The U.K Defence Industry - Essay Example

The U.K Defence Industry Introduction and rationale of industry The defence industry holds an important position in the economy of the U.K and the defence budget of the nation represents almost 3.5% of the net national budget (The Telegraph, 2014). The industry is majorly privatized and is primarily dominated by three large firms namely, British Aerospace, GKN Group and GEC-Marconi (The Telegraph, 2014). These represent the first tier defence companies. There are a number of other firms such as Rolls-Royce, BAE Systems, Smiths Group Plc and Airbus U.K who represent the second tier defence companies. The nation is currently the fifth largest exporter of defence equipments after Russia, the U.S, China and France. Defence exports of the nation are worth almost £5 billion on an average every year (The Telegraph, 2014). In the recent years however the share of government spending upon defence equipments have fell from 10% to 5%. The nation has had 21% share in the defence export market on a global scale from the year 2005 to 2010 (The Telegraph, 2014).The presence of a well developed export market has facilitated the creation of 65,000 jobs in the nation (Brauer and Dunne, 2004). The defence industry of the U.K successfully contributes £12 billion value addition to the nation’s economy (The Telegraph, 2014). The major challenges faced by the industry are to work in alliance with the government, to assist reformation of the procurement processes, to encourage authorities to spend more on research and reform and to further develop the export capabilities. The Ministry Of Defence of the U.K is seen to follow an open competition policy (Neuman, 2006). The figure below shows some of the largest firms of the U.K in the defence industry in terms of revenue. Figure: U.K defence companies turnover (Source: Key Note) Introduction and rationale of chosen companies Companies such as Rolls-Royce, Smiths Group Plc and BAE Systems rely on exports for their growth. Many such U.K based defence companies are looking towards selling their products in the emerging markets of the world which provide a greater opportunity for earning profits than the developed nations. The current paper analyses the general business and completion of three important defence firms of the U.K, namely Rolls-Royce, Smiths Group Plc and BAE Systems (Global Security, 2014). Rolls Royce Rolls-Royce is the 16th largest contractor of defence equipments in the world (Neuman, 2006). The company is one of the pioneers in providing defence goods and services and caters to fulfilling the defence equipments and parts needs of many nations of the world. Rolls-Royce is however is more active in the areas of civil aerospace, power systems and energy marine. The defence equipments accounts for a lower percentage of the net turnover of the company. The similar situation is seen exist with Smiths Group Plc where profits out of the defence equipments hold for only a small part of the total turnover of the company. Majority of the turnover arises out of aerospace and power equipment manufacturing (Neuman, 2006). BAE Systems In the U.K. BAE systems is the largest defence equipment supplier in the U.K. The Ministry Of Defence procures maximum defence equipments from BAE Systems (The Telegraph, 2014). The company has been able to establish itself successfully in the U.K defence industry. In the recent years the company has transformed by expanding its business globally. Compared with Rolls-Royce and Smiths Group Plc, the turnover and market stand of BAE Systems is very high. The company faces stiff competition from Boeing Co., which is currently at the second position. BAE Systems is currently the third largest arms maker in the world (Brauer and Dunne, 2004). Smiths Group Plc Smith group Plc’s turnover and market presence is comparatively lower than BAE Systems and Rolls-Royce. The company is known for technological superiority. The company operates in diverse number of industries and is particularly active in the hospitality industry. Smiths Group Plc’s business is seen to grow at a steady rate. The company specially concentrates in developing its business in the Asian subcontinent (Brauer and Dunne, 2004). Introduction and rationale for chosen ratios Financial ratios Profitability ratios-The gross profit margin facilitates identifying whether the revenue of the firm suitably covers the primary cost of production of the firm. The net profit margin of a firm indicates whether the net revenue of the firm is higher than the revenue earned. The return on capital employed ratio indicates how efficiently a firm is able to generate revenue from the capital which it employs (Fleisher and Bensoussan, 2003). The profitability ratios facilitates in understanding the manner in which the company is able to meet all its expenses so that there are adequate returns available to the stakeholders. These ratios were chosen to understand the profitability position of defence industry firms. Liquidity ratios- Current ratio helps in identifying whether a firm has the adequate ability to pay off its debts for the current financial period. Quick ratio helps in measuring the short term liquidity of the firm. (Garrison, Noreen and Brewer, 2003). The liquidity ratios were chosen so as to understand whether the firms selected from the defence sector have the potency of managing their day to day expenses without increasing their current liabilities. Efficiency ratios- The asset turnover ratio indicates a firm’s ability to generate revenues from the use