Structural change is an unavoidable reality for European national champions in naval shipbuilding. While the market opportunity both in Europe and in the wider world has not been as helpful for some time, longer term consolidation poses significant challenges and changes which in turn will require considerable political courage and commercial creativity.
Only in the far distant history is navy shipbuilding considered the most ‘racy’ segment of the defence industry or as a driver for positive sentiment within the wider military market, the naval industry in Europe may just be on the cusp of a significant change in tempo. The purpose of this note is not to go into the details of naval and maritime strategy, planning or the industry (frequently an area only for the fully committed!), but simply to outline at a high level some changes, both on the demand and the supply side, that may well be positive for the sector in Europe going forward.
The market for navy ships and equipment has generally been a slow-moving and, for much of recent memory, relatively unenticing from the point of view of growth. Inherently, it is a market with very long development times, extended production runs of low numbers of units which then have very long maintenance requirements and multiple upgrade programmes to be delivered over the course of a vessels’ life.
Furthermore, the maintenance of a capability to build ships for a country’s navy are frequently regarded as essential for national security reasons by many countries and, around the world, more and more countries are looking to develop an indigenous capacity to build naval vessels. This is no less the case in Europe and as a result the market within Europe is further characterised by considerable government subsidies, ‘national preference’ and chronic over-supply. Countries large and not-so-large have their own ‘national champion’: BAE Systems & Babcock (UK); Naval Groupe (France); Fincantieri (Italy); Navantia (Spain); TKMS, Lurssen, Blom & Voss & German Shipyards (Germany); Damen (Netherlands) and Vard (Norway).
Nevertheless, a combination of industrial necessities and an increased need for naval vessels in several key geographies has resulted in developments that will see the prospects for navy shipbuilders and systems suppliers see a boost, necessarily a long-term boost given the development lead-times and in-service revenues associated with combat ship construction.
Consolidation & Future Naval Strategies
Within the EU, the big news in naval ship-building over the course of the past 12 months has been the gradual process of Naval Group (France; former DCNS) and Fincantieri (Italy) attempting to come to an agreement to merge their operations. In inability to take the final steps complicated by changes in government in both countries with sharply diverging approaches to EU integration has led to this initiative being shelved, as did the mooted Thales-Leonardo tie-up and (how long ago it seems now!) the real prospect of a BAE Systems-Airbus merger. Nevertheless, consolidation has long been discussed as the solution to over-capacity within Europe with the UK, France, Italy, Germany, Sweden, Norway, Spain and the Netherlands all maintaining substantial naval ship-building and /or submarine capacity, producing ships not just for domestic markets but competing against one another abroad as well.
The proposed Naval Group-Fincantieri deal was preceded on the Italian side initially by the acquisition of Norwegian ship-builder Vard in 2013 and, more recently, by the approval to purchase 50% of the shares of French naval shipyard, STX. On the French side, in 2011 Thales raised its stake in Naval Group from 25% to 35%, with 62% owned by the French state.
The Thales stake matters at the moment as there is no similar Italian systems provider who has a significant stake in Fincantieri, which again is substantially owned by the Italian government (72%). Put simply, Thales systems go into Naval Group vessels and Leonardo (30% government owned) systems go into Fincantieri products. A merger at the shipyard level has made Leonardo feel very jittery about whether it will be at a disadvantage relative to Thales when bidding for future Naval Group-Fincantieri contracts. A further detail of considerable importance is that the Italian government owns 30% of Leonardo! These dynamics are typical and underlie the reality that however sensible European defence consolidation looks on paper (and in Brussels), making it work at a domestic and commercial level is fiendishly hard.
However, the proposed merger was an attempt to rationalise EU Naval manufacturing in order to prepare it for inevitable structural changes whose impact will be keenly felt in 10 to 15 years time. It is an indication of major structural change beginning to be addressed and therefore has implications across Europe. Both companies have combined sales of almost €9 billion but only €400 million of operating profit (4.4% operating margin). Even though sales growth for both companies has been consistent, making a profit even at the operating level has become increasingly challenging and this is typical of all European naval shipyards. The argument has long been made that, for the European naval industry to be sustainable, it needs to consolidate and be more efficient in both procurement and shipbuilding to maintain a viable industry.
An Opportunity for Growth?
And what of the demand side? While France has some modest plans to replace obsolete ships and submarines over the next 20 years and Germany has requirements for frigates, corvettes and 2 new submarines, Italy and the UK have more significant naval ship-building planes that will represent a significant increase in naval spending over the next 20 years.
Italy’s navy has not seen large investment over the past decade as a result of government spending restrictions but the migrant crisis as well as the effects of delayed replacement programmes means that the next decade will see planned programmes for frigates, landing craft, patrol vessels, support ships and most notably a new helicopter-carrier come to completion.
