to invest in R&D (and push for such credits) before they can bid or have a chance of winning government contracts.

ƒ ASC – new advantage for US players

A major impending development in the US is that for the first time after close to two decades of lobbying, the House of Representatives’ Ways and Means Committee unanimously voted in favour of a new credit – the alternative simplified credit (ASC) – which would allow companies to claim a potential 12% of “qualified research expenditures” that exceed 50% of a company’s research expenditure over the past three years. Assuming the House passes a planned USD70B tax-cut package before the end of the year, the ASC would be a major boost in incentives for higher-risk aero-defence research. Companies would get an estimated 6% return on their investments.

ƒ Boeing 787 vs. Airbus A380

One of the most contentious debates has been over repayable launch investment and actual or perceived subdues for the next generation of large commercial passenger aircraft – the directly competing Boeing 787 and Airbus A380.

What’s at issue?

At issue are Boeing’s contribution to the launch costs of the 787 which are estimated at USD 4.2 billion (60% of a total USD 7 billion) and Airbus’ parent companies at USD5.2 billion (51% of a total USD 10.2 billion). This means that close to 50% of launch investment came from government sources – with both the EU and US arguing that the other’s aid is prohibited and/or actionable at the WTO.

US arguments vs. the A380

The development and launch of the A380 lacked commercial justification without government subsidies;

• EU government aid only has to be repaid if the A380 was commercially successful after 17 years, thus significantly reducing risks – and as repayments are to be made on a per plane levy basis, Airbus has no liability to pay back of it fails to sell sufficient numbers and once the initial investment is paid back, Airbus pays royalties on additional sales;

• EU provided USD 1billion in infrastructure investments to make the A380’s development possible;

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• Airbus violated the 1992 agreement’s underlying commercial principle that companies must accept the risk of failure in the market place – by using repayable launch investment, it was able to develop a new line of aircraft in a shorter time than if it has had to rely on commercial funding and debt (i.e. of up USD35 billion)

• The A380 success and Airbus’ success in gaining market share undermines EU infant “industry arguments” – and contravenes the 1992 agreement and 1994 WTO code.

EU arguments vs. 787

• State of Washington gave Boeing tax incentives worth USD3 billion+ over 20 years to conduct final assembly of commercial aircraft in the State – which proportionately exceeds the subsidy levels received by the A-380 – as well as providing up to USD 4 billion in subsidies for improving physical plant & infrastructure;

• Both Japan and Italy are also considering repayable launch investment packages (for national firms acting as major subcontractors) and that Boeing’s access to Japanese aid is an indirect subsidy as the major national aero-defence companies are pro-Boeing and have access to government loans which facilitate their ability to work with Boeing

• US manufacturers have long benefited from much greater indirect governmental subsidies / technical cross-pollution – up to USD 20 billion since 1992 – largely in the form of military (Pentagon) and space (NASA) contracts and government sponsored aero- defence R&D;

• Its own launch aid causes less distortion than the support Boeing receives (none of which has to be repaid).

Possible outcomes

ƒ Mutually damaging WTO ruling

If both side continue to push the dispute forward and the WTO is forced to rule, there is a very strong possibility that it rules that both the US and EU complaints are valid, giving both sides the right to retaliate. This would create a great degree of uncertainty (and increased production costs), with both sides potentially spending years trying to sort through the plethora of fines and sanctions, and the situation further complicated by retaliatory trade measures by one or both sides. A multi-billion dollar limbo – a la Bombardier-Embraer – springs to mind.

ƒ US (Boeing) have more to lose!

Assuming the WTO did find against both parties, it is important to note that the US has much more to lose than Airbus, particularly with regard to 787 as it:

• Marks its first significant new commercial aircraft project in close to a decade;

• Would threaten its long-term competitiveness (i.e. competence) as the new aircraft marks a significant shift in its production model towards a more decentralised system integration approach coordinating the efforts of a number of international partners (nb – although this also has the advantage of significantly reducing development costs and risks);

• Threatens the support of international partners such as Italy and Japan, which could threaten sales with these likely customers;

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• Represents one of the last major chances to catch up and conceivably surpass Airbus in the commercial field.

In contrast, the risks for Airbus from an adverse ruling are mitigated by the fact that the US’ complaints centre on the A380, for which the investments have already been made (i.e. too late) and the A350 which has only just been launched (October 2005) and relies greatly on the A330. However, in the longer-term, European aero-defence players would probably suffer significantly from the loss of repayable launch aid.

ƒ Compromise solution(s)

Fundamental giving of ground by either side is highly unlikely given the major sea-changes required in the underlying stances on state influence and funding:

• For the EU – this would involve achieving US-style integration for both civil scientific and technology programmes and defence R&D; shifting towards an indirect funding model (in the context of always difficult EU budget decision-making processes); and developing synergies between civil and defence activities over a number of years.

• For the US – this would involve a shift towards Airbus government/EU-style funding; or moves to strengthen the existing anti-subsidy regime such as through a re-negotiated 1992 agreement. ƒ Cost(s) of compliance – what it will probably come down to

Ultimately, any resolution or lack thereof will be tied to the salient reality of cost – i.e. an assessment of the potential costs of compliance vs. the costs of non-compliance. While both Boeing and Airbus are important sources of jobs and exports, the fact is that the aero-defence sector no longer has the same social and economic importance in the US or in Europe that it had in years past. This could be a spur to comply with any potential ruling.

