Analysis: Proposed Merger Saves BAE, Handicaps EADS
(Source:; published Sept. 19, 2012)

By Giovanni de Briganti
PARIS --- While most observers and analysts are focusing on how the proposed merger between BAE Systems and EADS will be implemented, what each government is likely to demand to secure its sovereign interests, and what the US and EU competition authorities are likely to have to say, some basic questions about the advisability of the merger itself are being largely overlooked.

The first, over-arching question is what European governments could possibly gain from allowing the establishment of a huge, privately-owned supplier that would have a virtual monopoly on most sectors of defense equipment, and would thus be able to dictate its prices and conditions. This is a situation that the UK MoD has already experienced with BAE, and it would probably not relish an encore.

Other simple but troubling questions are: what would EADS get out of the merger? Why should BAE shareholders get fully 40% of the new company? What explains the proposed deal’s urgency, and abrupt timing? Why was the deal revealed by BAE, and not EADS? Many other aspects of the proposed deal require clarification, but these are the most pressing questions.

What’s in it for EADS?
Many observers have claimed that merging with BAE would allow EADS to reduce its dependence on the airliner market, reinforce its capabilities in defense, and gain improved access to the US defense market. None of this is a plausible justification of the merger.

EADS’ dominance of the airliner market generates most of its turnover and profits. This is a business with a ten-year order backlog worth about €500 billion, so it makes little sense to divert energy and money to the military business, where budgets in Europe and the US are in free-fall, and where credit agencies are likely to demand, and obtain, even more cuts to defense spending.

Sequestration, Pentagon defense cuts and the end of the wars in Afghanistan and Irak explain why access to the US defense market matters less today, and will matter even less tomorrow, and for the foreseeable future. In any case, BAE’s business in the United States is mostly focused on armored vehicles and artillery, areas in which EADS is not involved, so any alleged synergies are purely imaginary, if not outright hallucinatory.

As Barry Norris, founding partner of Argonaut Capital Partners and an EADS investor since 2009, concisely put it in the Daily Telegraph, shareholders might be “understandably angry” because “EADS needs BAE like a hole in the head”.

Why should BAE get 40% of the combined company?
BAE today represents less than one-third of the combined total in terms of sales, about 60% in terms of EBIT, and barely 10% in terms of order backlog. It is only in terms of employees that BAE represents about 40% of the combined total. So why should its shareholders get 40% of the combined total?

Putting aside the fiction that France and Germany act as one within EADS, the proposed arrangements would also give BAE shareholders the largest share of votes (40%), with France and Germany each having only 30%. BAE also would get a correspondingly larger number of seats on the board, again giving it a plurality that also has no obvious justification.

Another strange provision is that EADS has agreed to make a one-off payment of £200 million to its shareholders prior to the deal’s completion “to better align the parties' payout ratios.”

Now, not only is £200 million chicken feed compared to the amounts in play, but this payment means EADS will adopt BAE’s dividend policies, rather than continuing with its own, cautious payout ratios. Given that dividend policies are a major management decision, BAE here scores yet another victory.

In fact, overly generous dividends illustrate a major failing of BAE’s: a focus on short-term shareholder satisfaction that is unsustainable for a major defense contractor. BAE, for example, upped its dividend last year even as its sales dropped 14%, and slightly increased its interim dividend this year despite a 10% drop in H1 revenue.

In the past decade, BAE’s strategy has been to focus on short-term profits instead of the long-term – the very opposite of what is needed for long-term success in aerospace and defense, where programs last 20 or 30 years.

BAE says its strategy is primarily to “Drive shareholder value by improving financial performance,” which implies it must “Improve profit and cash generation” and “Drive value from our Platforms and Services positions.” R&D is not even mentioned in its strategic priorities document, and explains why the company is so dangerously unprepared for the next decade.

So what does BAE bring to the party?
The fact is that BAE brings to the party mostly mature technologies and metal-bashing businesses of which it is trying to dispose, like naval shipbuilding, or its US armored vehicle programs, that have little or no production future. Only the Swedish-designed CV90 continues to sell well, but there is nothing in the pipeline to succeed it. Again, that is, in a nutshell, BAE’s over-riding problem.

The company’s biggest programs are old and getting older (Hawk), or being cut back (Typhoon), while most of its other military (it no longer has any civil) aircraft business is in low-profit subcontracting, as on the F-35 JSF.

