Tag Archives: defense industry

The Arms Race: Who Lacks an Indigenous Defense Industry

XM1203 Non-Line-of-Sight Cannon (NLOS-C) prototype in 2009. image from wikipedia

Even though Colombia, Kuwait, Malaysia, Morocco and Singapore have very different perspectives and agendas, they are all expected to sharply increase their defence spending over the next 10 years. Due to the arms race and an increasing threat perception, the effects of the 2008 financial slowdown on defence spending in these transitioning markets are gradually reducing.

“Unlike leading transitioning economies like India, South Korea, Turkey, the United Arab Emirates and Brazil, the five countries selected for this study are still attempting to develop an industrial base …,” said Frost & Sullivan Aerospace & Defence Industry AnalystAlix Leboulanger. “Upon a closer look at these countries’ dynamics, it is found that their political intent is stronger than their financial and infrastructure capabilities.”  Several factors are dampening indigenisation plans. The increasingly competitive marketplace has left little room for emerging local players unless they can distinguish themselves appropriately – for instance, with price in Colombia and technology in Singapore. Moreover, weak market prospects beyond local demand, along with the absence of small- and medium-sized enterprises, have restricted partnership opportunities and transfer-of-technology ventures with foreign companies.

Investing in high-end foreign technology is perceived as the way forward to fulfil three objectives: achieving modernisation programmes, consolidating the domestic industrial base, and providing employment to locals,” explained Leboulanger. “This will require efficient and easily-applicable regulations to create an attractive and stable environment for foreign investments and industrial partnerships. The lack of skilled personnel and infrastructure, also need to be addressed.”… Financial constraints mean that governments will try to reduce armed forces and invest in combat-proven platforms, surplus material and second-hand equipment…

“As a matter of fact Colombia, Kuwait, Malaysia, Morocco and Singapore are expected to spend 21 percent of their total budget, circa 9.77 billion USD per year, on new equipment.”

Combat Readiness Plans Win Over Defence Indigenisation Targets in Select Markets, Finds Frost & Sullivan, PR Newswire, July 22, 2015

The Art of Selling Weapons: defense industry

image from wikipedia

[When governments buy weapons] it is standard to supplement the main deal with a side contract, usually undisclosed, that outlines additional investments that the winning bidder must make in local projects or else pay a penalty. Welcome to the murky world of “offsets”.

The practice came of age in the 1950s, when Dwight Eisenhower forced West Germany to buy American-made defence gear to compensate for the costs of stationing troops in Europe. Since then it has grown steadily and is now accepted practice in 120 countries. It has its own industry newsletter and feeds a lively conference circuit. The latest jamboree, hosted by the Global Offset and Countertrade Association, was held in Florida…. Yet its very structure serves to mask a build-up in the unrecognised financial liabilities of companies. It also, critics argue, fosters corruption, especially in poorer parts of the world.

Avascent, a consultancy, reckons that defence and aerospace contractors’ accrued offset “obligations”—investments they have promised but not yet made—are about $250 billion today and could be almost $450 billion by 2016. The industry’s own estimates are lower, but all agree the trajectory is upward.

Offsets come in two types. Direct offsets require investment in or partnerships with local defence firms. The idea is to develop self-sufficiency. Turkey, for instance, now meets half its own defence needs thanks to such arrangements. Indirect (non-defence) offsets include everything from backing new technologies or business parks to building hotels, donating to universities and even supporting condom-makers. Here the stated intention is to achieve more general economic or social goals.

Both types of offset are controversial. Economists view offsets as market-distorting. The World Trade Organisation bans their use as a criterion for contract evaluation in all industries except defence. Anti-corruption groups see them as a clever way to channel bribes. Even if many offset deals are clean, they are widely seen as a “dark art”, admits an industry executive. “Offset” has become a dirty word; the industry now prefers the euphemistic “industrial participation”.

The practice is frowned upon in some advanced economies. The European Commission is trying to impose a ban on all offsets in EU-to-EU contracts, and on indirect offsets when the supplier is from outside the union…

America has long been officially against offsets, though it practises something similar at home under the Buy American Act of 1933, which requires foreign arms-makers to source much of the work locally… And as embassy cables published by WikiLeaks make clear, America’s diplomats are sometimes closely involved in its firms’ discussions with foreign governments, including even squeaky-clean Norway’s, over proposed offsets.