of its assets. Sales to capital employed ratio is interpreted in a similar way as the asset turnover ratio. The sales to capital ratio also facilitate measuring a firm’s ability to generate sales through utilization of its assets (Palepu and Healy, 2007). Efficiency ratios were selected in order to understand how productively a firm utilizes its resources so that it can generate profits. Financial gearing ratio- The long term debt to equity and the gearing ratios helps in identifying the proportion of debt as compare to equity (Will, Subramanyam and Robert, 2001). Gearing ratios facilitate understanding the leverage and risk position of the firm. Investment ratio- The earnings per share (EPS) indicates the returns available to shareholders on each share. It is important to understand the EPS position as it is an indicator of the internal operational efficiency and profits of a firm. Non financial ratios Share prices indicate whether the profit position of a firm is favourable or not. When share values are high it becomes possible for a firm to raise capital through issue of new shares. Goodwill indicates a firms existing reputation in the market and its value. Employee turnover ratio indicates a firm’s ability to retain employees. It is preferred that the employee turnover ratio to remain low as it indicates that a firm has the capability to attract and retain talent (Revsine, et al., 2005). Research aim and objectives The current research aims to analyze the defence industry of the U.K. The defence industry plays an important role in the overall economy of the nation, contributing significantly towards its GDP (James, 2000). The paper critically analyzes the external market situations existing for companies in the defence industry. Chosen companies In order to gain deeper understanding of the subject matter, the research has taken into account information relating to three companies which operate in this industry which are; Rolls-Royce, Smiths Group Plc and BAE Systems. BAE Systems is one of the largest defence companies operating in the U.K whereas Smiths Group Plc and Rolls-Royce are smaller contributors to the defence industry (Britz, 2010). BAE Systems were chosen as one of the companies in the current research as it is considered to be one of the most successful companies operating in this sector. Rolls-Royce and Smiths Group Plc were also chosen from the second tier firms so as to obtain deeper understanding regarding all types of firms existing in the industry. The paper critically evaluates the environmental conditions which exists for these firms in the U.K and also analyses the performance and the reasons behind their success. A brief comparative evaluation regarding their financial performance has also been conducted through the comparison of their ratios. Critical competition analysis The completion existing in the defence industry is analyzed through Porters Five force Model. Threat of new entrants The defence industry’s success depends upon research and development. With technological innovations and the development of efficient defence systems, new companies may enter the market. The Ministry Of Defence of the U.K procures equipments and technologies on a cost advantage basis. Hence firms which are able to provide competitive technologies and at lower costs are able to earn higher profits (Golde and Tishler, 2004). This is one of the reasons why many smaller defence firms look towards selling their products and services to other nations, outside of the U.K where they can gain higher profits (Dombrowski and Gholz, 2006). Power of suppliers The power of suppliers in the defence industry of the U.K is high. Powerful suppliers are able to capture greater value for money for themselves and charge higher prices for their services. The defence industry is made up of a number of large corporations. The bigger and more powerful firms are experts in obtaining defence contracts. Many of these companies are simply suppliers who patent their products and services so that the government remains unable to shift to other suppliers. Also because many of the products are patented, it becomes difficult for the government to acquire the same product, technology or service from another supplier in the industry (Markusen, 2003). Power of buyers The defence industry is also characterized with superior buyer power. The most powerful and the only buyer existing in the industry is the Ministry Of Defence. The peer pressure and regulations imposed by the ministry may cause firms to reduce the prices of their services. The Ministry is seen to remain focused upon procuring in a cost advantageous manner by forcing companies to provide better quality prices at lower prices. This one reason due to which many firms such as Rolls-Royce and Smiths Group Plc focus on markets outside of the U.K. (Reppy, 2000; Mintz, Huang and Heo, 2002). Threat of substitutes The threats of substitutes are significantly low in the defence industry. General analysis states that there are no direct substitutes for defence related products and services. The high barriers to entry and power of suppliers make the industry characterized with a smaller number of firms. Defence contracts take a lot of time to be completed. As a result it becomes difficult for the government to switch suppliers or gain substitute products (James, 2005; Amara, 2008). Rivalry amongst competitors The defence industry is characterized with strong rivalry. Defence companies operate on the basis of contracts. Therefore obtaining defence contracts becomes an important