You do not have to be an astrologist to think that the proposed €35bn merger of EADS and BAE Systems is a good idea. But apparently it helps. As both companies work towards Wednesday’s “put up or shut up” deadline – to give more details, ask for an extension or call the whole thing off – executives on both sides of the merger insist that “all the stars are aligned” to pull off an industry-shaping transaction.
Investors are advised to keep their focus on earthly matters, however. They should ignore all the excited talk of a European engineering, sales and aerospace powerhouse to rival Boeing of the US. With few cost-saving synergies, a sketchy sense of how the two businesses would create more value combined than they do separately, a lot of meddling governments to contend with and an exaggerated view of BAE’s market position in the US, this merger asks way more questions of shareholders than its proponents say it answers for the two groups.
Of course, the deal to merge EADS and BAE will stand or fall on its politics. That does not mean, however, that investors should ignore three fundamental questions about the proposal. The first is whether such a “Big Bang” combination is the right way to resolve both companies’ accumulated problems and opportunities. The second is whether BAE, a top 10 (but still relatively modest) US military contractor, is really the springboard that will help EADS make the giant leap it craves in North America. And the third is whether the terms – especially the 60/40 split in favour of EADS shareholders – are attractive to both sets of investors.
Does a merger make strategic sense for both companies? Give the stargazers credit. BAE is at a crossroads as the US and Europe cut defence spending. EADS is struggling to reduce its exposure to the civilian aircraft cycle and achieve a 50/50 revenue split between its Airbus and non-Airbus divisions. Core EADS shareholders, such as German engineering giant Daimler and French media group Lagardère, are itching to sell. A Socialist government in France may be more sympathetic to the creation of a single European defence giant than its rightwing predecessor, and the UK wants more British influence at Airbus.
And as well as good timing, the idea of merging EADS and BAE is one of the easier slide packs that an investment banker can put together. Tom Enders, chief executive of EADS, and Ian King, his counterpart at BAE, have known each other for years. There is little operational overlap, so the two businesses would complement each other. The civilian and military aerospace cycles to which both are exposed tend to balance each other and there is scope for significant engineering, technology and skills transfers. Bulking up in non-commercial aerospace would reduce EADS’s exposure to further risks at Airbus, such as those associated with the A350, its current big project. Bulking up in civilian aircraft would allow BAE to leverage its huge military platform business. Let’s get married.
All about Airbus
The logic in seeking to imitate the Boeing model hinges on Airbus. The aircraft maker – originally a joint enterprise of the UK, French, German and Spanish governments – has over the past 40 years come to rival the US company for dominance in civilian aerospace. It had first-half revenues of €17bn, not far off Boeing’s $23bn. Airbus accounts for about two-thirds of EADS’s revenue and earnings, and is the reason investors buy the parent company’s shares. Airbus’s backlog – at least a decade’s worth of continuing business at current production rates – is worth about €485bn ($632bn), compared with Boeing’s $300bn.
That is the attraction for BAE.
More immediately, though, huge cost and time overruns on its flagship projects have left EADS operationally miles behind Boeing. Its margins are only about a third of those at the US company – roughly 3 per cent compared with 10 per cent. Prolonged delays to the A380 superjumbo – that project’s break-even production level has steadily climbed from 250 to 420 aircraft – contributed to BAE’s decision in 2006 to sell its 20 per cent Airbus stake. When Airbus admitted the scale of the A380 difficulties around the same time, its share price fell by a third over the next three months.
These operational and strategic problems helped lead former chief executive Louis Gallois to the conclusion that EADS was overdependent on Airbus. In addition, it had a sub-scale defence business and was too concentrated in Europe (three-quarters of sourcing and almost all employees). His “Vision 2020” strategy set goals to split group revenue roughly equally between Airbus and other businesses by then, to have 40 per cent of sourcing and one-fifth of employees outside Europe, to generate $10bn of non-Airbus revenue in North America, and “to gain a prime position with [the] US government”. He also targeted a 10 per cent earnings before interest and tax margin by 2015 and €80bn of turnover by the end of this decade.
If nothing else, Vision 2020 read like an aide memoire to buy BAE.