In less developed countries, where defence spending is generally rising, offsets are booming. One appeal is that they can be recorded as foreign direct investment, boosting the government’s economic-management credentials. The two biggest arms-buyers in the Gulf, Saudi Arabia and the United Arab Emirates, have long-standing, sophisticated offset programs…Brazil and India are catching up…

This growth is fuelling a thriving offsets industry. At one end are dozens of small brokers who hawk ideas for offset projects to arms-makers and their clients. With the right contacts in government and the armed forces, even small outfits can service the largest defence firms. Take Dolin International Trade & Capital, a one-man operation run by Dov Hyman from his home in suburban New York. Mr Hyman cut his teeth as a textile trader in Nigeria. Today he advises African governments looking to use offsets while helping multinationals craft offset packages.

Further up the chain are a few sophisticated outfits that structure complex deals and arrange financing. The best known is London-based Blenheim Capital. These are assembling ever more creative packages, including, for instance, helping procuring countries to use contractors’ offset obligations as collateral for loans, backed by the “performance bonds” that firms set aside to cover unfulfilled obligations.

These middlemen are offsets’ most vocal defenders. Mr Hyman cites reams of examples of deals that he believes brought great benefits for purchasing countries’ economies. The best of them are “beautiful solutions”: for instance when arms-sellers satisfy offset obligations by guaranteeing credit lines for local manufacturers, thus reducing their financing costs. Using a multinational’s good standing in this way is “an efficient means of making possible transactions that otherwise wouldn’t be viable,” he argues.

However, some projects take contractors disconcertingly far away from their core competence. Take the shrimp farm set up in Saudi Arabia in 2006 with backing from Raytheon, a maker of radar systems and missiles. Praised at first as a model offset, it reportedly struggled to keep its pools properly maintained in searing temperatures and eventually went bust.

Moreover, the academic literature on offsets suggests that the promised benefits are elusive. There are some technology-transfer success stories: for instance, China has boosted its defence-manufacturing capability by requiring offsets when buying kit from Russia. However, research by Paul Dunne of Bristol Business School and Jurgen Brauer of Augusta State University has found that such deals are generally pricier than “off-the-shelf” arms purchases and create little new or sustainable employment. The offsets associated with the giant South African arms purchases of the late 1990s have created 28,000 direct jobs, claims the country’s government. Even if true, it is well below the 65,000 first envisaged. India’s auditor-general recently concluded that some offsets have produced no value for the country.

Judging performance is hard because of a lack of openness. Asked for confirmation of the fate of the shrimp farm, the Saudi offset authority said it kept “minimum information” on projects after their founding and suggested contacting its commercial backers. Raytheon declined to comment and suggested contacting the Saudis. DevCorp, another backer, did not respond. A study published in February by Transparency International, an anti-graft group, found that a third of governments that use offsets neither audit them nor impose due-diligence requirements on contractors.

Worse, accounting rulemakers have failed to impose any requirement to disclose offset liabilities. Companies can thus choose how, or whether, to put them on the balance-sheet. Defence firms have lobbied successfully for offsets to remain classified as “proprietary”, so they do not have to disclose their obligations. In some ways things have got worse: the Commerce Department’s annual report on American contractors’ offsets no longer even breaks out the numbers country-by-country.

This murkiness makes it hard to determine who really pays for offsets. On the face of it, the defence companies do. But Shana Marshall, an offsets-watcher at George Washington University, believes that they build the cost into their bids (pdf). Politicians and officials in procuring countries know that they are paying the bill through padded prices, but they accept this because offsets give them some grand projects to trumpet and sometimes provide palm-greasing opportunities.

A study in Belgium found that the country ended up paying 20-30% more for military gear when offsets were factored in. If the costs are largely borne by taxpayers, the benefits accrue to individuals and institutions chosen by the procuring government. This make offsets a good way to conceal delivery of public subsidies to interest groups, according to Ms Marshall.