BAE no longer has the ability to design an aircraft’s crucial component – the wing – having sold its wing business to Airbus while its military know-how has slowly dissolved since it has not (even partially) designed a combat aircraft since the Typhoon. (For that matter, neither does EADS: the sum result of 40 years of European aerospace consolidation is that just two fiercely independent companies, Dassault Aviation and Saab AB, are still capable of designing a complete combat aircraft.)

BAE is also absent from some very lucrative segments, like helicopters, military transport aircraft, passenger transport aircraft, and airborne and ground-based radars, to which the merger would allow it to return. The merger would thus, to some degree, correct BAE’s major management errors of the past decade at little cost.

By merging with EADS, BAE would regain access to the huge market for civil aircraft, which it imprudently exited in 2006 by selling its 20% stake in Airbus to EADS for £1.87 billion.

(Added Sept. 20: This means that, at the time, BAE valued Airbus at less than £10 billion, which gives an idea of the competence of its board and management. Last year, Airbus increased sales by 10% to €33bn, and posted EBIT of €584m despite having invested €2.5bn in self-funded R&D. Had it followed BAE's priorities, it no doubt would have posted EBIT of €3bn and no self-funded R&D.)

The merger would also dilute BAE's excessive focus on two declining market, the Pentagon and Britain’s MoD, where money is increasingly tight, programs increasingly rare, and where the prospect of sequestration has US industry – and BAE - quaking in its boots.

Saudi Arabia has ensured BAE’s profitability for the past two decades thanks to the Tornado and Typhoon programs, but there are doubts about the future of this relationship, as Riyadh keeps deferring long-overdue follow-on contracts.

The company’s financials are also worsening. First-half 2012 sales declined by about 10%, year-on-year, after dropping 14% for the whole of 2011, so the trend is not good.

And during the first half of 2012, 52% of BAE’s sales came from services, and only 34% from its platforms businesses. This is worrying for the future, as the decline in sales of platforms will inevitably lead to a decline in revenue from supporting them.

Finally, it is worth noting that, based on 2011 results, EADS workers on average generate 50% more revenue than BAE’s: €369,000 per EADS employee compared to €254,000 per BAE employee. BAE still leads in profitability, but EADS is catching up fast (see tables).

Why merge now?
The timing of the proposed merger is another minor mystery. It has been widely reported that talks between the two companies began in June, which means immediately after the French elections saw Socialist François Hollande replace Conservative Nicolas Sarkozy as French president, and German Tom Enders replace Frenchman Louis Gallois as chief executive of EADS.

Negotiations are working to an initial deadline of Oct. 10, so a merger might be concluded well before the German government buys up the EADS shares that the Daimler group wants to sell, and before a buyer is found for the French Lagardère group’s intended disposal of its own EADS stake, once the EADS shareholders’ pact expires.

One explanation for the merger is that the proposed arrangements would encourage, and ultimately oblige, the French and German governments to swap their shareholdings for free “golden shares” to protect their interests. Tom Enders, EADS’ new CEO, is known to want no interference from government shareholders, but is this realistic when the same governments are also the only customers?

Why merge at all?
Mergers mostly make money by rationalizing and reducing duplication. In this case, however, there is little overlap between BAE and EADS, so there is little excess capacity to reduce. About 80% of mergers turn into disasters and destroy shareholder value because they had no economic or industrial justification.

Without a partner, BAE will likely become a smaller company – or be broken up - because it is overly dependent on old programs and businesses, and on declining military markets. EADS could simply sit back and buy the bits and pieces of BAE that it is interested by using its 11 billion euro cash pile, without giving away any of its valuable equity.

Many commentators have observed that a combined BAE-EADS would be the world’s largest defense and aerospace company, even bigger than Boeing. So what?

Being biggest is often a handicap, as Boeing’s tribulations with the 787 and 747-I have demonstrated, and does not per se make a company more profitable. In fact, a merged B-EADS, with 230,000 employees spread across five home markets and four languages, and spanning most aerospace and defense sectors, would likely be a management nightmare.

A previous German aerospace CEO, Deutsche Aerospace’s Jurgen Schrempp, who went on to head corporate parent Daimler, was ultimately fired because of the disastrous merger he implemented with Chrysler. It is a precedent worth pondering.


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