BAE-EADS Talks Could Spark Wave of Contractor Consolidation

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LONDON and PARIS — For several years, defense contractors on both sides of the Atlantic have been biding their time, building up cash and reviewing possible combinations, awaiting the start of a consolidation wave that will reshape the global military industrial landscape in the face of sharp spending cuts in Europe and the United States.

On one side, U.S. companies are waiting for the conclusion of presidential elections and the resolution of the budget battle in Congress that will determine the future of defense spending before making their move. But on the other side, Europe is not waiting.

The cannon blast that started the consolidation race went off Sept. 12 when BAE Systems and EADS confirmed talks to unite into a $96 billion giant that would be the world’s leading defense and aerospace titan.

The new company, already nicknamed “BEADS,” would be listed on the Frankfurt, London, Madrid and Paris stock exchanges, with EADS holding a 60 percent stake and BAE 40 percent. The combined firm would boast a formidable array of commercial and defense products, including fighter, transport and trainer aircraft; rockets and satellites; missiles and precision weapons; armored vehicles; unmanned systems; radars; command, control and communications gear; networks and cyber capabilities; ship repair and naval products; and intelligence and space services units.

The transaction is the brainchild of EADS Chief Executive Tom Enders, who took office in June, to expand his company’s defense product line and balance its military-commercial business base, improve its access to the United States and other key global markets such as India, and use the deal to change the company’s governance structure that now permits the French, German and Spanish governments to exert influence on EADS, allowing it to move toward a wholly commercial structure.

For BAE, the deal is a chance to boost its civil activity and balance its civil-defense mix.

The announcement prompted Boeing Chairman and Chief Executive Jim McNerney to quip that EADS was trying to look more like Boeing by better balancing its defense-commercial product mix.

BAE and EADS have until Oct. 10 to announce a deal, and while it is unclear whether it will secure antitrust, financial, security and tax approval from regulators in five governments as well as the European Union, the companies will have no choice but to review their options.

“All mergers can succeed or fail, and BAE and EADS still need eight months to wrap it up and 18 months to see if it works,” one senior retired European executive said. “But other CEOs cannot afford to wait that long to see if it succeeds, and they will all be looking around right now to see how they should react.”

Indeed, hours after the two giants confirmed their interest in merging, speculation swirled about who might be next.

And just as an EADS link with BAE would tap the all-important U.S. defense market that remains the world’s largest despite spending cuts, U.S. companies are exploring linking with European firms.

“There is a huge amount of change going on in our sector with budget pressure and other issues. There will be a lot of activity over the next five years, but what direction it will take is unclear,” one senior British executive said. “Whenever you get a shift like this, it forces people to think. It has the potential to be a game changer in terms of scale and geographic footprint.”

 

Not a done deal

But before that happens, the would-be European partners have some high hurdles to surmount.

The British executive added that the deal will not get out of the starting blocks as long as governments can exert influence in the new company, as they do in EADS.

“The important thing to consider is not their shareholding itself, it’s about the block voting rights. Before this deal can go ahead, at an absolute minimum those will have to be dissolved, dismantled and cease to exist,” he said. “If any shareholder has a share in the new company, all they will have are normal rights and nothing else. Unless the block rights are dismantled, this transaction cannot proceed.”

At issue is how that government shareholding could affect BAE’s lucrative North American business, with sales of some $15 billion annually, including across highly sensitive intelligence and other operations.

Since starting its acquisition of U.S. properties in the 1990s, BAE has operated them independently and under strict security guidelines to protect U.S. technology. While that is customary for all foreign companies that own or operate units in the United States that do business with the Pentagon, the British giant benefited from greater access to technology thanks to the special defense relationship between London and Washington.

“If France and Germany maintain political control over EADS, this will be viewed poorly in the U.S., but I see it as unlikely that France would abandon EADS,” the retired European executive said.

Then there are the regulatory approvals that could prove challenging for the companies. The British, French, German, Spanish and U.S. governments would have to approve the deals, as well as European Union regulators.

Steven Grundman, the defense industrial analyst at the Atlantic Council in Washington who oversaw defense mergers and acquisitions at the Pentagon during the administration of former U.S. President Bill Clinton, added that while governments should rightly view the new company as a trans-Atlantic industrial bridge, the combination still will face scrutiny on both sides of the Atlantic, including from competition authorities.

“Recall that the European Commission rejected the proposed merger of General Electric and Honeywell on a theory of ‘portfolio effects’ that took issue not with horizontal overlaps or vertical integration but the supposed unfair challenge to competitors of the resulting conglomerate’s scale and scope,” Grundman said.

Antitrust regulators will solicit the views expressed by customer governments — the two companies do compete against one another for business worldwide — as well as take account of competitors who may attempt to argue the combination could materially disadvantage them.

Still, Grundman said he anticipates relatively few traditional antitrust problems on either side of the Atlantic, adding that security issues loom larger for the Pentagon. On the one hand, he said, the Defense Department (DoD) already supervises industrial security programs at both companies’ U.S. businesses. At the same time, the Pentagon is sure to scrutinize closely the changing ownership of BAE’s U.S. assets.

Lockheed Martin Chairman and Chief Executive Robert Stevens, however, told a Morgan Stanley investor conference in New York the merger could be a test for the Pentagon’s policy of not supporting any more consolidation at prime level.

DoD leaders have said that while they are open to consolidation on a case-by-case basis, they do not want leading firms to unite.

“It might be an early test of whether the unfavorability of consolidation at that tier would in fact be changing or evolving,” Stevens said.

 

Tom Kington in Rome and Zachary Fryer-Biggs in Washington contributed to this report.