A number of deals have been exposed as, or are suspected of being, corrupt. A commission has been set up to look into South African contracts dating back to 1999; the government has already conceded that offset credits changed hands at inflated prices. Since 2006 prosecutors in Portugal have been investigating offsets connected with a €1 billion ($1.3 billion) submarine contract with Germany’s Ferrostaal, HDW and ThyssenKrupp. Three Ferrostaal board members and seven Portuguese businessmen are on trial, charged with fraud and falsifying documents.  EADS, a large European contractor, is facing multiple inquiries over its sale of 15 Eurofighter planes to Austria. Prosecutors in Vienna and Munich are looking into allegations that millions of euros in kickbacks flowed through a web of offshore firms and side-deals, linked to offset agreements worth €3.5 billion, twice the value of the main contract. (In other words, EADS was supposed to generate €2 of business for Austrian firms for every euro it received for the planes—an unusually high ratio even in fiercely bid contracts.) Tom Enders, EADS’s chief executive, told Der Spiegel, a German magazine, that he “knew nothing about the shadowy world of dubious firms allegedly behind this.” The company says it is co-operating fully with prosecutors and that an internal investigation has so far found no evidence of punishable activity.

Prosecutors are also looking into whether AgustaWestland, part of Finmeccanica, an Italian defence firm, paid bribes to secure the sale of 12 helicopters to India in 2010. Finmeccanica’s former chief executive and the former head of AgustaWestland are due to go on trial next month. According to Italian court filings, suspicious payments allegedly flowed through a sham offset contract for software with help from a Swiss-based consultant. The helicopter-maker and the charged individuals deny wrongdoing.

Industry figures point out that all but the Indian case are at least five years old. They argue that corruption is harder to get away with today because of stricter anti-bribery laws and enforcement in America and Europe. Companies’ general counsels pay much more attention to offsets than they did a decade ago, says Grant Rogan, the head of Blenheim Capital.

Even if graft really is on the wane, offsets’ complexities make it hard to measure the true cost of defence deals. Procuring governments may apply generous “multipliers” to give extra credit to projects they deem exceptionally beneficial, especially if they are keen to buy the kit in question. As a result, defence contractors often find their liabilities turn out to be a lot less than their nominal obligations. A $5 billion sale of military kit might come with, say, $4 billion of gross offset requirements, but after multipliers it might only cost $500m to fulfil. A book on the arms trade, “The Shadow World”, by Andrew Feinstein, describes a contract Saab won in South Africa: to receive more than $200m in credits all the planemaker was required to do, the book says, was to spend $3m upgrading pools in Port Elizabeth and marketing the town to Swedish tourists. Saab says the tourism project cost much more, and suggested that it was up to the authorities to decide what value they put on what it achieved.

This sleight-of-hand helps to explain why industry executives are better disposed towards offsets in private than in public, says Ms Marshall. They say they could happily live without them, but they do not lobby to have them banned. Indeed, some big contractors see their ability to craft a package of attractive offsets as a “source of competitive advantage”, as Boeing’s boss, Jim McNerney, puts it.

The largest such firms will employ dozens of offset specialists to give them an edge in bidding. Lockheed, another American contractor, has about 40. As long ago as 2005 the firm was touting its leadership in offsets to win Thai contracts, according to a leaked diplomatic cable.  A downside for the companies is that dealing with national offset agencies can be frustrating. And though the companies’ offset liabilities are smaller in reality than on paper, they can still be daunting: one American contractor, for instance, has $10 billion of nominal obligations in a single Gulf state that will cost $1 billion-2 billion to fulfil, according to a consultant (who will not say which firm or country)….

How long can the offsets boom last?  But in the shorter term, their growth will be fuelled by American and European contractors’ intensifying efforts to sell outside their shrinking home markets, to big developing countries whose defence budgets are growing…. Remarkably, offsets are now said to be the main criterion in contract evaluation in Turkey and some Asian countries—more important than the price or the technical capability of the defence equipment itself.

The defence industry: Guns and sugar, Economist,May 25, 2013, at 63

The Military-Industrial Complex: aerospace and defense industry

The U.S. is the world’s largest aerospace and defense market, and also home to the world’s largest military budget. The growth of the Aerospace and Defense industry depends largely on the spending outlook of government departments, with the U.S. defense budget being the primary driver. The industry largely depends on U.S. government contracts….

