U.S. Firms Rule Global Arms Market, But Dominance May Not Last

The U.S. weapons industry is the 800-pound gorilla in the global arms market. But maintaining that dominance could become increasingly difficult, experts warn, as buyers demand more economic benefits from arms purchases.

U.S. companies will continue to be favored in competitions for advanced systems that few countries can produce such as high-tech military aircraft and missile-defense systems. But they may struggle in the future to win international deals based on technological merits alone, said Peter Nicholas Lengyel, president and CEO of Safran USA, the American subsidiary of France’s aerospace giant Safran Group.

In most countries, governments are under growing pressures to justify big-ticket purchases of weapon systems, and they expect arms manufacturers to provide local jobs and other economic rewards. “Governments have to be able to explain to their people why they are buying from a foreign company” rather than produce domestically and protect the nation’s workforce, Lengyel said in an interview.

U.S. firms typically sign "offset" agreements as part of major defense contracts. They agree to buy products from arms-buying countries to help offset the cost of the deal. The U.S. government, which actively helps Pentagon contractors score international sales, does not support offsets but recognizes that it is the way business is done. According to the latest data by the consulting firm Avascent, by 2017, U.S. aerospace and defense exporters will rack up a half-trillion dollars worth of offset obligations.

Offset liabilities are turning into a “bubble that is waiting to burst,” said Lengyel. Over the years, companies have ignored this, but they may no longer be able to.

At a time when U.S. defense firms are turning to the international market as a hedge against declining Pentagon sales, they need a new business model, he said. Rather than pursue sales by negotiating industrial offsets, U.S. companies should offer “strong partnering solutions,” said Lengyel. “Partnering is not offsets. It’s honest work share.”

The mindset in the U.S. defense establishment is that sharing production work and technological know-how with foreign suppliers “creates a peer competitor,” he said. “They’d rather pay the offset penalty.”

That thinking eventually could hurt U.S. manufacturers as they compete head to head with European and Asian companies that are more willing to “truly partner” with the buying country, Lengyel said. “If you are making the investment in local communities, you are perceived as a partner. So when a product is sold to the government, that country has a significant stake and economic growth. With work share, you provide wealth in those nations.”

Even if the work is shared with foreign companies, the original manufacturer retains the intellectual property and the global availability of the product.

“It’s what Safran has done in the United States,” Lengyel said. The company teamed up with GE to build new aircraft engines and signed on to several other joint ventures to manufacture Safran products in the United States. “We didn’t create a peer competitor,” he said. “We created a strong partnership.”

The international market, despite what analysts might say, is no panacea, he noted. Economic austerity has hit most of the world, and arms purchases are being challenged as countries struggle with domestic fiscal crises.

For a U.S. defense firm, said Lengyel, “It’s got to be more than going over and selling your stuff to foreign partners. The approach has to change fundamentally. It has to be relationship based.”

Safran did that in order to secure a deal with India for biometric security. “We didn’t just sell them a biometric identity card for the entire nation. We partnered with Indian companies to provide biometric data for 200 million citizens,” said Lengyel. “We just got another contract for 200 to 300 more people.”

It remains to be seen whether U.S. firms — now firmly on top of the global arms industry — perceive an incentive to change the current approach. Sales by the world's leading 100 companies (excluding Chinese firms) more than doubled in the last decade to $410 billion in 2011, and U.S. companies accounted for nearly 60 percent of those sales, according to the Stockholm International Peace Research Institute. West European firms had 29 percent of global sales and Russian firms had 3.5 percent. Companies from all other countries tallied just 7.8 percent.

Lengyel credits the U.S. government for doingstrong advocacy work on behalf of American industries. The State Department has a “very well run” advocacy program, he said. “It’s a service that is overlooked by many U.S. companies.” The U.S. government does what it is legally allowed to do, he noted, considering it is helping private companies and not state-owned enterprises. “Many people are unaware of the U.S. government capabilities.”