From 36,000 feet, merging the two companies to create a European Boeing looks like a logical strategic move. But that does not guarantee success. Sure, Boeing’s 1997 purchase of McDonnell Douglas looks to be working. It reaped $16bn, or 40 per cent, of its total first-half 2012 revenue from its defence, space and security operations. And it leverages its formidable in-house engineering and technology capabilities to produce some of the industry’s juiciest margins. As a result, its shares trade on a multiple of 15 times next year’s earnings, consistently the highest in the aerospace and defence sector.
But the Boeing model is a product of US aerospace and defence consolidation in the 1990s and came at the beginning of a military spending boom. An EADS-BAE combination would have to manage a more disparate and far-flung operation (BAE is the most globally spread defence contractor), would come at the start of a military spending slump, and may not produce similar returns. The creation of a European aerospace and defence champion would also leave management with little operational independence, since governments would be all over it.
BAE my baby
Even if the model makes sense, the second big question is whether BAE is the right partner for EADS. The UK group is certainly one route into the Pentagon. After selling its Airbus stake, BAE bet big on the US military. It now generates more than 40 per cent of its revenues in the US – $6bn in the six months to the end of June from businesses such as the Bradley tank and armoured vehicles.
But some perspective is needed. The US contractors Northrop Grumman and Lockheed Martin – the gang BAE wants to hang out with – generated twice and four times as much revenue respectively in the first half. And BAE’s shares are not even relatively cheap, trading on a multiple of 7 to 8 times next year’s earnings, roughly equal to Lockheed or Northrop.
What is more, BAE’s first-half 2012 revenues were down 10 per cent on the same period in 2011 and earnings before interest, tax and amortisation were down 3 per cent – and the outlook is for more of the same. A pension deficit of nearly £5bn restricts its room for strategic manoeuvre. And it faces losing skilled workers as contracts come to an end. That is not where a group with the ambition to be “the premier global defence, aerospace and security company” should find itself.
If EADS wants to vault up the league of US defence contractors, why not buy a big US defence contractor? Because the Defense Department has hinted it does not want any mergers and acquisitions among its top contractors (for now), and a transatlantic merger would be even more complex than a cross-channel one.
The reality is that EADS wants to absorb BAE not because it is the right choice for its US strategy but because it is the only choice.
Split the difference
The third and final big question is about the terms. The companies have proposed a 60/40 split in favour of EADS. This represented a premium of about 12 per cent for BAE shareholders when the combination emerged in mid-September. The premium has since evaporated as investors bet that the deal will not happen, but it would return if things hotted up again. Yet the deal makes sense for EADS shareholders only if the capitalised value of any synergies exceeds the premium handed to BAE. With so little overlap, there is no chance of that.
There would be marginal cost savings – including the opportunity to wring some of the legacy costs from existing EADS-BAE joint ventures such as the Typhoon fighter aircraft. EADS’s existing but second-tier Cassidian defence business, which makes up about a 10th of group revenues, would also yield some synergies if properly integrated into BAE, which has shaved its costs to the bone. But the reality is that EADS shareholders can balance their civilian aircraft exposure more cheaply by simply buying BAE shares in the market directly.
The mathematical flipside for BAE shareholders is that the merger is a no-brainer at 60/40. And it is wrong to argue that BAE’s future prospects justify an even greater share of the spoils – the earnings profile of both companies is already reflected in their share prices.
BEADS of sweat
The 60/40 split is said to be as solid as an M2 Bradley tank. And besides, even if the ratio favours BAE shareholders, the fact that EADS is in effect controlled by the French and German governments means the deal can be pushed through, so long as BAE shareholders are happy.
If there is no agreement among the governments, there will be no deal. In which case, both companies will be in limbo. BAE will be in play but shareholders should not count on a bidder coming to the rescue given the UK government’s golden share. EADS’s strategy will be in tatters, and its chief executive out on a limb. So do not underestimate how desperate both companies must be to seal the deal.
But nothing is written in the stars.
A merger is like any acquisition: what matters for the shareholders of the acquiring company is whether the value of the annual synergies covers the premium paid to the target company.
This interactive tool helps with that calculation. The bid premium is the difference between the undisturbed market capitalisation and the current market capitalisation of BAE. This will move with the share prices of both companies.
The net present value of synergies is derived from your estimates of annual synergies, tax rate, and synergy multiple. If this NPV is bigger than the bid premium, the deal adds value for EADS shareholders. If lower, it does not. (Any premium is good for BAE shareholders.)