ƒ Trade war – worst case outcome

The greatest risk – and a reasonable probability – is that the Boeing-Airbus dispute gets further rolled into the complex web of existing US-EU trade tensions. This would probably lead to racketing up of tit-for-tar retaliatory trade measures (direct and indirect) and the possibility of an all-out trade war leading to instability for the sector and the global economy. This would make any resolution of the Boeing-Airbus trade battle nigh impossible – and an immediate truce or mutually-acceptable compromise solution all the more attractive (i.e. vs. a WTO decision which is damaging for both sides).

Hope on the horizon

Boeing has recently said that the dispute over subsidies can be resolved through negotiation with Thomas Pickering, VP for International Relations publicly stating that “There should be a disputes settlement, self-contained within a negotiated settlement One potential compromise – particularly interesting from an extra-financial perspective – would be for both sides to commit to restrict … perhaps even of binding character to resolve such future spats”. Such words have been openly welcomed by the EU with Trade Commissioner Peter Mandelson also advocating a negotiated settlement as the preferred option. Despite this, there is no clear timeframe for settlement and both sides are engaging in tit-for-tat trade retaliation.

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ƒ Long-term returns, government intervention & shareholders

The EU-US conflict is ultimately rooted in conflicting visions and models of socio-economic policy. Both sides are committed to preserving jobs and exports (their own, of course), but are on totally different wavelengths when it comes to the role of government.

ƒ EU’s approach has paid dividends

Airbus’ improved market share and profitability over the last decade can partly be attributed to the focus of EU governments’ on long-term strategy and returns including through active intervention through direct aid – as well as a better ability to spend heavily on civil R&D because of its relative insulation from shareholders (vs. Boeing).

ƒ Boeing’s damages are partly self-inflicted

In the same vein, Boeing’s slide in market share over the last decade can partly be attributed to the lack of long-term strategy – some would say poor strategy – as well as insufficient investments in civil R&D and the predominance of short-term shareholder value over long- term strategy and returns. Boeing has been in a strong cash position over the last decade but chose not to invest in commercial aircraft development and instead returned cash to shareholders. Its non-contract R&D budget has been stalled at USD 800 million p.a. – enough to develop variants of existing aircraft (vs. all-new design). Airbus on the other hand has invested heavily in new product development – spending 2x as much as Boeing over the past few years. Given Boeing’s unimpressive new product spending record, there is no guarantee that US aid would lead to increased R&D or that they could actually prove damages at the WTO.

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Appendix: Aero Defence Sector and employment: chicken and egg

European employment profile

ƒ 1 million strong workforce

Total direct employment in the European aerospace & defence industries (ADI) at the end of 2003 was estimated at 414,500 (+1.6% on 2002). An additional 50,000 employees work in ADI subsidiaries outside the EU (i.e. North America et. al.). Taking into account associated jobs in the supply chain, the overall employment generated by the European ADI is estimated to be well over 900,000 people (ASD, ACEMA).

ƒ National, regional and local importance of workforce

The ADI is extremely focused on certain countries with a significant proportion of its workforce employed in the UK (124,400) and France (105,900). In both these countries, ADI-related employment constitutes a relatively significant proportion of overall industrial employment - 4.1 and 4.4 per 1,000 employees respectively. Germany follows closely behind with Italy, Spain and Sweden accounting for still significant levels of employment. Employment in other EU countries is relatively negligible.

Employment in the ADI also tends to be very much localised with jobs frequently concentrated in certain regions. This is particularly the case in Germany (Schleswig-Holstein, Lower Saxony and North Rhine-Westphalia) and France (Provence- Alpes-Côte d'Azur or PACA, Centre and Brittany) but also Italy and the UK. Associated SME employment is also quite significant in these regions. ƒ Highly skilled workforce

The average level of qualifications of the ADI workforce is generally-speaking higher than the national averages in European countries. The ADI provides a large number of highly skilled jobs with 29% of all employees having a university degree or equivalent. Another 33% have received education at below university level – including technicians, draughtsmen, craftsmen and secretaries. The remaining 38% of employees working as manual workers have been highly trained, either within or outside the ADI to cope with the sophisticated nature of the technologies at play in the sector (ASD, ACEMA).

ƒ High value-added workforce

The level of turnover per employee has been on the rise over the course of the last 25 years and has grown from approximately €72k per employee in 1980 to €117k in 1990 and to €180k in 2003 (ASD). While a reduced workforce patterns has inevitably played something of a role in this increase, much of it can also be attributed to the specialised and technologically advanced nature of the ADI as well as the highly skilled nature of its workforce.

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ƒ A partially subsidized industry: the UK example

… An Oxford Economic Forecasting (OEF) study, commissioned by Defence Industries Council, indicates that the cost to Government of supporting defence exports amounts to some £140 million at most (and some of this is attributable to broader defence diplomacy objectives, so would continue anyway). But the UK Government benefits from more efficiently priced defence equipment by £300 million a year. BASIC, and other NGOs, disagree in principle with defence exports. However the facts indicate that defence exports benefit the economy and national security.

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Appendix

Environmental efficiency, another potential source of conflict over the next 15 years

Of the panel studied, only EADS, Boeing, RR and Safran (and to a lesser extent Dassault Aviation) operate civil manufacturing activities. Air companies, their end-customers, are increasingly concerned by climate change issues. Seven years after the Intergovernmental Panel on Climate Change (IPCC) report on the aeronautic sector and green-house gas emissions, the European Commission is now trying to introduce economic incentives to reduce green-house gas emissions. At a global level, pressure is being put on the International Civil Aviation Organisation (ICAO) and at European level on the air companies, which has led to a tax on aviation fuel and the implementation of a CO2 quota exchange system (the EU ETS - European Union Greenhouse Gas Emission Trading Scheme). Definite decisions are expected to be taken in 2007-2008. However, the issue of emissions is only a by-product of the broader issue of efficient aircraft consumption. No new environmental incentives are on the cards but customers are stepping up pressure for greener aircraft (more efficient engines, higher passenger and freight capacity, wing types, better fuselage). Given the information available, we do not expect any major revolution in this area (hydrogen, biofuel, solar engines) or in aerodynamics before 2020.

