Excerpt from Sept. 11 Letter to Shareholders by BAE Systems Chairman Dick Olver:
Following a strategic review, the Board of BAE Systems determined that its minority shareholding in Airbus was not core to the long-term development of the Company and, on 7 April 2006, BAE Systems announced that it had entered into discussions with EADS regarding the disposal of the Airbus Shareholding.
BAE Systems served the Put Notice upon EADS on 7 June 2006 and, the parties having failed to reach an agreement on the price to be paid by EADS for the Airbus Shareholding, an independent expert was appointed on 21 June 2006 in accordance with the terms of the Shareholders’ Agreement.
On 2 July 2006, BAE Systems announced that the price payable by EADS in relation to the Proposed Disposal of the Airbus Shareholding had been determined by the independent expert to be EUR 2,750 million (£1,903 million based on the prevailing exchange rate on 2 July 2006 and £1,868 million based on the prevailing exchange rate on 8 September 2006).
Due to its size, the Proposed Disposal requires the approval of Ordinary Shareholders at an Extraordinary General Meeting (the ‘‘EGM’’) to be held at 10.00 am on 4 October 2006. Notice of the EGM is set out at the end of this document.
I am now writing to you to explain the background to the Proposed Disposal, to explain why your Board considers that the Airbus Proposals are in the best interests of the Company and its shareholders as a whole and to recommend that you vote in favour of the resolution approving the Airbus Proposals, as the Directors intend to do in respect of their beneficial shareholdings in the Company.
2. Background to and reasons for the Proposed Disposal
Following a detailed strategic review of BAE Systems’ principal businesses, the Board determined that the Company’s shareholding in Airbus was non-core and a candidate for disposal. In reaching this judgement it weighed heavily with the Board that BAE Systems’ 20 per cent shareholding in Airbus represents a minority shareholding in a business over which BAE Systems does not have full control and has no realistic prospects of gaining full control.
Furthermore, there are a number of other factors regarding the sector in which Airbus operates and its position within it that persuaded the Board that a disposal in the near term was appropriate, including:
- Industry cyclicality: The commercial aerospace industry in which Airbus operates has historically shown cyclical trends. The Board believed that the market for passenger aircraft would continue to be cyclical and that downturns in broad economic trends could have a material adverse effect on Airbus’ future financial results.
- Increasing competition: Airbus’ primary competitor, Boeing, has recently demonstrated increased resilience and improved performance. The Board concluded that the level of competition posed by Boeing was likely to be more significant in the future than it has been in recent years.
- Currency exposure: Airbus’ revenues are largely U.S. Dollar-based whilst a significant proportion of its costs are incurred in Euros. The prevailing exchange rate between the U.S. Dollar and the Euro therefore has an adverse impact on Airbus’ profitability as compared with the average U.S. Dollar/Euro exchange rate from 2001 - 2005 of 1.09.
Although the effect on Airbus’ profitability of this exchange rate is partially mitigated in the short term by favourable hedge contracts into which Airbus previously entered, the majority of Airbus’ current hedge contracts will have expired by 2010.
While Airbus may enter into new hedge contracts in the future, these may be on significantly less favourable terms than its current contracts.
- Funding requirements: In recent years, the Airbus business has been increasingly cash generative and Airbus’ shareholders have benefited directly from this. However, it is now entering the next phase of its long-term development, which will require significant investment in the launch of new product lines and the upgrade of existing product lines.
The Board concluded that the shareholders of Airbus were likely to see a reversal in the previous cash generative trend of Airbus over the medium term to fund this investment. Since the Airbus Shareholding is non-core to the Company’s strategy, the Board did not believe it was appropriate for BAE Systems to be exposed to this potential cash reversal.
On 7 April 2006, BAE Systems therefore announced that it had entered into discussions with EADS regarding the disposal of the Airbus Shareholding. Following a period of discussion, on 7 June 2006 BAE Systems served upon EADS a formal notice of exercise of its Put Option requiring EADS to purchase the Airbus Shareholding on the terms set out in the Shareholders’ Agreement.
On 13 June 2006, Airbus announced delays to its A380 programme. On the same day, EADS announced that from 2007 to 2010 it anticipated annual shortfalls of EBIT contribution as a result of these delays of approximately 0500 million relative to Airbus’ original baseline plan for each of those years.
On 21 June 2006, in accordance with the Shareholders’ Agreement, BAE Systems and EADS appointed N M Rothschild & Sons Ltd and Rothschild & Cie (together, ‘‘Rothschild’’) to act as an independent expert for the purposes of determining the Price. Rothschild made its determination after receiving information from EADS, Airbus and BAE Systems.
