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BAE-EADS Deal Faces Questions From Investors

Sep. 24, 2012 - 09:19AM   |  
By ANDREW CHUTER, PIERRE TRAN and ZACHARY FRYER-BIGGS   |   Comments
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Despite ongoing uncertainty surrounding the massive deal being discussed by Britain’s BAE Systems and EADS, shareholders of both companies’ stock have not hesitated to act, with sharp adjustments to share prices occurring as news of negotiations broke.

EADS’ stock closed at 29.67 euros ($38.52) on Sept. 11, the day before news of the deal broke. Reflecting fears that BAE and its defense-heavy portfolio might drag down margins, the price had dropped to 25.74 euros at the close of the markets one week later, a 13.2 percent dip.

That dip is largely because of the composition of EADS shareholders, who invested in the European aerospace giant because of its booming commercial aviation business, said Byron Callan, a defense market analyst at Capital Alpha Partners.

“The current shareholder base owns EADS because of Airbus, not because of EADS’ defense businesses,” he said. “By merging with BAE, that cyclic exposure is diluted.”

BAE, on the other hand, saw a healthy spike in its price on the London Stock Exchange, from 328.7 pence Sept. 11 to 340 one week later, a 3.4 percent increase.

In the vacuum of notable progress on the deal, market analysts are stepping back and considering the broader strategy behind a potential merger.

“I see this as a big game of chess,” said Joseph Schneider, president of the consulting firm JSA Partners. “Everything that’s going on right now is short-term thinking, looking at what’s on the table.”

Schneider said the proposal is a tactic to allow prime contractor defense consolidation.

“This is a Trojan horse proposed deal designed to put big company mergers on the table and then enable BAE to merge with a U.S. company like Northrop Grumman or General Dynamics,” he said. “Without the BAE-EADS threat in the background, [the Defense Department] would unlikely approve a prime merger involving BAE.

“They played this game before when they were discussing merging with Aerospatiale [of France] in the late ’90s, only to get the U.K. government to sanction their takeover of GEC,” Schneider said. “Aerospatiale then merged with DASA [of Germany] to form EADS, which was their second choice.”

Others doubt the possibility of an alternative deal. Sash Tusa, a partner at London research house Echelon, said in a report that a counter-bid from a U.S. prime is difficult to see happening.

Tusa said all the uncertainty is around the politics of the situation. “If they [the companies] can square the three governments,” the deal “will probably happen, but it could be prolonged and therefore messy,” he said.

Hurdles remain for a potential merger, and successful clearance by regulatory authorities is not certain, given the massive size of the new combined company.

Even though EADS’ footprint in the U.S. is small enough to keep the potential combination roughly the same size as other prime contractors, investment bank Espirito Santo said in a market report that it thought the deal is unlikely to proceed.

“First, we believe there is a big risk of political obstruction from the U.S.,” the bank said. “Second is the fact that we don’t feel the offer is sufficiently compelling for BAE’s shareholders”

Titling its report “Grand Theft Aero,” the bank said that on current terms, the merger proposals outlined by BAE would represent a “steal” for EADS.

In Europe, where the two companies represent the lion’s share of defense contracting, the potential for monopoly poses a greater threat to approval.

“It makes sense for BAE and EADS to get together, but the question has to be asked whether it is a good thing to have such a large group for the defense ministries, which are the main clients,” said François Lureau of consulting firm EuroFLconsult.

While a consolidation of combat aircraft makes sense, the defense ministries will likely wish to avoid a “verticalization” of activities, as the proposed new company would also make the radar and missiles for the fighter jet.

That would lead to asset sales to obtain government approval, leading to a second wave of defense consolidation, Lureau said.

For instance, France’s Thales could be a buyer if BAE and EADS were forced to sell their respective 37.5 percent stakes in MBDA, the European missile company.

A consolidation of Europe’s fighter jet business raises the question as to whether France’s Dassault will put its military aviation activities into the merged group, as there will likely be only one European combat aircraft in 2040, Lureau said. Dassault builds the Rafale fighter jet and previously built the Mirage.

Owner Serge Dassault will have to consider the future, as will the French government. EADS holds 44 percent of Dassault, widely seen as a holding operation for the state.

An industry executive, however, said European governments have accepted and lived with an effective verticalization of the missile market, as BAE and EADS own 75 percent of MBDA and hold two-thirds of the votes.

Finmeccanica owns 25 percent but holds a third of the votes.

Possible changes to the ownership stakes held by European countries involved in BAE and EADS also concern investors, as key company officials desire to change the power dynamics in the potential new company.

But French defense consultant Bruno L.G. Carré said state control of defense is in the French DNA. “If the deal brings a significant political signal in favor of l’Europe de la défense, I would think that the French would accept a compromise and be comfortable with ‘just’ a super golden share.

“Without that, would the French abandon any control? I doubt it,” he said. “Complete privatization? Certainly not. Neither will they let the Germans control the group.

“Let’s not forget that EADS is a Dassault shareholder, which in turn is a shareholder of Thales and DCNS,” the French shipbuilder, Carré said. “So could it mean a global restructuring? That would require Dassault and EADS to get on together … unlikely.”

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