AirBus vs. Being: the Hydrogen Divide

ƒ Long-term air traffic growth and emissions

Air traffic has experienced strong growth over a long time, and it is predicted that such growth will continue at rates of 4 – 5 % p.a. over the next decades. Current traffic losses in the aftermath of September 11th 2001 are expected to be only temporary. Assuming continuing worldwide economic growth, saturation of air traffic is not yet in sight. For the aircraft manufacturers, this is a highly welcome prospect, because only one third of their production is for replacement of old aircraft, two thirds of the production serves the needs of traffic growth. On the other hand, it is generally accepted that the emission of greenhouse gases, most notably of long-living carbon dioxide (CO2), resulting from men’s activities, cannot be allowed to continue increasing if adverse global climate change is to be avoided. Air traffic today contributes only some 3% to the anthropogenic greenhouse effect. Advances in aeronautical engineering have led and will lead to significant improvement in energy efficiency of transport aircraft. But there is no realistic prospect that such gains in efficiency will be sufficient to compensate for expected traffic growth as far as CO2 emissions are concerned. Nor is it likely that aviation will be accorded a privileged exemption from the general need to reduce CO2 emissions. Greenhouse gas emissions from air transport are increasing more than other modes of transport such as rail or road. If nothing is done, then these emissions will get considerably worse before the oil runs out.

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CO2 emissions worldwide: domestic and international split

Source: Danish Government, EIA1999

Between 1985 and 2000, annual carbon dioxide emissions from aircraft in the 15 EU member states more than doubled, in contrast to road transport that showed a mere 50% increase. In May 31, 2002, the European Commission has come out in favour of a project led by Airbus to develop aircraft that run on hydrogen. The plans drew a mixed reaction from Boeing Co., which is also researching liquid hydrogen fuels.

ƒ Standards and limits of emissions for air transport

Only a fraction of atmospheric pollution is caused by aviation. According to a 1999 report issued by the Intergovernmental Panel on Climate Change, airplanes produce just 3.5 percent of man-made emissions that may contribute to climate change. By far, the biggest producers of emissions are cars, trucks, buses, motorcycles, power plants, home heating systems, and industrial manufacturing. Since 1970, airplane emissions per passenger-mile have been cut by half. Most emissions are directly related to fuel consumption, and newer airplanes such as the Boeing 777 are twice as fuel efficient as airplanes built 30 years ago. Compared with 1950, the reduction is even more dramatic. In the past 50 years, airplane fuel use per passenger-mile has been reduced by 70 percent.

Scenarios for aviation emissions in 2015

Source: IPCC 1999

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Standards established by the International Civil Aviation Organization set technical limits for emissions of nitrogen oxides, carbon monoxide, unburned hydrocarbons, and smoke. Although established for takeoff and landing, the regulations effectively limit emissions during flight, as well. Now, efforts are underway to modify the standards to specifically address emissions of all greenhouse gases during all phases of flight.

ƒ Innovation and technological changes in favour of the environment

The cost of investment and quality certification levels are such that most players prefer to be involved in multi-player research partnerships. There is no individual research strategy where future technologies are concerned.

In Europe, manufacturers are working with operators to achieve the objectives set out by ACARE (Advisory Council for Aeronautics Research in Europe) between now and 2020:

• a 50% reduction in constant traffic terms of CO2 emissions (fuel consumption to be halved),

• an 80% reduction in Nox emissions (a greenhouse gas),

• a 7 dB reduction in noise pollution.

Despite these improvements and very tough confrontation among international air transport organisations, the EU definitely wants to implement the EU ETS mechanism in its territory. On December 2, 2005, Europe’s environment ministers called on the EU to draw up a proposal for legislation to produce environmental and economic efficiency, backed up by an impact report between now and the end of 2006.

Stratus Consulting (2002) estimates that, with regard to the avoidance of CO2, 60 % of increased aircraft efficiency is attributable to engine improvements, with the rest due to improvements in aircraft themselves and in their operation. Average improvement in fuel efficiency is assumed to be 1 % per year. For example, if a 30 year-old aircraft is retired and replaced by a new aircraft three years earlier than planned, 30 % of fuel consumption, and thus 30 % of CO2 emissions are saved in each of those three years. Savings in NOX emissions are lower, since the energy efficiency of new engines can mostly only be increased at the cost of the emission index for NOX. According to estimates of Stratus Consulting (2002), NOX emissions could be reduced by 0.02 % per year of operation of the retired aircraft; that is, in the case of early retirement of a 30 year-old aircraft, a 0.6 % reduction in NOX emissions is assumed.

ƒ Airbus active player of the Cryoplane project

This week the E.U. revealed the first results of the commission’s funded Cryoplane project. From the Commission, the results show use of liquid hydrogen is technically feasible, and would greatly reduce the environmental impact of aviation without affecting safety.

The E.U. is keen for hydrogen-powered planes to be developed because they produce far fewer emissions of greenhouse gases than conventional kerosene-powered engines.

When hydrogen is used instead of kerosene jet fuel, emission of CO, CO2, hydrocarbons, SOx, and particles is avoided. Because of high temperatures in jet turbines, some NOx is emitted (NOx is not generated by the fuel but rather the temperature in the combustion chamber), but otherwise there is just water. But there are several reasons that NOx emissions can be reduced somewhat as compared to conventional airplanes.