Similarly, in the Netherlands a parliamentary report revealed the parlous state of readiness of the Koninklijke Marine as well as the fact that a number of planned programmes have been delayed for a number of years and can no longer be pushed out further. As a result, an additional €1.5 bn. was allocated to the navy for the years up to 2020 when this arrangement will be reviewed again. As things stand now, programmes for frigates, corvettes, new submarines and support ships will move forward. In addition, the Netherlands is taking control of Belgium’s planned M Class Frigate replacement programme. The two countries have 4 M Class vessels between them, and all four will be replaced after 2024.
Finally, but perhaps most importantly in terms of size, the Royal Navy is enjoying a period of favour as far as its share of the UK defence budget is concerned not known for many years. In truth, the combination of the F-35 and the carrier procurement decisions have driven considerations for the Type 26 and Type 31 programmes; to field a credible carrier strike force a minimum number of support and protection vessels are necessary to operate alongside the limited numbers of the Type 45 and such is the number of ships that the RN now operates this would have made the carriers (now completed) very expensive tourist attractions and not much more.
The carrier protection issue has also significantly increased due to a significant increase in Russian submarine activity in the North Sea which further prompted the decision to go ahead with an order for an additional Astute-class attack submarine. The sub-surface side of new procurement will get more of a boost, however, from the programme to replace the Trident nuclear deterrent (the Dreadnought Class) which is underway with construction having started on the first 2 boats.
Thus, as a consequence of postponed spending and replacement programmes that can no longer be put off, the market for European naval equipment is seeing a considerable revival which, given the long lead times involved, will last a considerable time especially if the support service revenues are factored in. This in-service support also tends to be a much higher margin business in much the same way that aviation MRO is more profitable than actually making an aeroplane.
The Wider World: Competition for Exports
Although there are signs of a revival of sorts in naval acquisition in Europe, ship-builders in Europe are also increasingly focussed on even greater opportunities in the wider world which are considered essential to pad-out production in order to viably maintain national strategic ship-building capabilities.
The reality is that in several key areas of the world defence spending in general is on a strong upward trajectory and it is naval procurement that is receiving the lion’s share of resources. In the Middle East tensions continue to rise between Saudi Arabia and Iran causing nervousness among all their neighbours. Naval spend isn’t always the answer in such congested waters as the Persian Gulf, but an emphasis on coastal security is noticeable.
But it is in the Asia-Pacific region where demand for new and upgraded naval assets is really attracting attention from manufacturers and suppliers from all round the world. The claim and counter-claim over waters and islands with some vague proximity to China has led already to a significant number of new off-shore patrol vessels as countries such as Indonesia, the Philippines, Malaysia and Vietnam seek to assert their rights within their designated Economic Exclusion Zones (EEZ).
The destabilising factor here is China’s insistence that its EEZ should effectively be the entire South China Sea, including not only the islands therein but also the fishing rights. Of course, there is also a much broader, more strategic imperative to China which is to control the narrow sea lanes in the South China sea in order to ensure the flow of vital raw materials to the country in the long-term. China uses both its navy, extensive Coast Guard as well as co-opting occasional Chinese fishing fleets to probe and test, control and assert its dominance around the waters of Vietnam, the Philippines and Indonesia.
This factor has also led to countries such as Australia, Singapore and most significantly India also focussing defence resources on naval assets to assert a presence in this vital area and in reaction to the Chinese attempt at hegemony. The recent announcement of the Type 26 contract for the Australian Navy is just the latest sign of this new strategic focus. But this contract indirectly points to renewed interest in the area on the part of western European navies. The Type 26 Australian contract was won on the back of a deepening strategic partnership between Australia and the UK. Both France and the UK have undertaken ‘freedom of navigation’ operations in the South China Sea to signal their support for continued internationalisation of waters that China claims as its own sphere. Provocative as they are they nevertheless demonstrate an increasing focus on tensions in the Asia Pacific region and indicate a willingness to intervene, albeit in a non-kinetic way and in alliance with others.
It is therefore very likely that for smaller, less advanced but more proximate countries a posture of tactical response and reaction to Chinese incursions (of whatever kind) will be combined with a strategic approach of ‘area-denial’ in terms of the make-up of their forces. This has and will continue to mean that OPVs as well as multi-purpose Frigates and Corvettes will be in demand in the area. But by the same token, the submarine is similarly the obvious answer to ‘area-denial’ should ever what can currently be called a series of ‘Cold’ skirmishes at sea ever turn into a ‘Hot War’.
Several European ship builders have already benefited from the demand for OPVs in the region most notably Damen (NL), BAE Systems (UK), Lurssen (GD) and Ocea (FR). However, going above Corvette-class in terms of size restricts the number of countries who can provide such vessels. The ability to provide submarines such as can operate in shallow water with a small range, is even more restricted. However, Europe has several such yards and they are competing hard to win lucrative contracts.
Ultimately, European shipbuilding is barely profitable on current terms and future over-supply and increasing global competition will only mean domestic naval businesses relying to an unsustainable degree on government subsidies.
While there remains a buoyant market globally as well as an uptick in spending at home, national shipbuilders will have to work very hard to remain viable and this is likely to require some creative thinking in order to establish a naval sector that can remain afloat for the long term.