The aerospace industry as a whole is expected to be shaken up, as two major industry players, European Aeronautic Defense and Space Co. (EADS) and BAE Systems, revive a decade old plan to merge and form a company as big as Boeing (NYSE:BA), currently the largest aerospace company in the world. The new company, after the merger, is expected to generate $90 billion in revenues annually, and will have a market value of $49 billion. Approval from European and U.S. regulators does not seem to be a big issue. However, the deal does pose threats to the main players of the industry like Boeing , Lockheed Martin (NYSE:LMT) and United Technologies (NYSE:UTX).
Advantages to EADS and BAE
The following shows the comparison between both companies.
The merger is expected to solve strategic challenges for both potential partners. EADS has for long struggled to penetrate the market for defense products in the U.S., but has not been able to do so in a convincing manner. EADS is overly dependent on its civil aerospace division - Airbus, the arch rival of Boeing. Although Airbus is doing big business and managed to sell the most number of planes in a year in its history last year, EADS wants to establish itself in the defense division as well. Also, Airbus has considerable backlogs, and is years behind delivery on planes like the A380 jet and the A400M military plane.
The French and Spanish governments have stakes in EADS. The German government also often intervenes in decision making. CEO Tom Enders wants to end this political meddling that is often a source of friction in the company.
BAE, on the other hand, has a much larger presence in the U.S. market, as it employs 39,200 employees in the U.S. as compared to a meager 3,200 U.S. workforce for EADS. It is a supplier of different airplane parts to companies like Boeing.
A deal with BAE will not only provide more financial and technical support to EADS, but will also help it enter more convincingly in the defense industry, and compete with defense contractors like LMT and BA. EADS recently lost a contract to Boeing worth $35 billion to make a new refueling tanker for the U.S. Air Force.
Therefore, the merger will reduce EADS' dependence on the commercial aircraft cycle. This is important, especially as Boeing, with its fuel efficient MAX series, is vying to take back its number one position in the U.S. commercial aviation market after Airbus snatched it last year. This deal will help EADS benefit from both commercial aviation and defense business cycles. This strategy was proposed by ex EADS CEO Louis Gallois in 2007, which he called 'Vision 2020'. Now it seems this might happen as early as 2013.
BAE will benefit from the plan by gaining access to newer markets in which EADS is already established. The two have already worked together on a project to produce combat jets by the name of the Eurofighter Typhoon.
The combined EADS-BAE will have sales of $90 billion and 220,000 employees worldwide, and 45,000 workers in the U.S. alone. EADS and BAE will have 60 and 40 percent stakes respectively. The company will be listed in Britain, and will have two operating companies run by a single team.
Both companies think that the merger will provide them with more financial stability and increase their market reach. According to them, the synergies will save the company an annual $1 billion.
The combined company plans to get rid of government control. For this, it will issue 'golden share' to the French and British governments to block takeovers, and take care of sensitive assets like nuclear weapons. However, the government will not be allowed to sit on the board, or interfere in the management concerns. No shareholder will be allowed to hold more than 15% of the total shares of the new company. Such an action will not only free EADS from the political bureaucracy, but also help it get approval from U.S. regulators.
The shares of EAD were down 10.2%, while BAE shares were down 7.29%. Investors did not appreciate the merger after analysts told the market that both companies hardly overlap in work, and therefore cost savings may not be that much.
Shrinking defense budgets in the U.S. and Europe make it hard for investors to believe that the merger will really be fruitful to any of the parties.
Also, things will become tougher for BAE, as with EADS controlling 60% of the new company, BAE will not be able to work for the U.S. government in sensitive areas, such as cyber security.
However, the market still seems to be confused about the matter. The prices will settle after BAE and EADS disclose the expected boost in revenues and the cost cutting through synergies.
BAE supplies military and commercial aircrafts to BA, including the control panel on the 737 airliner, flight control systems for V-22 Osprey, and engine control systems on the 787 Dreamliner jet. Boeing's CEO Jim McNerney dismissed the potential threat by saying:
"I have a pretty deep and abiding faith in our company's strength, so I don't think this is going to threaten us fundamentally."
Some people are expecting that this potential will lead to an acquisition by Boeing of Northrop Grumman Corp (NYSE:NOC) worth $16 billion.
Grey Hayes, the CFO of UTX and the maker of Blackhawk helicopters, also dismissed the threat by saying that such a deal was inevitable given the shrinking defense budgets.
Similarly, LMT's CEO to-be, Christopher Kubasik, said the defense industry needs to be consolidated for the players to survive the deep defense cuts expected in the future. LMT is a partner of BAE in providing troop carriers and computer systems to the Pentagon.
The pressure of the proposed defense budget cuts, and massive demand for airplanes from Asia, have both been important factors behind what seems to be the most important deal in the aerospace industry in the last two decades. Although competitors have not shown any alarming reactions towards the deal, the news is definitely going to affect their business in the coming future. Important catalysts will be the official announcement of the deal, the official estimates of savings and revenues released by both partners, and the approval of U.S. and European authorities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Qineqt's Industrials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.