BERLIN (Reuters) - Merger talks between Airbus owner EADS EAD.PA and Britain's BAE Systems (BAES.L) highlight the scramble for defense companies to offset shrinking revenues from military budget cuts with more commercial civilian activities.
In what could produce the biggest shake-up in Europe's aerospace and defense sector in more than a decade, the two companies said on Wednesday they were in advanced talks, just as global aerospace companies discussed ways to compensate for elusive defense contracts at the ILA Berlin Air Show.
"The military business is not a growth promoter these days. There's no growth in military budgets for the next two years," Egon Behle, the chief executive of jet engine maker MTU Aero Engines (MTXGn.DE), said at the show.
That contrasts with a boom in orders for commercial aircraft, with Airbus predicting that global airlines will buy a total of $4 trillion of aircraft over the next 20 years as they seek efficient new models to counter high fuel costs and meet relentless demand for travel to and from emerging markets.
The switch from defense to civil can be already seen at firms like MTU Aero Engines and German family-owned supplier Diehl, which has built up its commercial offering via acquisitions.
"How different the world is for defense companies," Diehl Defense Managing Director Claus Guenter said at the Berlin air show on Wednesday after his counterpart at sister company Diehl Aerosystems spoke of revenues quadrupling and a 50 percent increase in production rates for his business.
"We find ourselves in a tough competitive environment with other international companies who are all trying to get sales outside of their home markets," Guenter added.
A combination of BAE and EADS would certainly help to give EADS more of a presence outside of continental Europe.
"(The deal) has good industrial logic with BAE now feeling over-exposed to defense and EADS clearly looking to gain a foothold in the U.S.," said Edison analyst Roger Johnston.
BAE derives 98 percent of its revenue from defense & security, and Morningstar analyst Neal Dihora said he estimates that government contracts account for about three quarters of the company's revenue.
"With a slowing defense spending environment around the Western world, it appears to us a sound move to combine forces and reduce the number of competitors offering similar goods in the marketplace," he said.
MTU expects military business to make up just 8 percent of its sales in 2020, down from 14.6 percent this year and a far cry from 80 percent it accounted for back in 1985.
"The commercial business is growing so fast that the military business is being pushed down," CEO Behle said.
An EADS-BAE combination would echo the set-up of U.S. rival Boeing (BA.N), whose revenue is divided fairly evenly between $36.17 billion for commercial aircraft and $31.98 billion for defense, space and security.
Together, EADS and BAE would create a company generating about 41 percent of its revenue in civil aerospace and 43 percent from defense and security, according to calculations by Deutsche Bank, with the rest coming from other businesses such as helicopters and space.
The new company would have about 72 billion euros ($92.8 billion) in sales based on 2011 figures, meaning it would overtake Boeing.
EADS Chief Executive Tom Enders had earlier in the week warned that companies may just shift their capacity to the civil sector, while others had warned Europe risks losing military technological know-how.
Eurocopter's Chief Executive Lutz Bertling said he expects the industry's focus to be on development for the civil market in the future, while military orders will be for derivative versions of those civil helicopters.
Firms in Berlin were also seeking new roles for military hardware, such as supplying the oil and gas industry with helicopters or using transporters for humanitarian relief.
Unmanned aerial vehicles currently used in places like Iraq and Afghanistan could have uses in situations like the Fukushima nuclear disaster and EADS is pushing the credentials of its much delayed military transporter, the A400M, in transporting items such as medical supplies, water purifiers and bringing back people from disaster areas.
EADS and BAE will likely not be the last to shake up their businesses, with some analysts suggesting further consolidation may be on the cards.
"Companies that are very dependent on national contracts have to adjust their capacities or expand internationally," EADS's Enders said.
(This story was filed to remove comment from Stefan Ohl at Alix Partners which was made before the BAE-EADS talks were announced)
Reporting by Maria Sheahan