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Emissions of water from a hydrogen-fuelled airplane are 2.6 times greater than from a kerosene-fuelled plane. The greenhouse effect on the atmosphere coming from steam at altitudes up to 10 km. is practically nil, but at higher altitudes the steam can produce a greenhouse effect. The only disadvantage compared with kerosene jet fuel is that hydrogen has a lower density and therefore requires larger fuel tanks. While the environmental benefits are impressive a number of technical challenges remain.

Infrastructure must also be developed, including production sites and refuelling facilities. At present, the only major hydrogen producer is in French Guiana for the Arianne 5 rocket.

Getting the fuel into the aircraft is another technical challenge, as the pumps used to fuel rockets are not suitable for planes.

ƒ Boeing believes in the fuel-cell generated Auxiliary Product (APU)

The Boeing Co. is also looking into ways to make airplanes more environmentally friendly. The company announced in 2001 that it will develop and test an electrically powered airplane as part of a study to evaluate environmentally friendly fuel-cell technology for future Boeing products. Boeing is using its Research and Technology Centre in Madrid, Spain, to modify a small, single-engine airplane by replacing its engine with fuel cells and an electric motor that will turn a conventional propeller.

Fuel cells and electric motors cannot replace jet engines on commercial transports, but they could one day replace gas-turbine auxiliary power units (APU). Auxiliary power units, which typically are located in the rear fuselage with exhaust ports through the tail, are coupled to generators and compressors to produce electricity and air for airplane systems while on the ground and for backup use in flight.

As a general rule, something like 10% of all fuel is used on takeoff; another 5% is used in taxi. Alternative fuels are ideal for this phase of flight. If we can make alternative fuels cheaper

NASA has studied a fuel cell-powered aircraft the size of a Boeing 737 within its Revolutionary Aeropropulsion Concepts programme. In 2003 the hydrogen 737 study cost $7 million. The solid oxide fuel cell (SOFC) was the engine of choice. Boeing now aims to test an SOFC auxiliary power unit on one of its 737s to investigate its feasibility by 2008. The APU is 45% efficient in turning hydrogen into electricity. In contrast, a gas turbine is 15% efficient. The APU will have a reformer to process jet fuel to obtain the hydrogen and would be used for powering landing-gear movements. However, Boeing admits that its studies have already found that fuel cells are not economic on current costs. Yet, by 2010, the technology will reach a maturity level at which the APU could be offered on future versions of the Boeing 787.

Surprise, surprise – most of Boeing’s research on fuel cells is conducted in Europe!

Paradoxically, most of the work on the electric airplane is being done in Europe. Boeing Madrid will design and integrate the experimental airplane's control system. NASA, fuel-cell manufacturers, the automotive industry and several European universities are supporting the project.

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We strongly believe that in doing so Boeing tries to kill three birds with one stone:

• developing partnerships with European airlines which are Airbus “home” market

• setting up a conterfire against the likely legislation including air transport in the CO2 European market (EU ETS)

• developing an American alternative solution to Airbus ƒ Horizon target: not before 2015 at the soonest

The CRYOPLANE analysis concludes that hydrogen could be a suitable alternative fuel for future aviation. Based on renewable energy sources it offers the chance to continue the long- term growth of aviation without damaging the atmosphere. Importantly no critical barriers to implementation were identified in the study. Further research is needed, but implementation could take place within 15 to 20 years.

Partners of CRYPLANE Project

Airbus Deutschland GmbH (Germany); Advanced Products NV (Belgium); Airbus France (France) Alenia Finmeccanica S.p.A (Italy); Aristotle University of Thessaloniki, Lab. of Heat Transfer & Environmental Eng. (Greece); Aristotle University of Thessaloniki, Laboratory of Atmospheric Physics (Greece); DIEHL Avionik Systeme GmbH (Germany); Airbus UK (UK); Bundesanstalt für Materialforschung und -Prüfung (Germany); Centro Italiano Ricerche Aerospaziali (CIRA) (Italy); Airbus Espana (CASA) (Spain); Cranfield University, College of Aeronautics (UK); Cranfield University, School of Mechanical Engineering (UK); Deutsches Zentrum für Luft-und Raumfahrt e.V. (Germany); Fairchild Dornier GmbH (Germany); ET GmbH Hydrogen Technology and Test Center (Germany); European Commission – Joint Research Centre Ispra ISIS (Italy); Fachhochschule Aachen (Germany); FOI Swedish Defense Research Agency (Sweden); Fraunhofer Gesellschaft e.V, IfU (Germany); Grimm Aerosol Technik GmbH & Co KG (Germany); Air Liquide (France); Linde AG (Germany); Universitetet i Oslo (Norway); Secondo Mona S.p.A. (Italy); Snecma, SEP Division (France);THALES Avionics SA (France); Shell Hydrogen B.V. (Netherlands) ; MI Developments Austria AG&Co.KG (Austria); Technische Universität Berlin (Germany); Technische Universität Hamburg-Harburg (Germany); Technische Universität München (Germany); Techspace Aero (Belgium), Delft University of Technology (Netherlands); Universidad Politecnica Madrid (Spain); MTU Aero Engines GmbH (Germany)

ƒ Scenarios for Hydrogen Plane: a smooth transition to be expected

According to estimations made during this project the earliest implementation of this technology could be expected in 15 to 20 years, provided that research work will continue on an adequate level. From the operating cost point of view hydrogen remains unattractive under today’s condition, with kerosene is much cheaper as hydrogen and production/infrastructure is completely missing. Assessments based on conservative calculations and today’s understanding have confirmed that the use of hydrogen would reduce aircraft emissions to a minimum.