On 2 July 2006, Rothschild informed BAE Systems and EADS of its determination of the Price. The terms of the Shareholders’ Agreement preclude the Company from discussing with Rothschild the basis of Rothschild’s determination of the Price. The Price determined by Rothschild was significantly lower than had been expected by the general market.
Accordingly, on 5 July 2006, the Company announced its intention to undertake an audit of the Airbus Group in accordance with Clause 10.6 of the Shareholders’ Agreement (the ‘‘Audit’’) in order to assist the Board in assessing its recommendation with regard to the Proposed Disposal. The Audit was undertaken by PricewaterhouseCoopers LLP and involved an appraisal of certain areas of Airbus’ business, programmes and financial prospects.
Having assessed the results of the Audit, the Board believes that Airbus is facing a challenging short to medium-term outlook, in particular with respect to certain of its principal programmes.
The Board believes that a significant amount of management focus, time and investment will be required to address the issues currently facing Airbus to improve its operating and financial performance and thereby to increase its value. Inevitably, there are risks involved in such a recovery programme and, having reviewed the Audit, the Board is concerned about the possible cash requirements of the Airbus business in the medium-term.
The Board therefore believes that it is in the best interests of the Company to exit at the Price determined by Rothschild. In arriving at this judgement, it weighed with the Board that, if it does not proceed with the Proposed Disposal, it may be necessary to retain the Airbus Shareholding for an extended period to be confident that it could be sold for materially more than the Price.
Whilst the Board is recommending the Proposed Disposal, shareholders should be aware that this recommendation does not alter the fact that, along with a number of EADS’ shareholders and several regulatory authorities, the Board remains concerned about recent developments relating to Airbus and their impact on the exercise of the Put Option along with the circumstances in which the A380 delays were announced and their financial impact was assessed.
In order to preserve the Company’s right to bring a claim against EADS or Airbus, the Board is recommending the Proposed Disposal without prejudice to any claim or cause of action which the BAE Systems Group may have arising out of or in connection with any of these matters or otherwise in connection with the Airbus Shareholding (the ‘‘Airbus Proposals’’).
Accordingly, in approving the Proposed Disposal at the Extraordinary General Meeting, shareholders will be doing so while allowing the Board to continue any further courses of action open to it relating to its Airbus Shareholding.
Following the Proposed Disposal, the Board believes that BAE Systems will have a strong, balanced and growing business based upon its position across the defence markets in which it is a key domestic supplier, including the U.K. and Europe, the U.S., Saudi Arabia, Sweden, South Africa and Australia. The proceeds from the Proposed Disposal will provide BAE Systems with additional resources to invest in these markets.
3. Information on Airbus
Airbus is a leading manufacturer of commercial aircraft. The Airbus product line includes a comprehensive range of passenger aircraft models, from the 100 seat, single-aisle A318 jetliner to the new, long-range 555 (or more) seat A380. In addition to commercial jet airliners, Airbus produces freighter aircraft and is developing the A400M military transport aircraft.
The shares that BAE Systems owns in Airbus represent 20 per cent of Airbus’ ordinary issued share capital. The remaining 80 per cent. of Airbus’ ordinary issued share capital is owned by EADS. Airbus has no other shareholders.
For the year ended 31 December 2005, BAE Systems’ 20 per cent share in Airbus generated profits before taxation of £254 million on sales of £3,002 million. As at 31 December 2005, BAE Systems’ 20 per cent share in Airbus represented an amount of net assets of £110 million and gross assets (excluding goodwill) of £4,784 million. This financial information has been extracted without material adjustment from Part III of this document, which also sets out further information on BAE Systems’ 20 per cent share in Airbus.
On 13 June 2006, Airbus announced that the delivery schedule for the A380 programme would undergo a delay of six or seven months due to production ramp-up issues, which are likely to limit aircraft deliveries to nine in 2007 and result in further delivery shortfalls in 2008 and 2009. Also on 13 June 2006, EADS announced that from 2007 to 2010 it anticipated annual shortfalls of EBIT contribution as a result of delays to the A380 programme of approximately 0500 million relative to the Airbus original baseline plan for each of those years.
In its Consolidated Interim Financial Statements dated 26 July 2006, EADS stated that a detailed review of the A380 production and delivery programme was being implemented, which included an assessment of other aircraft programmes, especially the A400M. Further details regarding these announcements are set out in Part VI of this document.
4. Financial effects of the Proposed Disposal and use of proceeds
The aggregate consideration payable by EADS for BAE Systems’ 20 per cent shareholding in Airbus is EUR 2,750 million (£1,903 million based on the prevailing exchange rate on 2 July 2006 and £1,868 million based on the prevailing exchange rate on 8 September 2006).