aspect for their success. Since the industry is characterized with a small number of firms, they vigorously compete with each other for obtaining contracts (Mintz, Huang and Heo, 2002; Markusen, 2000). Critical environment analysis Using PEST analysis the macro environmental conditions existing in the defence sector has been analyzed in the following section. Political The defence industry gets adequately influenced by government strategies and spending. A cut in defence expenditure may cause loss of revenue in the defence industry. Defence firms also have the capability to influence the government into buying their services by providing superior technology and patenting the same (Gansler, 2011). Many defence firms require the help and financial support from the government for carrying out research related activities. Political turmoil and unrest may influence the operations of the firms operating in the defence sector. The recent recession had impacted the government expenditure in the defence sector. Since the strength of the national security depends upon the defence firms, government authorities allocate a considerable portion of their budget for spending on arms and ammunitions. The mergers with public companies and subsidies received from the government play an important role in the development of the defence sector companies. The political presence in the U.K defence sector has remained and plays a salient role in its success. Political policies however may affect the exports of the firms which operate in the defence sector. In order to export services, technologies and products to other nations, it is essential the government of the host nation is friendly with that of the U.K. In case of hostile relations, it is not possible to develop business relations. Changes in the political policies also effect the strategic operations of the firms operating in the defence sector. Most of the defence companies are seen to have long term contracts with the government (Markusen, 2000). Economic Conditions existing in the economy are seen to influence defence sector firms in an indirect manner. Economic turmoil may cause governments to reduce their spending in procuring defence goods and services. This may negatively impact the profits of the defence sector. The U.K defence sector is highly dependent upon the revenue generated through exports (Capelle-Blancard and Couderc, 2008). Other nations are seen to procure from the U.K based defence firms since their indigenous firms are less competent. The developing nations are considered as an important opportunity for growth by many of the U.K based defence firms. However, if emerging nation’s defence firms become strengthened, it may negatively impact the revenue of the U.K based defence firms (Mantin and Tishler, 2004). The defence industry is highly capital intensive, thereby preventing easy entry. Highly skilled labour and continuous efforts towards research and development becomes essential for the growth of firms in this sector. Globalization has paved way for many defence sector firms to spread their operations worldwide and increase their revenues. Trade policies and political relations play an important role in the transfer of defence industry related products from one nation to the other. The level of completion existing amongst the firms which operate within the defence sector also determines many decisions which are taken by the management of the defence sector firms (Markusen, 2000). Social The growth of the defence sector depends upon the existence of skilled labour. Without the existence of highly skilled workforce it would become difficult to meet the needs of the defence sector. The growth of the firms in this sector is also dependent upon the strong technological development and advancement in the society. Proactive management culture is also an essential aspect for the growth of firms in this industry (Hasik, 2008). Defence firms are seen to provide other services and products as well such as aerospace machine parts and power generating machine parts. Hence the development of firms which use such machines and technologies in the society also becomes an essential aspect. The increasing levels of terrorism and unrest in the Middle East nations are influencing the U.K to increase their military spending. This has increased the number of contracts available to many of the U.K defence firms (Weidenbaum, 2003). One of the significant social challenges faced by the defence sector firms is the development of technologies and products which are not harmful to the environment. Defence equipments are considered to destroy natural resources and environment protection agencies restrict their use unless there is threat to national security. Defence sector requires high level of skills and talent existing in the society for its development and success. Aging population and changes in the demographic conditions influences the manner in which defence sector firms meets it personnel needs (Markusen, 2000). Technology The dependency on technological advancement is high in this industry. Defence firms are required to spend hugely upon research and development so as to continuously innovate new products and services. The superior investment required to be made in the research and development hinders smaller firms to enter this sector (Hagedoorn, 2002). Many existing defence firms of the U.K are seen to continue their research related activities through government funding. Partnership amongst defence firms in respect of research is also seen to be a common