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After Europe has succeeded, North America could introduce five years later hydrogen fuelled aircraft. In 2024 Asia & Pacific will introduce small and medium sized liquid hydrogen aircraft. Ten years later, large aircraft will follow. Latin America, Africa and the Middle East are the less developed regions, so Latin America and Africa & Middle East are the latest regions to introduce liquid hydrogen aircraft. In 2027 the introduction will start for both small and medium-sized aircraft, and in 2037 the large aircraft will follow.

ƒ Long-term efficiency trend

A good example of this can be seen in the Boeing 747, which was first developed in the late '60s. The current Boeing 747-400 is about 25% more fuel efficient and half as noisy as the original models. Modern aircraft emit about 85% fewer hydrocarbons and 70% less carbon monoxide than engines built in the 1970s.

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Worldwide ranking of countries by defence spending (USD) – sample of 50/167 countries

Rank Countries for which no information is available are not included in the list. Military expenditures Date of Information

1 United States $ 370,700,000,000 March 2003 2 China $ 67,490,000,000 2004 3 Japan $ 45,841,000,000 2004 4 France $ 45,238,100,000 2003 5 United Kingdom $ 42,836,500,000 2003 6 Germany $ 35,063,000,000 2003 7 Italy $ 28,182,800,000 2003 8 Saudi Arabia $ 18,000,000,000 2002 9 India $ 16,970,000,000 2004 10 Australia $ 16,650,000,000 2004 11 Korea, South $ 16,180,000,000 2004 12 Turkey $ 12,155,000,000 2003 13 Brazil $ 11,000,000,000 2004 14 Spain $ 9,906,500,000 2003 15 Canada $ 9,801,700,000 2003 16 Netherlands $ 9,408,000,000 2004 17 Israel $ 9,110,000,000 FY03 18 Taiwan $ 7,574,000,000 2003 19 Mexico $ 6,043,000,000 2004 20 Greece $ 5,890,000,000 2004 21 Sweden $ 5,729,000,000 2004 22 Korea, North $ 5,217,400,000 FY02 23 Singapore $ 4,470,000,000 NA 24 Argentina $ 4,300,000,000 NA 25 Iran $ 4,300,000,000 2003 est. 26 Norway $ 4,033,500,000 2003 27 Belgium $ 3,999,000,000 2003 28 Pakistan $ 3,848,000,000 2004 29 Poland $ 3,500,000,000 2002 30 Portugal $ 3,497,800,000 2003 31 Chile $ 3,420,000,000 2004 32 Colombia $ 3,300,000,000 NA 33 Denmark $ 3,271,600,000 2003 34 South Africa $ 3,172,000,000 2004 35 Kuwait $ 2,584,500,000 2004 36 Switzerland $ 2,548,000,000 FY01 37 Algeria $ 2,480,000,000 2004 38 Egypt $ 2,440,000,000 2003 39 Morocco $ 2,305,600,000 2003 40 Czech Republic $ 2,170,000,000 2004 41 Finland $ 1,800,000,000 FY98/99 42 Thailand $ 1,775,000,000 NA 43 Malaysia $ 1,690,000,000 NA 44 Venezuela $ 1,687,000,000 2004 45 United Arab Emirates $ 1,600,000,000 NA 46 Austria $ 1,497,000,000 FY01/02 47 Jordan $ 1,460,000,000 2004 48 Indonesia $ 1,300,000,000 2004 49 Iraq $ 1,300,000,000 FY00 50 Libya $ 1,300,000,000 NA Source: http://www.cia.gov; 20 September 2005

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Worldwide ranking of countries by defence spending (as % of GDP) – sample of 55/167 countries Rank Country Military expenditures - % of GDP Date of Information 1 Jordan 14.60 2004 2 Eritrea 13.40 2004 3 Oman 11.40 2003 4 Angola 10.60 2004 5 Qatar 10.00 NA 6 Saudi Arabia 10.00 2002 7 Israel 8.70 FY02 8 Yemen 7.80 2003 9 Armenia 6.50 FY01 10 Bahrain 6.30 2004 11 Burundi 6.00 2004 12 Macedonia 6.00 NA 13 Syria 5.90 NA 14 Maldives 5.50 2004 15 Kuwait 5.30 2004 16 Turkey 5.30 2003 17 Brunei 5.10 2004 18 Morocco 5.00 2004 19 Pakistan 4.90 2004 20 Singapore 4.90 NA 21 Ethiopia 4.60 2004 22 Bosnia and Herzegovina 4.50 NA 23 Djibouti 4.40 2004 24 China 4.30 2004 25 Greece 4.30 2003 26 Zimbabwe 4.30 2004 27 Botswana 3.90 2004 28 Libya 3.90 NA 29 Tajikistan 3.90 FY01 30 Chile 3.80 2004 31 Cyprus 3.80 NA 32 Colombia 3.40 FY01 33 Turkmenistan 3.40 NA 34 Egypt 3.40 2004 35 Iran 3.30 2003 est. 36 United States 3.30 February 2004 37 Algeria 3.20 2004 38 Rwanda 3.20 2004 39 United Arab Emirates 3.10 NA 40 Lebanon 3.10 2004 41 Guinea-Bissau 3.10 2004 42 Namibia 3.10 2004 43 Cambodia 3.00 NA 44 Comoros 3.00 2004 45 Sudan 3.00 2004 46 Indonesia 3.00 2004 47 Congo, Republic of the 2.80 2004 48 Korea, South 2.80 2004 49 Australia 2.70 2004 50 Afghanistan 2.60 2004 51 Azerbaijan 2.60 NA 52 Taiwan 2.60 2004 53 France 2.60 2003 54 Sri Lanka 2.60 2004 55 Bulgaria 2.60 2003 Source: http://www.cia.gov; 20 September 2005

