Completed acquisition by Babcock International Group plc of Devonport Management Limited

Affected market: Maintenance and support of surface ships and submarines

No. ME/3078/07

Please note that the full text of the decision can be downloaded by using the link on the right. What follows are extracts regarding the parties, the transaction, jurisdiction, third party views, assessment and decision.

The OFT’s decision on reference under section 22(1) given on 20 August 2007. Full text of decision published 3 September 2007.

PARTIES

Babcock International Group plc (Babcock) is an asset management business which manages fixed infrastructure in the rail, power networks, defence and nuclear sectors together with defence assets such as military aircraft, warships and nuclear submarines. Babcock owns the Rosyth Royal Dockyard on the Firth of Forth and manages the HM Naval Base Clyde at Faslane.

Devonport Management Limited (DML) was founded in 1987 to manage the Devonport Royal Dockyard as part of the UK Ministry of Defence's (MoD) reforms to introduce commercial management to its facilities. The Devonport Royal Dockyard was privatised in 1997, but the MoD retained a special share in Devonport Royal Dockyard Ltd (DRDL), which is otherwise wholly owned by DML. This special share grants powers to the MoD to intervene in matters affecting DRDL's ownership in light of Devonport's strategic importance. DML's UK turnover for the year ended December 2006 was £454 million.

TRANSACTION

Babcock acquired the entire issued share capital of DML from the existing shareholders. The transaction completed on 28 June 2007 and the statutory deadline for a decision on reference, as extended by virtue of a notice issued under section 25(2) of the Enterprise Act 2002 (the Act) on 12 July 2007, expires on 28 October 2007. The administrative deadline is 20 August 2007.

JURISDICTION

As a result of this transaction Babcock and DML have ceased to be distinct. The UK turnover of DML exceeds £70 million, so the turnover test in section 23(1)(b) of the Act is satisfied. The OFT therefore believes that it is or may be the case that a relevant merger situation has been created.

THIRD PARTY VIEWS

The MoD is the only customer of the merging parties and supports the merger. Its views on specific topics have been dealt with throughout the decision.

A number of competitors to the merging parties were concerned that the merger would lead to conglomerate issues and allow cross-subsidisation between submarines and surface ships. These issues have been dealt with within the wider assessment of whether the merger leads to the creation or strengthening of market power. Given its findings described under he headings horizontal issues and assessment, the OFT has insufficient basis to conclude that the merger gives rise to material non-horizontal issues.

ASSESSMENT

The parties overlap in a number of naval services, and in all of them the MoD is the only customer. The white paper on defence industrial strategy, DIS, favours consolidation of the naval industry and the substitution of tendering and other competition-based tools by other negotiation mechanisms for certain industry segments relevant to this merger.

The merger does not raise any competition concerns in relation to equipment support, submarine refitting and deep maintenance and surface ships design support. In equipment support, a number of competitors remain in the market, the combined share of supply of the merging parties is very small, and no third party expressed any concerns. In relation to submarine refitting and deep maintenance, DML was already the monopolist supplier, and therefore the merger does not lead to an increase in market power. Finally, there was no or limited current competition in surface ships design support since all work is shared under the DSA according to criteria unrelated to competition, and therefore the merger cannot lead to a lessening of competition.

The OFT believes that there was very limited, if any, pre-merger competition in relation to submarine in-service support and disposal and to surface ships in-service support and refitting and maintenance. Submarine and surface ships in-service support are covered by WSMI agreements, and as a consequence work is allocated according to the vessel's home base rather than according to competition criteria. Submarine disposal works are currently on hold, pending definition of Project ISOLUS. Finally, the MoD has moved away from competition for surface ships refitting and maintenance since 2005**, when it started to explore the possibility of forming the SSSA.

The OFT therefore believes that, due to the virtual absence of pre-merger competition in those segments, the merger does not eliminate material competition.

Nor does the merger reduce the scope for potential and future competition in those markets. Competition in submarine and surface ships in-service support would only have been reintroduced if the MoD decided to change its policy of commissioning the services to the manager of each HM Naval Base according to the vessel's home base irrespective of competition considerations. However, the MoD has not indicated any intention of doing so, and it has expressly declared that it does not intend to tender nuclear submarine projects.