phenomenon. The competitive position of many U.K based defence firms are maintained due to the fact that their technological resources and competencies are significantly high (Lovering, 2000). Defence firms continuously compete with each other in respect of obtaining more resources for the development of better defence technologies. The growth of the firms highly depends upon technological innovations (Reed and Walsh, 2002). The changing demands of military also induce firms to invest greatly upon innovation. The technology which gets developed in the defence sector is used by a number of other companies belonging to different sectors such as telecommunication firms (Hagedoorn, 2002). Reference List Amara, J., 2008. Military industrialization and economic development: Jordan's defense industry. Review of Financial Economics, 17(2), pp. 130-145. Brauer, J. and Dunne, P., 2004. Arms Trade and Economic Development: Theory, Policy and cases in arms trade offsets. London: Routledge. Britz, M., 2010. The role of marketization in the Europeanization of defense industry policy. Bulletin of Science, Technology & Society, 30(3), pp. 176-184. Capelle-Blancard, G. and Couderc, N., 2008. What drives the market value of firms in the defense industry?. Review of Financial Economics, 17(1), pp. 14-32. Dombrowski, P. J. and Gholz, E., 2006. Buying military transformation: Technological innovation and the defense industry. New York: Columbia University Press. Fleisher, C. S. and Bensoussan, B. E., 2003. Strategic and competitive analysis: methods and techniques for analyzing business competition. New Jersey: Prentice Hall. Gansler, J. S., 2011. Democracy's arsenal: creating a twenty-first-century defense industry. Massachusetts: MIT Press. Garrison, R. H., Noreen, E. W. and Brewer, P. C., 2003. Managerial accounting. New York: McGraw-Hill/Irwin. Global Security, 2014. United Kingdom Defense Industry. [Online] Available at: [Accessed 25 October 2014]. Golde, S. and Tishler, A., 2004. Security needs, arms exports, and the structure of the defense industry determining the security level of countries. Journal of Conflict Resolution, 48(5), pp. 672-698. Hagedoorn, J., 2002. Inter-firm R&D partnerships: an overview of major trends and patterns since 1960. Research policy, 31(4), pp. 477-492. Hasik, J., 2008. Arms and Innovation: Entrepreneurship and Alliances in the Twenty-first Century Defense Industry. Chicago: University of Chicago Press. James, A. D., 2000. The place of the UK defense industry in its national innovation system: co-evolution of national, sectoral and technological systems. The Place of the Defense Industry in National Systems of Innovation, 1(1), pp. 96. James, A., 2005. European military capabilities, the defense industry and the future shape of armaments co-operation. Defense and Security Analysis, 21(1), pp. 5-19. Lovering, J., 2000. The defense industry as a paradigmatic case of ‘Actually existing globalization’. Occasional Papers, 1(1), pp. 25. Mantin, B. and Tishler, A., 2004. The structure of the defense industry and the security needs of the country: a differentiated products model. Defense and Peace Economics, 15(5), pp. 397-419. Markusen, A. R., 2003. The case against privatizing national security. Governance, 16(4), pp. 471-501. Markusen, A., 2000. Should we welcome a transnational defense industry? The Place of the Defense Industry in National Systems of Innovation, 1(1), 24. Mintz, A., Huang, C. and Heo, U., 2002. 2 Defense spending and economic performance: a disaggregated analysis1. Defense, Welfare and Growth: Perspectives and Evidence, 1(1), pp. 21. Neuman, S. G., 2006. Defense industries and global dependency. Orbis, 50(3), pp. 429-451. Palepu, K. and Healy, P., 2007. Business analysis and valuation: Using financial statements. Connecticut: Cengage Learning. Reed, F. M. and Walsh, K., 2002. Enhancing technological capability through supplier development: a study of the UK aerospace industry. Engineering Management, IEEE Transactions on, 49(3), pp. 231-242. Reppy, J., 2000. The place of the defense industry in national systems of innovation. New York: Cornell University. Revsine, L., Collins, D. W., Johnson, W. B., Collins, D. W. and Johnson, W. B., 2005. Financial reporting & analysis. New York: Pearson/Prentice Hall. The Telegraph, 2014. Two thirds of UK defence companies look to emerging markets for 'significant' growth. [Online] Available at: [Accessed 25 October 2014]. Weidenbaum, M., 2003. The Changing Structure of the US Defense Industry. Orbis, 47(4), pp. 693-703. Will, I., Subramanyam, K. R. and Robert, F. H., 2001. Financial statement analysis. New York: McGraw-Hill Internation. Appendices 1) Financial ratios Profitability ratios Gross profit margin BAE- 63.21 Rolls-Royce- 21.38 Smiths- 44.93 Net profit margin BAE- 9.89 Rolls-Royce- 9.89 Smiths- 12.79 ROCE BAE- 7.06 Rolls-Royce- 17.48 Smiths- 11.55 Efficiency ratios Asset turnover ratio BAE- 0.80 Rolls-Royce- 0.75 Smiths- 0.77 Sales to capital employed BAE- 3.52 Rolls-Royce- 2.45 Smiths-2.97 Liquidity ratios Current ratios BAE- 0.73 Rolls-Royce- 1.31 Smiths- 1.84 Quick ratio BAE- 0.61 Rolls-Royce- 0.95 Smiths- 1.20 Financial gearing ratios Gearing ratio BAE- 5.76 Rolls-Royce- 3.66 Smiths- 2.72 Long term debt to equity BAE- 0.74 Rolls-Royce- 0.34 Smiths- 0.64 Investment Earnings per share BAE- -84.15 Rolls-Royce- -40.42 Smiths- 38.21 2) Plan and timetable Area First week Second week Third week Introduction Research and objectives Critical competitive analysis Critical environment analysis Financial and non-financial ratios Read More