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To what extent do you perceive the following sectors in this country to be affected by corruption? (1: not at all corrupt,5: extremely corrupt) Registry Legal Business/ and Political Parliament/ system/ private Tax Medical Education permit Religious Country parties Legislature Judiciary Police sector revenue Customs Media services system services Utilities Military NGOs bodies Afghanistan 3,1 2,9 3,4 3 2,9 3 3,3 2,6 2,8 2,5 2,9 3 3 2,9 2,2 Albania 2,9 3 3,2 3,1 3,5 3,5 3,7 2,2 3,3 2,1 2,7 2,4 2 1,8 1,9 Argentina 4,6 4,6 4,3 4,4 3,7 3,6 4,2 3,5 3,3 3,1 3,8 3,7 3,4 2,9 3 Austria 3,3 2,8 2,6 2,8 2,9 2,7 2,6 2,8 2,4 2,3 2,5 2,4 2,5 2,4 2,5 Bolivia 4,5 4,3 4 4,2 3,2 3,6 4,2 2,8 3 3 3 3 3,6 2,7 2,2 Bosnia and Herzegovina 4,3 4,1 4 3,9 3,8 3,3 4 3,1 3,8 3,5 3,1 2,7 2,3 2,5 2,5 Brazil 4,5 4,3 4,2 4,4 3,8 4,2 3,9 3,6 3,9 3,9 3,6 3,8 3,4 3 3 Bulgaria 4,3 4,2 4,3 3,8 3,7 3,5 4,5 3 3,8 3,3 3,6 2,8 2,7 2,9 2,6 Cameroon 3,5 3,3 4 4,3 3,5 3,9 4,3 3,3 3,6 3,5 3,4 3,2 3,5 2,5 2,1 Canada 3,8 3,5 3,2 2,8 3 3,1 2,6 3,2 2,7 2,6 2,5 3 2,6 2,6 2,6 Costa Rica 4,5 4,3 4 4,2 3,8 4,3 4,1 3,6 4,4 3,8 3,5 4,1 0 3,6 4,2 Croatia 3,6 3,6 3,8 3,3 3,5 3,5 3,3 3,1 3,6 3 3,5 3,1 2,7 2,4 2,6 Czech Republic 3,9 3,5 3,5 3,8 3,1 2,9 3,4 2,9 3 2,6 2,3 2,1 2,8 2,6 2,2 Denmark 2,6 2,2 1,9 1,9 2,3 1,7 1,7 2,6 2 1,7 1,5 1,7 1,9 2,1 1,9 Ecuador 4,9 4,8 4,5 4,3 3,2 3,5 4,4 3 3,3 3,5 4,3 3,7 3,6 3,1 2,8 Estonia 3,5 3,1 3,1 2,9 3,1 2,5 3 2,8 2,7 2,4 2,9 2,4 2 2,8 1,7 Finland 3 2,6 2 1,7 2,7 2 1,6 2,9 1,9 1,6 1,6 2 1,6 2 2,3 France 4,1 3,4 3,3 3,1 3,5 2,5 2,7 3,5 2,2 2 2,2 2,2 2,3 2,5 2,2 Georgia 3,5 3,4 3,8 4,2 3,3 3,9 3,9 2,7 3,6 3,3 3,4 3 2,9 2,7 2 Germany 3,9 3,2 2,8 2,5 3,3 2,9 2,6 3,1 2,7 2,5 1,9 2,6 2,5 2,7 2,5 Ghana 3,7 3 3,7 4,5 3,3 3,7 4,3 2,8 3,3 3,5 3,3 3,8 2,4 2,6 2,6 Greece 3,8 3 3,1 3,2 3 3,7 3,3 3,5 4 2,8 2,8 3 2,2 2,4 2,7 Guatemala 4,2 4,1 4,1 4,2 3,9 4,1 4,1 3,7 3,8 3,8 3,7 3,9 3,8 3,6 3,2 Hong Kong 3 2,5 2,5 3 3,2 2,1 2,5 3 2,1 2,2 1,8 2 2 2,4 2 Iceland 3,1 2,5 2,2 2 3 1,7 2,1 2,9 2 1,7 1,8 2,4 0 1,9 1,7 India 4,6 4 4 4,5 2,9 3,4 3,9 2,7 3,8 3,8 3,7 3,5 1,9 2,7 2,7

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To what extent do you perceive the following sectors in this country to be affected by corruption? (1: not at all corrupt,5: extremely corrupt) Legal Business/ Registry Parliament/ system/ private Tax Medical Education and permit Religious Country Political parties Legislature Judiciary Police sector revenue Customs Media services system services Utilities Military NGOs bodies