In relation to submarine disposal, the MoD is considering a wide range of issues to decide where project ISOLUS will be carried out. If the MoD does not change its views (and the OFT has not received any evidence of indications that this is likely) that the decision on the site for project ISOLUS will take into account factors not affected by competition, it is irrelevant whether the Devonport and Rosyth facilities are managed by the same undertaking as they will not be in competition for the project.

The reintroduction of competition into surface ships refitting and maintenance is related to, but not dependant on, the future of the SSSA. If this alliance is implemented as expected, there will continue to be limited or no scope for competition in this market. However, even if the SSSA is aborted, the MoD may still choose to maintain the status quo, namely the situation in which firms do not compete for the provision of services. Nonetheless, the OFT recognises that the MoD may theoretically choose to re-implement competition in this market, even if it goes against the direction of its recent policy for this segment, although it attaches little weight to this scenario occurring in the foreseeable future.

In sum, the prospects for actual and potential competition absent the merger pre-merger are limited in both the supply of submarine in-service support and disposal, surface ships in-service support and refitting and maintenance. There would only have been scope for future competition between the parties if the MoD reintroduces competition in these sectors.

Moreover, the MoD maintained that there are a number of negotiating tools available that enables it to obtain the best value for money in negotiations with suppliers in these specific sectors even in the absence of competition, and that the merger will not cause any detriment to its negotiation power. While as a general matter the OFT is sceptical that mergers to monopoly do not reduce the negotiation power of even a monopsonist, the OFT has no evidence in this case that would contradict the MoD's own judgment of its position.

Overall, the impact of this merger on the relevant markets appears to be limited. While the merger clearly reduces any existing and potential future rivalry between the parties, the scope of such rivalry appears limited under the MoD's current procurement policy agenda and, in any event, the prospects for injecting or reducing supplier competition into the procurement process is largely driven by the MoD's judgment about its own best interests on behalf of the UK taxpayer, which limits the potential for merger effects compared with non-military markets. Indeed, the MoD actively supports this transaction as favourable to its interests, taking the view that it will be better off, rather than harmed, and that it can protect its position on account of its value-for-money procurement strategies.

While rivalry will be weakened by the merger to the extent it would exist without the merger, the OFT's Guidance notes that a substantial lessening of competition arises only where the OFT expects that a merger's weakening rivalry 'to such an extent that customers would be harmed'.  It is therefore doubtful, in the OFT's judgment, that there is a realistic prospect of a substantial lessening of competition in the relevant markets, and that a duty to refer arises.

Finally, even if the OFT were to conclude it was under a duty to refer, the OFT has a discretion not to make a reference on the basis of customer benefits. The MoD, the sole customer, has expressly taken the position that it supports the transaction because it will benefit from it, and not only in strategic or ‘contextual' terms, but also strictly in terms of value for money. These value-for-money benefits have also been quantified as arising through the merger: through the Heads of Terms signed between Babcock and the MoD it is agreed that, because the merger allows Babcock to operate in a more cost-effective manner, Babcock intends to provide the MoD with cost savings of at least [REDACTED] per year from the financial year 2011/2012 onwards. It might be the case that any detriment loss of competition would be outweighed by the benefits that would be passed on to the MoD. Although in the overwhelming majority of cases the customer benefits exception is subject to strict evidentiary standards due to information asymmetries and the speculative nature of such claims, in this case such claims are endorsed by the only customer: in other words, the MoD's express belief is that it will be better off in procurement cost terms with the merger than without. These exceptional circumstances make it appropriate to invoke the customer benefits exception in the event that the OFT were otherwise under a duty to refer.

Consequently, the OFT does not believe that there is a realistic prospect of a substantial lessening of competition giving rise to a duty to refer; in any event, if such prospect were realistic, the OFT would be minded on the unusual circumstances of this case to exercise its discretion in favour of the customer benefits exception to the duty to refer.

DECISION

This merger will therefore not be referred to the Competition Commission under section 22(1) of the Act.

NOTE

** The MoD clarified that the correct year is 2006, after the Competition Exclusion Order was granted.

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