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The proposed merger between EADS and BAE Systems certainly surprised many in industry, politics and finance. Despite the sensation, it is important to unpack the many challenges the deal will face.
The crux of the proposition, if the transaction goes ahead, is essentially twofold. First, there is the composition and structure of the combined business to consider. Reports from both companies suggest that BAE Systems' shareholders will own 40 per cent of the merged entity, whilst EADS's owners will hold the balance of 60 per cent. It is anticipated that the business will retain separate listings for aerospace and defence, the former in the Netherlands and the latter in London, mirroring the current arrangements for both companies. There is also a sense that governments in London, Paris and Berlin will be able to retain a 'golden share' over the activities of the new leviathan, so that the combined business would not be able to undertake activities contradictory to the national interests of the respective governments. This, of course, reflects current arrangements that bind BAE Systems to the UK government, and is cognisant of the fact that, directly and indirectly, the German and French governments each own 22.5 per cent of EADS (with the Spanish government holding a further minority stake).
The second point to make refers to the sheer bulk of the proposed business. The market capitation of the new company would probably be in excess of €38 billion, easily rivalling the US aerospace and defence giant, Boeing, which has a market value of about €41 billion. The new company would be one of Europe's largest employers, manufacturers and exporters; moreover, on merger, the revised balance sheet would leave the new company well placed to undertake further acquisitions. For the investor, modest synergies in research, applied research and development - especially across current EADS/BAE Systems' joint ventures of Eurofighter and MBDA - could substantially improve combined profits even before new revenue streams are considered. Lastly, the size of the new business and the perception of different business cycles for civil aerospace and defence - allowing one to, potentially, cross-subsidise the other - represents a bold and strategic response to reduced defence budgets in Europe and the United States. Indeed, EADS shares have grown in value by 40 per cent over the past five years whilst BAE Systems have shrunk by a similar amount; this proposed tie-up could be viewed as a strategic attempt to rebuild some of that lost value to BAE Systems' shareholders.
Challenges to the Deal
The deal is not without difficulties. The United States is notoriously zealous in protecting its on-shore intellectual property so BAE Systems' businesses in the US would need to be robustly ring-fenced to ensure American technologies are not either inadvertently or deliberately transferred to Europe. Indeed, concerns are already being raised about the stakes held in EADS by the French, Germans and Spanish governments, with some politicians questioning whether it is appropriate for foreign governments to have a substantial holding over the assets of BAE Systems. Questions around sovereignty and independence of action are clearly both delicate and emotive, adding much colour to the media coverage of the issue. Without down-playing these complexities and concerns, it is worth noting that both EADS and BAE Systems already have multiple government customers and are adept at ring-fencing their programmes and portfolios. Providing governments are appropriately engaged and their concerns actively managed, issues around state ownership and intellectual property, whilst challenging, are potentially manageable.
Equally emotive is the risk of further redundancies across BAE Systems' sites. Whilst most mergers usually see some form or rationalisation of manpower or other key resources in the mid-long term, it must be noted that over the past two years BAE Systems has already undertaken significant rationalisation across its sites and businesses. Indeed, a senior executive from the company has us briefed that very little fat remains. Once more, both EADS and BAE Systems must actively engage with their work force, their union representatives, and civil leaders from the communities in which their sites are located. This stakeholder management activity is critical if the deal is to go forward, but this is hardly news to the executives involved.
No Choice But Merge
A more salient point is to consider what strategic choices exist for BAE systems. If it is accepted that defence budgets in the West will reduce in real terms over the rest of the decade (as discussed by Michael Clarke), the company probably has only four choices. First, it could accept this probable reduction in revenues and manage decline as effectively as possible. It could seek to access a new market - civilian vehicles, for instance - through purchase. Third, it could consider a total strategic exit from defence or, fourth, it could seek to consolidate and merge, seeking growth through volume and the strength of its broader balance sheet. There are no other smart ideas and, realistically, either accepting stagnation followed by corporate decline or exiting defence en masse are just not realistic options. Buying a non-defence business to enable diversification seems a somewhat tired and tame option hardly likely to be applauded by the markets, so the company is left with a bold choice almost by default.
The merits, or otherwise, of this transaction can only be judged on the detail. At the moment precious little of that is in the public domain. We do know that concerns exist around notions of sovereignty, the need to protect national intellectual property, the case for or against European defence industrial integration and the possibility of further redundancies. Weighed against these very real concerns is the opportunity to create a European monolith of real bulk, with the confidence of a robust order book, a strong balance sheet and an extensive list of government and civil clients. It is a nuanced argument, of course, but understanding what other options exist for BAE Systems is equally challenging. Whatever happens to this potential tie-up over the next weeks and months, the 'do nothing' option for BAE Systems, probably, can now be discounted.