Indonesia 4,4 4,4 4,2 4,2 3,7 4 4,3 2,6 3 3,2 3,7 3,1 3,3 2,4 1,8 Ireland 3,9 3,2 3,3 3,1 3,1 3 2,3 2,8 2,8 2,2 2 2,3 2,1 2,2 2,8 Israel 4,3 4,1 2,7 3 3,1 3,3 3,1 3,1 3,1 2,7 3,1 3,2 2,3 3,2 3,8 Italy 4,2 3,7 3,2 2,5 3,5 3,5 2,8 3,3 3,4 2,5 3,5 2,9 2,4 2,4 2,2 Japan 4,3 3,7 3,1 3,9 3,3 3,4 3 3,3 3,7 3,1 2,6 3 3 2,9 3,6 Kenya 4,1 4 3,8 4,3 3,7 3,9 4 2,7 3,5 2,9 3,9 3,4 3 2,9 2,5 Korea(South) 4,4 4,5 3,6 3,8 3,4 3,4 3,7 3,6 3,4 3,5 2,5 2,5 3,4 2,8 3,1 Kosovo 3 2,4 2,9 1,9 3,1 2,7 3,5 2,3 3,5 2,6 2,8 3,1 1,4 2,3 1,5 Latvia 4,2 4 4,1 4 3,7 3,5 4,1 3,1 3,6 3 3,1 2,3 2,5 2,4 2 Lithuania 4,2 4,2 4,2 4,1 3,5 3,5 4,3 3,2 3,8 3 2,9 2,7 2,4 2,8 2,3 Luxembourg 2,9 2,4 2,5 2,4 2,7 2,2 2,2 2,6 2,1 2 2 2 1,9 2,1 2,4 Macedonia(FYR) 4,2 4,1 4,3 3,8 3,8 3,6 4,2 3,3 4,2 3,8 3,1 3 2,7 3 3 Malaysia 3,5 3 2,9 3,8 3,1 2,6 3,4 2,4 2,2 2,3 3,2 2,2 2,3 2,4 2 Mexico 4,5 4,2 4,3 4,5 3,7 4 4 3,6 3,5 3,4 3,8 3,7 3,2 3,3 3,1 Moldova 4,1 4,1 4,1 4,3 3,7 3,8 4,3 3 3,9 3,6 3,8 2,8 2,9 2,8 2,1 Netherlands 2,8 2,6 2,6 2,7 3 2,5 2,6 3 2,2 2,1 2,3 2,6 2,4 2,4 2,3 Nigeria 4,5 4,2 3,8 4,8 3,4 3,8 4 3 3,1 3,8 3,3 3,5 3,9 2,7 2,4 Norway 3,1 2,7 2,3 2,3 3,4 2,1 2,3 3,2 2,4 2 2 2,4 2,4 3 3,4 Pakistan 4,1 4 4,1 4,4 3,7 4 3,9 3,5 3,8 3,6 3,9 3,8 3,3 3,3 3,1 Peru 4,6 4,5 4,5 4,5 3,9 4,1 3,8 4,2 3,9 4 4,2 3,9 4,2 3,9 2,8 Philippines 4,1 4,1 3,6 4,2 3,4 3,8 3,9 2,8 3,2 3,3 3,6 3,3 3,4 2,9 2,1 Poland 4,2 4,1 4 3,9 3,8 3,5 3,1 3,4 4,1 3,5 3,7 3,1 3,1 3,3 3,1 Portugal 3,9 3,4 3,5 3,4 3,4 3,9 2,9 3,2 3,3 3 2,7 2,9 2,7 3,1 2,8 Romania 4,2 4 4,1 3,8 3,7 2,9 4,2 2,6 3,9 3,3 3,4 2,5 2,4 2,7 2,2 Russia 3,8 3,7 3,7 4 3,6 3,4 3,5 3,4 3,4 3,5 3,2 2,7 3,4 2,7 2,1 Singapore 1,9 1,6 1,7 1,7 2,4 1,6 1,8 2 1,6 1,6 1,5 1,5 1,7 2,2 2 To what extent do you perceive the following sectors in this country to be affected by corruption? (1: not at all corrupt,5: extremely corrupt) Legal Business/ Registry Parliament/ Tax Medical Education Religious Country Political parties system/ Police private Customs Media and permit Utilities Military NGOs Legislature revenue services system bodies Judiciary sector services

South Africa 3,8 3,4 3,4 3,8 3,2 2,9 3,1 2,8 3,4 3,2 3,5 3 2,9 2,9 2,3 Spain 3,8 3,2 3,4 2,9 3,5 3,4 3 3,6 2,6 2,7 2,9 3 2,7 2,5 3 Switzerland 3,2 2,8 2,3 2,3 3 2,7 2,3 3,1 2,3 2,1 2,1 2,3 2,4 2,4 2,3 Taiwan 4 4,1 3,4 3,3 2,9 2,9 3,5 2,7 2,5 2,7 1,8 3,1 3,3 1,9 2,5 Turkey 4 3,8 3,9 4 4,1 4,2 4,1 3,8 4,1 3,9 3,8 4,1 3,1 3,5 3,3 Ukraine 4,3 4,3 4,2 4,3 4 4,2 4,3 3,4 4,1 3,9 3,4 3 3,1 3 2 United Kingdom 3,4 3,2 3 2,8 3 2,6 2,5 3,3 2,4 2,4 2,2 2,3 2,5 2,6 2,6 Uruguay 4,3 4,1 3,9 4,2 3,6 3,3 4,2 3,4 3,3 3,1 3 3,1 3,5 2,6 3,1 USA 3,6 3,3 3,3 2,9 3 3,2 2,6 3,5 3 2,8 2,2 2,9 2,5 2,6 2,5 Venezuela 4,1 4,2 4,3 4,2 3,8 3,9 3,9 4 4 3,9 3,8 3,6 3,6 3,5 3,3 Total sample 4 3,7 3,6 3,6 3,4 3,4 3,3 3,3 3,3 3,1 3 3 2,9 2,8 2,7

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Potential ethical concerns over involvement in certain aspects of the arms trade

