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] Business as usual 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 Page 3 Business as usual 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 Page 4 Business as usual 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