It is nonetheless not easy for newcomers to the export market to break in, Lengyel said. “If you don’t speak the language, you’re not culturally integrated and you’re parachuting into a country and wanting to sell defense equipment, the national response is going to be, ‘What’s in it for me?’”

Americans have to offer something “better than the promise of an offset penalty that we’re going to have to assess you and fight in court.”

Non-U.S. defense firms that are trying to sell to the Pentagon face the same challenges, he said. “The barriers to entry to the U.S. defense and aerospace market are huge.” It is well known that the Defense Department and its congressional allies tend to have an institutional bias against products that are not created in the United States.

Safran, which is the world’s largest maker of helicopter engines, was shut out of an Army program to develop a fuel-efficient engine. Only U.S. companies with facility clearance for secret work could join the group of eligible competitors, known as the Vertical Lift Consortium. “Ours are commercially available products that we militarize for the Defense Department,” Lengyel said. “For the number-one helicopter engine manufacturer in the world, that was a disappointment.” He called it an example of “cutting off your nose to spite your face.”

But companies understand that protectionism is here to stay, he said. “Business is business.” Like other European defense firms that supply the U.S. military, Safran has opened manufacturing plants in the United States to boost its products' local content.

In a perfect world, defense sales would be based on the performance and price of the weapon systems, but that is far from the reality for arms manufacturers, noted Frank Cevasco, an industry consultant. It is the case in any country that the “man on the street doesn't benefit from weapon buys,” he said during a Bloomberg Government webinar. To ensure support from their legislatures for an arms deal, governments have to prove that these contracts will either create jobs or not jeopardize existing ones. “It's been alleged that some countries give more weight to offset packages than to the quality of the military systems they are buying,” said Cevasco.

Bloomberg Government analysts said the Middle East will remain, by far, the primary source of overseas sales opportunities for U.S. defense companies. In fiscal year 2013, Middle Eastern countries sought $42.5 billion worth of U.S. weapon systems, compared to $22.5 billion for the Asia-Pacific region and $2.9 billion from European nations, Bloomberg reported. That trend is likely to continue as oil-rich nations seek to bolster their arsenals during times of regional tension and security concerns.

Meanwhile, offsets will remain a key marketing tool in international arms deals. “Failure to include generous offset packages in proposals may render them noncompetitive,” noted a Bloomberg briefing chart. “Defense firms are motivated to promise offsets in excess of what is demanded to win in competitive source selections.”

Of interest to defense companies has been the Obama administration's massive overhaul of export control regulations — an effort that had begun under George W. Bush’s White House. Although Pentagon contractors have cheered these reforms on the belief they would bolster sales, revised regulations should not have such effect, experts said.

The overhaul of the export system mostly affects “dual-use” technologies that have commercial applications. Hundreds of dual-use items that had been administered by the Department of State are being transferred to Department of Commerce oversight.

“The big weapons integrators are not the beneficiaries of this. They were not intended to be,” said Brandt Pasco, an attorney at Kaye Scholer LLP. The export reforms, he said, are not about “decontrolling the arms trade.”

The beneficiaries are more likely to be subcontractors that provide spare parts and components, Pasco said. “Right now we're at a stage where industry is still adjusting to new regulations and reclassifying product lines, supply chains, and figuring out what the impact of these changes is on them.”

Aircraft components were one of the first categories to shift from State to Commerce. “You'll see companies looking to take advantage of the licensing flexibility to find new markets,” he said. “You'll also see European integrators seeking opportunities to source U.S. components.”

Nothing in the administration’s export control reform was “designed to increase the proliferation of weapons,” said Pasco. “But for countries that are U.S. allies and already are in this business, it should be easier for them to access U.S. parts and components.”

U.S. manufacturers of satellites and electronics anxiously await for their categories of products to be transferred to the Commerce list. That is expected to happen in 2014.

Topics: Business Trends, Partnering, International, Manufacturing, Missile Defense