Transatlantic deal or not, BAE has developed a sweet spot in America

From virtually nowhere, BAE is now the seventh-largest defence company in America
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The Independent Online

The Reston research centre on the outskirts of Washington DC is an unprepossessing five-storey building housing some 330 employees. But its non-descript appearance belies the highly sensitive and secretive activity that goes on inside. Visitors are barred from carrying mobile phones, laptop computers, cameras and any kind of recording equipment and virtually all the staff require high-level security clearance for the work they do on behalf of the American government.

Reston is one small but important example of the burgeoning presence in the US of the British defence and aerospace company BAE Systems. Opened four years ago, its client list reads like a Who's Who of the US military and intelligence community. The CIA, the Pentagon, the National Security Agency, the Department for Homeland Security - all of them use its expertise to assist in President George Bush's self-declared war on global terrorism.

For obvious reasons, BAE is coy about what goes on at Reston. Dr Bill Ballhaus, the president of BAE's National Security Solutions division, says: "Ninety per cent of the programmes we are involved in don't have a name, just a number. In many cases, we can't even acknowledge we work for a particular intelligence agency."

That secrecy extends all the way back across the Atlantic and into the boardroom of BAE Systems, whose chief executive, Mike Turner, is not privy to any details of classified or "black" programmes that his own company is working on for the simple reason that he is not a US citizen.

America's fixation, some would say paranoia, about keeping its military secrets to itself, has not stopped BAE expanding there at a breathtaking pace, however.

From virtually nowhere less than a decade ago, BAE is now the seventh largest defence company in America, thanks to a series of takeovers culminating in the $4bn (£2.1bn) acquisition of United Defence Industries, the maker of the Bradley fighting vehicle, in 2004. It is involved in everything from electronic warfare suites for the F-22 and F-35 Joint Strike Fighter to the next generation of naval destroyers and unmanned land vehicles. Now that the group is rid of its 20 per cent stake in the European aircraft manufacturer Airbus, we can expect that pace of expansion to accelerate even faster.

Today the US accounts for 40 per cent of BAE's sales and more than half its 86,000-strong workforce. Crucially, for the purposes of bidding for Pentagon contracts, the company is classified as a US contractor, which is why the board of BAE Inc is stuffed with four-star generals, former Congressmen and ex-CIA officials, put there to ensure the "special security agreement" which protects classified US defence programmes is adhered to.

Is it good judgement, timing or just sheer luck that BAE has gained such a strong toehold in the world's biggest defence bazaar - a $500bn market growing at 4 per cent a year? Mark Ronald, the president and chief executive officer of BAE Systems Inc, says: "It would be a huge challenge for another non-US defence company such as EADS and Finmeccanica to achieve what we have achieved. We have been at it for a long time and during that period there has been a lot of consolidation in the market which means there are fewer opportunities for others to come in. Britain is also America's closest ally and the fact that BAE is a publicly traded company with none of the baggage of government ownership also helps."

In the past four years, BAE's US business has grown at an annual rate of 10 per cent, thanks to that string of acquisitions. Over the next four years, it expects that growth to moderate slightly to 7-8 per cent, but it will still be twice that of the market overall. BAE occupies many of the "sweet spots" of Pentagon spending and homeland security and the UDI acquisition is paying its way back in spades as a result of the Iraq war. Bradley fighting vehicles are returning from the Gulf for repair and overhaul at 10 times the normal rate and it is highly profitable business. Each "re-set", as it is known, costs about $2m and BAE is doing 400 of them a year.

At current growth rates, it is therefore entirely conceivable that the US market will account for more than half of BAE's business in a few short years, even with the after-burn from the latest £10bn Eurofighter order signed by the Saudis under the Al Yamamah arms-for-oil deal.

But BAE has loftier ambitions than that. For a long time, its holy grail has been a transforming transatlantic merger with one of the titans of the US defence industry. It has talked to Boeing and General Dynamics, but in both cases the discussions have proved fruitless. How does Mr Ronald assess its chances now? "Personally, I don't think anything will happen in the next three years; it will take longer than that."

His caution is based on a belief that the current political mood is not particularly favourable to a big transatlantic deal - or indeed a merger of two home-grown American defence companies.

For those reasons, Mr Ronald is also dubious that BAE will forsake its UK domicile and UK listing any time soon and move its headquarters to the US, despite the apparent lack of opposition to such an idea from the defence procurement minister, Lord Drayson. "One of the best things about my job is having the Atlantic ocean between me and London," he jokes. "Some day it may happen, but it is not in the plan. Maybe if we ended up with 80 per cent of our business in the States, it would become a possibility but I don't see that happening in the short term. It would require us to do a fair number of other acquisitions or one very large deal."

Not that BAE isn't looking for further takeover opportunities on top of the 13 it has pulled off in the past six years. The group's balance sheet is not a constraint, but the price at which some US defence companies have been hawking themselves around is. "We have steadfastly said we will not overpay and that remains our mantra. Values in the public market have come down from the very full prices that were around, but I'm not sure that the sellers are looking at current prices."

Mr Ronald retires at the end of the year and hands over the top job to Walt Havenstein, a former US marine, who runs BAE Inc's electronics and integrated solutions business.

Mr Havenstein will inherit Mr Ronald's wish-list of businesses to buy. Ideally, these would include a helicopter manufacturer and an airborne radar business - two sectors of the market from which BAE is absent.

"We would like to have more platform presence in the US in the same way as we do in the UK," says Mr Ronald. "But that requires these businesses to be available. It would be nice to own a helicopter maker but there are only three in the US and none of them is for sale."

If BAE is to grow in the US market in the way it wants to, it is important it is seen as a good corporate citizen - something Mr Ronald and his successor set a great deal of store by. Hence the company's annual Christmas donation of bikes to the children of troops serving in Iraq and Afghanistan and its contributions to the tsunami and Katrina appeals. So far, the running sore of the Serious Fraud Office investigation into alleged corruption involving BAE arms contracts does not seem to have tarnished its US reputation which Mr Ronald has worked so hard to polish. "When I get on a plane in the States and the guy next to me asks who I work for, there is usually a one-in-three chance he will have heard of the company. It used to be one in 10 not long ago, so we are becoming better known and I'd say everyone on the Hill [the US Congress] is familiar with us."

What could halt BAE's progress stateside? An abrupt end to the Iraq war might hurt its land systems business - but it would take a year to 18 months before the pain was felt in reduced re-fit work on Bradleys. Of more pressing concern is the outcome of the mid-term elections in less than a fortnight. The Democrats look almost certain to regain control of Congress. And even if the Republicans hang on to the Senate, John McCain, the party's presidential hopeful, will assume the chairmanship of its Armed Services Committee. Unusually for a Republican and an ex-service man, Mr McCain comes to the job with a zest for budgetary reductions. He is in favour of fixed-price contracts for military-equipment suppliers and may support the cancellation of one of more of the DoD's high-profile but expensive next-generation programmes.

Then there is technology transfer - or rather the lack of it - a source of increasing friction between the US and its closest ally. Lord Drayson has publicly warned the Bush administration the UK could cancel its order for JSF aircraft if the impasse over the UK's lack of access to the software codes needed to fly the planes is not resolved. A mini-cold war between London and Washington over technology transfer would not help BAE's cause.

Meanwhile, BAE is making the most of double-digit margins that it and other US defence manufacturers are able to earn. In America, it has adopted the slogan "We protect those who protect us". Back at company headquarters in Farnborough they prefer a more familiar motto: God Bless America.