On 2 July 2006, EADS announced that it would pay the consideration in cash. Following repayment of certain debts outstanding between BAE Systems and Airbus at Completion and the payment of transaction related costs, net cash proceeds to BAE Systems are estimated to be approximately 01,786 million (£1,236 million based on the prevailing exchange rate on 2 July 2006 and £1,213 million based on the prevailing exchange rate on 8 September 2006).
The Board of BAE Systems proposes to return up to £500 million to Ordinary Shareholders by way of onmarket purchases of shares following completion of the Proposed Disposal using authorities granted at the last annual general meeting of the Company (the ‘‘Return of Capital’’). Following the purchases, the shares repurchased will initially be held in treasury. The Board also intends to consult with the trustees of the Company’s pension schemes and the Pensions Regulator with regard to any further investment in those schemes (the ‘‘Pension Funding’’).
Following the Return of Capital and any Pension Funding, the remaining proceeds, together with the Group’s other cash resources, will be available for debt repayments and future investment in the Group and to pursue selected value enhancing acquisitions to strengthen the core business.
Whilst the Proposed Disposal together with the related Return of Capital and any Pension Funding may result in near-term dilution of the earnings per share of the Continuing Group, it will strengthen BAE Systems’ financial position.
An unaudited pro forma statement of net assets of the Continuing Group as at 31 December 2005 is set out, for illustrative purposes only, in Part IV of this document. As at that date, BAE Systems had consolidated net assets of £2,804 million. As shown in that statement, the illustrative unaudited consolidated net assets of the Continuing Group as at 31 December 2005, on a pro forma basis and adjusted to reflect the Proposed Disposal and the maximum amount of the Return of Capital as if Completion and the maximum amount of the Return of Capital had occurred at that date, would have been £2,992 million.
It is anticipated that there will be no material taxation payable in connection with the Proposed Disposal.
5. Current trends in trading and prospects
As stated in the Company’s Report and Accounts for the financial year ended 31 December 2005, BAE Systems anticipates an improved performance for the 2006 financial year from the Continuing Group’s defence businesses, with modest organic growth and a full year contribution from the former United Defense activities. The Company also expects to translate operating profit into operating cash flow, other than some small utilisation of customer advances.
Since this statement, there has been no change to the Board’s expectations for the Continuing Group.
In the Company’s Report and Accounts for the financial year ended 31 December 2005, BAE Systems included reference to the Understanding Document signed on 21 December 2005 by the Kingdom of Saudi Arabia and the United Kingdom of Great Britain and Northern Ireland related to Saudi armed forces modernisation.
On 18 August 2006, it was announced that the Governments of the Kingdom of Saudi Arabia and the United Kingdom of Great Britain and Northern Ireland have agreed the required commercial principles which will effectively initiate the purchase of Typhoon aircraft and the associated commitment to the industrial plan to be launched.
In the Company’s Report and Accounts for the financial year ended 31 December 2005, BAE Systems also stated its intention to make one-off cash contributions to its pension schemes in 2006. On 13 June 2006, the Company announced one-off contributions by the Company totalling £1,087 million comprising the transfer of assets and cash. £661 million will have been contributed by the end of September 2006 (of which £181 million will be contributed in cash) with the balance to be contributed over the next 10 years.
Following the completion of the Proposed Disposal, the remaining activities that currently fall within BAE Systems’ commercial aerospace segment will comprise the Regional Aircraft leasing and support business and will be reported within ‘HQ and other businesses’.
6. Extraordinary General Meeting and shareholder approval
The Proposed Disposal is conditional on the approval of BAE Systems’ shareholders. The notice convening the Extraordinary General Meeting of BAE Systems, to be held at Novotel London West, One Shortlands, London W6 8DR at 10.00 am on 4 October 2006, at which the ordinary resolution to approve the Airbus Proposals will be proposed, is set out at the end of this document.
To approve the Airbus Proposals, a majority of those voting (whether in person or by proxy) must vote in favour of the Resolution.
The Board of BAE Systems, which has received financial advice from Goldman Sachs International and Gleacher Shacklock, considers the Airbus Proposals to be in the best interests of the shareholders of BAE Systems as a whole. In providing advice to the Board of BAE Systems, Goldman Sachs International and Gleacher Shacklock have relied upon the Board of BAE Systems’ commercial assessment of the Airbus Proposals.
The Board of BAE Systems unanimously recommends shareholders of BAE Systems to vote in favour of the Resolution to be proposed at the EGM, as the Directors intend to do in respect of their own beneficial holdings, which, in aggregate, amounted to 2,044,973 Ordinary Shares as at 8 September 2006 (being the latest practicable date prior to the posting of this document), representing approximately 0.063 per cent. of the entire issued ordinary share capital of the Company.
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