The news that the two largest European defense companies (BAE, based and listed in the United Kingdom and EADS, based and listed in France and Germany) were discussing a merger caught the sector by surprise. At first glance, the creation of a behemoth with $90 billion in sales is intriguing. The firm's cores are, for the most part, complimentary. Besides its home market of the UK and Europe, BAE has substantial business in the United States whereas EADS is in its home markets of France, Germany, and Europe and strengths in the Mid East, India, and Asia. BAE has strengths in ground warfare and tanks, whereas EADS has strength in aviation both military and with Airbus, Boeing's (NYSE:BA) major global competitor in commercial planes. BAE's foothold in the U.S. is a valuable asset to EADS which wants to attract more U.S. military and aerospace contracts, stating that it is a major strategic imperative of theirs. Combined the firms would have significant resources to compete against U.S. prime contractors. Considering the trend toward greater EU integration and budget issues which have seen the local European market for defense decline and the case can be made that this merger makes a lot of sense.
Unfortunately, the positives end and the political realities set in. Make no mistake about it, politically this deal is a hot potato on two continents. While the defense primes Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Raytheon (NYSE:RTN), Northrop Grumman (NYSE:NOC), and Boeing (BA) will keep a watchful eye on it (and employee a number of lobbyists no doubt), the likelihood that a deal goes through is slim.
- In Europe, both BAE and EADS are major employers with staff totaling more than 200,000. Considering the EU economic state and a deal which would see cuts of some 15,000 to 20,000 people this is not going to be seen in a good light.
- Although both BAE and EADS are public companies, the merger to create EADS took a lot of political wrangling in France and Germany with numerous restrictions being placed on the firm to preserve core military competencies within its borders. Likewise, BAE has extensive military and technological capabilities in the United Kingdom. Will all three governments be willing to share or give up a duplicate competency?
- Subsidies: The Boeing/Airbus subsidy battle went to the WTO to determine what and what does not constitute a government subsidy that impacts competition. This will be fresh in the minds of regulators on both sides of the Atlantic
- The issue also surfaced during the $30 billion Air Force competition for a new tanker. Awarded to Boeing, EADS offered to assemble the planes in Alabama (though manufacture parts in France) but it met with great opposition raising the question as to (A) whether a government contract should go to non-U.S. workers when the U.S. needs the manufacturing jobs and (B) how to define government subsidies when evaluating cost proposals
Ultimately I don't think investors in U.S. defense firms need to worry. When the announcement was made, U.S. defense stocks didn't react, positively or negatively. Neither did PPA, the Powershares Aerospace & Defense ETF that tracks our SPADE Defense Index. Even if the merger does pan out, it'll likely take more than a year (and likely closer to two) before all the governments involved give their approval.
Additional disclosure: The author manages the SPADE Defense Index, an investing benchmark for aerospace and defense sector companies. The Index is the udnerlying benchmark for the Powershares Aerospace & Defense ETF (NYSE: PPA).