Defense spending is the major source of revenue for the top nine global aerospace and defense companies, with the US accounting for more than 40% of total global defense spending. However, with the U.S. government expected to institute greater austerity in its defense budget going forward, defense companies will need to source more orders from global clients. The geostrategic significance of the industry and the related heavy export restrictions will come in the way, to some extent, of those marketing efforts by U.S.-based operators.

The U.S. defense budget for 2012 was $645.7 billion, with the base budget at $530.6 billion and $115.1 billion approved for Overseas Contingency Operations (“OCO”) as supplementary defense spending, mainly to fund ongoing wars.  In February this year (2012), the Department of Defense (DoD) requested a Pentagon base budget of $525.4 billion for 2013, which is approximately $5.1 billion or 1% less than what is approved for fiscal 2012, with $88.5 billion earmarked for OCO spending. The significant reduction in OCO funding is mainly due to the decline of U.S. military operations in Iraq in 2011. Going forward, OCO funding is expected to continue to decline as troops redeploy out of Afghanistan.  Since the September 2001 attacks, the U.S. government has spent significant amounts on military campaigns overseas. The country has already decided to gradually move out of Afghanistan, and the war in Iraq has finally ended, which is expected to lower its expenditure on foreign campaigns. However, its clandestine military operations in other nations as part of anti-terrorism operations will continue to add to foreign war expenses. However, the overall trend in overseas military spending is unmistakably on the downtrend.

The big defense operators armed with a strong balance sheets are expanding their operations inorganically through acquisitions. The U.S. Defense department also endorses mergers among U.S. defense companies, provided they don’t involve the top five or six suppliers acquiring each other.

Lockheed Martin Corporation bolstered its product portfolio by acquiring Procerus Technologies, a company specializing in autopilot and other avionics for micro unmanned aerial systems. In November 2011, it had acquired Sim-Industries B.V., a commercial aviation simulation company located in the Netherlands. This acquisition would expand both companies’ closely related markets and expand the customer base.

Another defense major, L-3 Communications Holdings Inc., acquired the Kollmorgen Electro-Optical (“KEO”) unit of of Danaher Corporation This unit will improve L-3’s product suite with products like submarine photonics systems and periscopes, ship fire control systems, visual landing aids, ground electro-optical and sensor-cueing systems.

In December 2011, General Dynamics Corporation completed the acquisition of Force Protection, Inc. The latter provides blast- and ballistic-protected platforms that support the armed forces of the U.S. and its allies.

In December 2011, Raytheon Company announced that it has acquired Pikewerks Corporation, a privately held company, to further extend Raytheon’s capabilities to defend against sophisticated cyber-security threats facing customers in the intelligence community, the DoD and commercial organizations.=

Excerpts, Zacks Industry Outlook Highlights: Lockheed Martin, L-3 Communications, Danaher, General Dynamics and Raytheon, PRNewswire, May 15, 2012

Expensive Weapons of the Future

(The F-35 aircraft fighter is expected to be) the “fifth generation” fighter, far more effective in both its primary ground-attack role and air defence than “legacy” aircraft… (The costs of developing the F-35 are huge)but the cost of operating and supporting them are staggering: $1 trillion over the plane’s lifetime…

Even if America and some of its NATO allies cut their orders (of F-35), Lockheed Martin is confident that the numbers will be more than made up by countries such as Japan, South Korea, Singapore and Taiwan. All these nations are rich and nervous of Beijing. Mr Burbage draws comparison with the F-16, of which more than 4,500 will be built over its long life.

But the longer-term outlook for the F-35 is uncertain. Its costly capabilities are intended to make it effective against the air defences of a sophisticated enemy, such as China. But the growing vulnerability of American aircraft carriers to Chinese missiles will mean operating from well beyond the F-35’s 600-mile (1,000km) range.

Some military strategists already think that the job the F-35 is meant to do can be better handled by cruise missiles and remotely piloted drones. In many roles, unmanned planes are more efficient: they carry neither a bulky pilot nor the kit that keeps him alive, which means they can both turn faster and be stealthier. And if they are shot down, no one dies. Even the F-35’s champions concede that it will probably be the last manned strike fighter aircraft the West will build.

Excerpts from, The defence industry: The last manned fighter, Economist, July 16, 2011, at 67