EU Arms Embargo Begins to Bite: Could Russia Lose Its New Carriers?

A war of words -- and of trade sanctions -- could have the unintended consequence of sinking one of Europe's leading defense companies.

Aug 10, 2014 at 9:48AM

Don't look now, but the war of words (and trade sanctions) between Russia on the one side and the United States and Europe on the other is heating up again.

This week, Russia responded to a series of new trade sanctions imposed upon it in the wake of the MH17 disaster by banning the import of meat, fish, fruit, vegetables, milk, and dairy products from the U.S. and Canada. Similar imports from the 28 European Union member countries are also subject to the ban. But there's one thing in particular that Russia is decidedly not importing again from Europe.

Mistral
Photo: Wikimedia Commons

Two Mistral-class helicopter carriers built for it by privately held defense contractor DCNS of France.

What is Mistral?

Classified as a multipurpose intervention ship, and often referred to as an "amphibious assault ship," "helicopter carrier," or (more colorfully in Japan) even a "helicopter destroyer," France's Mistrals weigh in at a hefty 16,500 tons displacement, making them even bigger than America's newest fleet of Zumwalt-class battle cruisers. Each warship is capable of carrying into battle as many as 35 fully armed light attack helicopters, 40 main battle tanks, and a battalion of troops.

Russia has ordered two of these beasts from France's DCNS. The first, dubbed the "Vladivostok," is due to be commissioned into the Russian navy as early as this November. The second, "Sevastopol," should be delivered next year. At last report, France was still committed to delivering both warships to Russia as contracted.

Zumwalt
The USS Zumwalt (DDG-1000) is a big warship. France's Mistrals are bigger. Illustration: Wikimedia Commons

When the left hand doesn't know what the right is doing

Why would France proceed with the sale of two warships to a country that it is sanctioning on other matters, and that has just imposed sanctions against it? I'll give you 1.6 billion reasons.

If France forbids DCNS from delivering the Mistrals to Russia, that's how much money the defense contractor will lose -- $1.6 billion in sales proceeds from the contract. That would be highly problematic for DCNS.

State-controlled, but with 35% of its equity owned by publicly traded European defense conglomerate Thales SA, DCNS has proven to be a bit of a burden to its partner. The only reliably financial data we have for this company, compiled by S&P Capital IQ, shows that in fiscal 2012, DCNS was barely eking out a $161 million profit from its business -- just 5.2% of revenues, far below average profitability for U.S. contractors, for example.

Those profits appear to have taken a turn for the worse. Reporting earnings last month, Thales noted that contributions from its interest in DCNS have already declined, and warned that overall profits from its DCNS stake will fall in 2014, in comparison to 2013 levels.

Thales CEO Jean-Bernard Levy says he hopes to see DCNS "restore an improved profitability" eventually. But DCNS recently lost its own CEO to early retirement, and has imported a new leader from Airbus (NASDAQOTH:EADSY) who must now try to learn the ropes aboard an apparently sinking ship.

Throwing DCNS a line

Given the dire straits of a defense contractor in which it owns a majority stake, France's reluctance to scuttle DCNS's Mistral sale to Russia is understandable. Meanwhile, the rest of the EU is floating an idea that might simultaneously save the company -- and deny the Mistral warships to Russia.

The EU could buy the Mistrals itself.

Quoted on DefenseNews.com earlier this week, European Council on Foreign Relations official Edouard Tetreau said there is at least "a possibility" that the Mistrals could be drafted into the European armed forces as a way of softening the financial blow on DCNS, should their sale to Russia be forbidden. Potentially, the carriers could be put under the jurisdiction of NATO, or even of the EU itself, whose European Defence Agency could take possession of the ships.

While no final decision has yet been made, Tetreau says "it is being discussed in Paris as an option." Furthermore, such a move would align with German arguments that the EU needs an amphibious warfare capability such as the Mistrals could supply.

What it means to investors

As a privately owned, state-controlled firm, what happens to DCNS vis-a-vis the Mistrals might not seem that important to U.S. defense investors. But in fact, the situation does bear watching for a couple of reasons. If the EU forbids sale of the Mistrals to Russia, and DCNS is unable to find another buyer for them, the company would have to absorb a sizable financial loss, equal to more than six months' revenues.

A blow of this magnitude could stagger the company, which is a major competitor to U.S. military shipbuilders Huntington Ingalls (NYSE:HII) and General Dynamics (NYSE:GD). That would give these companies a competitive advantage over DCNS in future arms contracts negotiations.

Alternatively, should Europe elect to "save" DCNS by forbidding the Mistrals' sale to Russia, but drafting them into the EU's armed forces, the EU would be correspondingly less likely to need to buy amphibious warfare ships from the U.S. in the future. (Here, it would be Huntington Ingalls that gets disadvantaged, as it's the primary builder of such warships for the U.S.)

Whichever way this plays out, one thing is clear: It matters very much what France ultimately decides to do with its new Mistrals. It matters not just to Russia, but to U.S. investors as well.

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Will the EU bring "Vladivostok" to Europe? Photo: Wikimedia Commons

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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