Company Small arms Cluster munitions Nuclear Ballistic Missile Def Depleted Uranium BAE - Produces full range of small arms - Producer (Royal Ordnance) - Possible involvement through contract to - UK Missile Defence Centre, THAAD (US) - Stopped using DU in products in ammunition (Royal Ordnance); Man- develop and produce ASMP-A missile for 2003 & is decommissioning portable missiles (MBDA, JV with BAE & the French (37.5% owner of MBDA); Featherstone manufacturing Finmeccanica) Astute subs facility

Boeing -- -- - Supplier of various forms of maintenance - Overall BMD systems integrator with - 747s & B-52s contain and upgrade services for the Minuteman Lockheed; Part of "Alliance Shield", counterweights made of DU III ICBM; B-52H bombers competing for NATO Theatre Missile Defence Systems Engineering and Integration contract (with EADS et al.) Dassault -- -- - Produces Rafael & Mirage fighters -- EADS - Produces mortars & ammunition (TDA - Prime contractor for French M51 sub- - Part of NATO Theatre Missile defence -- - Produces artillery grenade (TDA - 50% Armaments - 50% JV with Thales); Man- launched ballistic missiles (EADS Launch program / "Alliance Shield", competing for JV with Thales); AFDS portable missiles (MBDA, JV with BAE & Vehicles); Medium range missiles NATO Theatre Missile Defence Systems Finmeccanica) (Aerospatiale Mantra Missiles) Engineering and Integration contract (with Boeing et al.) Finmeccanica - Producer of light weapons; Man-portable - Possible involvement through contract to - Part of "Alliance Shield", competing for -- missiles (MBDA, JV with BAE & develop and produce ASMP-A missile for NATO Theatre Missile Defence Systems Finmeccanica) the French (25% owner of MBDA) Engineering and Integration contract (with Boeing et al.) General Dynamics - Produces wide range of small arms (GD - Produces fuses for BLU-97 (explosive - Produces nuclear-powered subs (Electric -- - Produces ARAMs tank –DU Armament Systems, GD Weapons devices in various cluster weapons) Boat); F-16 fighters armour & deploys 120mm shell w/ Systems) DU penetrate; DU anti-tank ammunition

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Company Small arms Nuclear Ballistic Missile Def Depleted Uranium Cluster munitions Lockheed - Produces mortars (LM Missiles & Space) - Design, production & testing of nuclear - Overall BMD systems integrator with - Produces DU AUP-3(M) - Produces various missiles which can be weapons (Sub-launched Trident missiles) Boeing; Lead contractor for THAAD missiles; Some aircraft contain categorized as cluster weapons (egg. programme; makes Patriot missile; prime counterweights made of DU MLRS M 26-S) contractor for SBIRS-HIGH

Northrop Gr. -- - Producer - Nuclear-powered aircraft carriers & subs - Developing battle-management system -- (Newport News); Prime contractor for B-2 for US system; Prime contractor at the stealth bomber; Contractor for Joint National Integration Centre; Leading maintenance and upgrading of the US Air an industry team to develop & test the Force’s Minuteman III ICBM; Provides Kinetic Energy Interceptor system Prime tactical systems for ICBMs; contractor for Air and Missile Defence Workstation program; Pursuing contract for NATO with EADS Raytheon - Produces JSOW and cluster munitions to Produces guidance systems for Trident - One of 4 major BMD players (boost, mid- - DU in “Bunker Buster” bombs these missiles course, terminal & sensors); production of (eg. GBU 28) Standard-Missile 3, Systems Integrator for Patriot missile; Prime contractor for Exoatmospheric Kill Vehcile, X-band & Upgraded Early Warning Radars Rolls Royce -- -- - Produces propulsion systems for all UK -- -- nuclear sub’s (nuclear reactors & fuel) Safran - Produces military small arms sights -- -- - Main subcontractor for French M51 sub- (Sagem); Contract for FELIN launched ballistic missiles (Snecma) Thales - Produces mortars & ammunition (TDA - Produces guidance systems for French -- - Produces artillery grenade PR Cargo Armaments - 50% JV with Thales); Optic, nuclear sub’s (“area-weapon” primarily used against electrooptic, personnel) (TDA - 50% JV with EADS & electronic infantry equipment United Tech. ------Conducts upgrading and testing of thrusters for the USA’s MX Peacekeeper ICBMs (Rocketdyne Propulsion & Power, acquired Brom Boeing, 08/2005) Source: Company information and data, CM-CIC Securities estimates, Jane’s, Advisory Council on Ethics for the Norwegian Government Petroleum Fund, Norwegian Initiative on Small Arms Transfers, CAAT (Campaign Against the Arms Trade), Netwerk Vlaanderen, Small Arms Survey.

ASMP-A - Nuclear warhead air-to-surface missile. FELIN – French Army future infantry soldier system: consists of an integrated sighting, fire control, and communication system to be fitted on the FAMAS assault rifle, the Minimi light machine gun, and the FRF2 sniper rifle.JSOW – Joint Stand Off Weapon (integrates BLU-97 combined effects bomblets and the BLU-108 sensor fused weapon submunitions for area targets or armoured vehicles. MEADS – NATO Medium Extended Air Defence System programme. MLRS M 26-S - surface-to-surface missile which is fired from artillery systems of the type MLRS. M 26 contains 644 bomblets of the type M77 DPICM cluster ammunition. PR Cargo - “area-weapon” primarily used against personnel. SBIRS-HIGH – early warning system for BMD. THAAD – Theater High-Altitude Area Defence programme – designed to intercept mediul-to-long-range missiles.

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