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A month after the initiation of talks of a merger between U.K.-based BAE Systems (OTCPK:BAESY) and European Aerospace giant and the parent of Airbus, EADS, both companies scrapped the deal due to a political deadlock. In the end, a potential breakthrough in the aerospace industry turned out to be nothing more than a waste of time.

The deal didn't come through because of the insurmountable political hurdles that emerged after both companies decided to form the world's largest aerospace company with a combined value of $45 billion and $90 million in combined revenue. The major impediment in the fulfillment of the deal between EADS and BAE Systems was the political interference that was expected through BAE Systems, as the French and German governments held 15% and 22.5% of EADS.

After the merger, the combined stakes of both governments would have dropped to 9% each, which would have left them with only enough power to veto a hostile takeover. Problems arose when BAE decided to abandon the deal, unless the combined entity was allowed to run as a normal company, free of any political interference. Regulators in Washington announced that they were ready to give the green signal for the merger, if BAE sacrificed on its part and agreed to make its Special Security Agreement (SSA) stricter, just like that of EADS.

BAE was not willing to give up its special relationship with the Pentagon, which it has developed over a long period of time. The SSA has been predominantly lenient to BAE, despite belonging to the U.K., because its senior leadership in the U.S. is made up of Americans. The SSA has helped BAE win many lucrative projects with the Pentagon, including the $1,500 billion project of the F-35 joint strike fighter, the world's most advanced radar-evading jet fighter. Also, BAE's SSA has helped the company win the status of the most trusted foreign military supplier to the U.S. It was apparent then why EADS wanted to use BAE to target the military segment.

If that was not enough, the German and French governments refused to give up their stakes in EADS. In a paper that Reuters got hold of, in the last week of September, it was stated that the German government had reservations regarding the merger. The main reason cited was that the German government was wary of the merger leading to new factories being built in new areas, which might lead to job losses. Although it is widely believed that the issue was resolved afterwards, the French government still showed resistance in giving up its stake in EADS.

The deal was canceled, hours before the U.K. deadline, as BAE stated that:

"It has become clear that the interests of the parties' government stakeholders cannot be adequately reconciled with each other or with the objectives that BAE Systems and EADS established for the merger."

After the deal and conclusion:

The cancellation of the deal has left BAE in a tough situation. BAE will now have to convince investors that the company's operations are strong enough to sustain profitability without merging with another company. This will be exactly the opposite of what the company had been advocating for during the merger talks.

Investors were wary of the dividend sustainability of BAE in case it merged with EADS, which has historically been giving low dividends. On the other hand, EADS chief Tom Enders stated that he had underestimated the difficulties in getting the merger through. He said that he was especially surprised by the constant hindrances put up by German Chancellor Angela Merkel, who he considers as the major anti-merger force.

Almost all the aerospace companies saw their prices shoot up, including Boeing (NYSE:BA), Northrop Grumman Corp (NYSE:NOC), Lockheed Martin (NYSE:LMT) and Raytheon Corp (NYSE:RTN). The potential sequestration that is expected to follow at the start of the next year implies that major restructuring will be required in the aerospace industry. Big whales will eat up small fishes and, therefore, a lot of consolidation is expected to follow, which seems the only way for the industry players to survive the huge defense cuts.

General Dynamic (NYSE:GD) is being considered as the potential buyer of BAE. GD would love to acquire BAE because of its combat vehicle production. Also, both companies build navy ships so some cost synergies can also be reaped.

Some industry analysts believe that BAE would be a better offer if it breaks itself up into different parts. Companies like Boeing may be willing to buy its civil aviation unit.

However, a lot depends on the elections in November, which will ultimately decide the fate of the industry.

Source: BAE Sytems And An Update On M&A Activity In The Aerospace And Defense Sector