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The announcement of merger talks between BAE Systems and EADS on 12 September 2012 has electrified policy makers, industrialists, and analysts. If implemented successfully, the potential implications of the deal would be far reaching for the structure of the European and global defence market, European defence and defence industrial policy as well as for the transatlantic defence industrial relationship.
The decision of BAE Systems and EADS to engage in merger talks appears to be the consequent, perhaps even 'bold', answer to an ever more demanding commercial environment in the defence sector. Faced with a significantly decreasing demand in their traditional home markets in Europe and strongly increasing competition in the global defence market, both companies are naturally interested to create a corporate structure that would secure their commercial viability in the long run.
When in June 2012 the merger talks became more serious, both companies' commercial health was not at its best. BAE Systems was languishing at its all-time cheapest price-earnings ratio excluding the financial crisis with its stock falling to 7.3 times earnings on June 1, while EADS - although finally cashing in on its commercial aerospace branch Airbus - was grappling with operating margins that are less than a third of the industry median. Since setting a target of an operating profit of 10 per cent of sales in 2000, EADS has constantly failed to achieve this level of profitability, with the highest annual operating margin being 8.16 per cent in 2001 and a disappointing figure of 3.61 per cent for June this year. BAE's operating margin of 10 per cent is almost three times higher and close to the industry median of 11 per cent.
The creation of a dual listed company structure, under which both companies would operate as one group by means of equalisation and other agreements but with separate listings on their existing exchanges, would significantly increase the companies' market power, with a total sales volume in the region of £58bn ($93bn; €72bn) based on last year's data, and access to a broad skills, technology and production base. Whereas BAE Systems would gain improved access to the Continental European defence market, EADS could capitalize on BAE System's extensive business networks, particularly in the Arab world, the Indian sub-continent and the USA, where Airbus, EADS's commercial jet maker, plans to build an assembly line for its popular A320 jets in Mobile, Alabama.
Moreover, BAE Systems would benefit from EADS's activities in the commercial aerospace sector - thereby partly reversing its controversial decision in 2006 to sell its share in Airbus -, and EADS at the same time would be able to reduce its dependency on this highly profitable but also volatile sector. The new group would generate approximately 53 per cent of its revenues from commercial aerospace and 47 per cent from military and security activities, with a fifth of its sales deriving from North America.
In addition to the companies' better financial resilience, their ability to exploit business opportunities in Europe would arguably benefit from the merger. With a corporate structure that advocates the notion of 'brand Europe' in defence in contrast to national notions of 'brand UK', 'brand Germany' and 'brand France', a merged BAE Systems and EADS would be in a good position to win substantial multinational European defence contracts, promoted by EU and NATO member states as part of their 'Pooling & Sharing' and 'Smart Defence' efforts.
An enlarged European 'reference market' would also most certainly improve the companies' ability to exploit the global defence export market. With the groups increased market power and more coherent political sponsorship driven by the new ownership structure, which would see the British, French and German governments each holding a 'golden share' in the new group, it could engage potential customers much more efficiently and present better competitive offers than in the past.
The potential advantages of the merger set aside there is a multitude of political, regulatory and commercial obstacles both companies will have to tackle in order to be successful. To name but a few: the precise nature of the group's governance, including the allocation of senior management jobs, the level of management complexity, the ring-fencing of assets of national strategic interests like UK nuclear submarines and French ballistic missiles, the unwillingness of EADS shareholders to dilute earnings from Airbus and the amount of the combined business to be sold off to satisfy regulators. Not surprisingly, one of the main obstacles will be to reach the consent of the US government.
With BAE Systems being one of the top five contractors of the US Department of Defence (DoD) and one of the main reasons for the merger giving EADS access to the US market, the US government will be watching closely if and how the merger talks will proceed. Its biggest concern, apart from the creation of a strong competitor for US defence companies like Boeing and Lockheed Martin, will arguably be the persistent control over technology transfers from BAE System's US business into a merged BAES-EADS. The dual listed company structure may partially mitigate such concerns by preserving the distinction where needed; however it will take quite an effort by both the companies' representatives and European policy makers as well as formal arrangements to reach US consent to the merger.
In the end, the US will have to balance its economic interests and sensitivities about the transfer of intellectual property against its constantly formulated demand that Europe must close the large gaps in its military capabilities portfolio - which would arguably be in the interest of the US broader strategic security and defence posture. The potential BAES-EADS merger could therefore represent a test case for the seriousness of the US demands, as the provision of such capabilities - as agreed among US and European policy makers, military practitioners, industrialists and commentators - is dependent on a healthy defence industrial base, which would arguably require extensive consolidation in the European defence market.
In essence, the BAE Systems-EADS merger could trigger such consolidation and have far reaching implications for the market's overall structure as it seems unlikely that companies like Finmeccanica, Thales, Saab, Rheinmetall, Krauss-Maffei-Wegmann and others would not feel pressured to look for ways to strengthen their own position in the market in order not to find themselves in the 'strategic corner'.
Accordingly, it could be argued that policy makers on both sides of the Atlantic must now put their cards on table if they stand by their declaratory commitments to defence. The level of detail of the companies' announcements and the early involvement of government officials from the UK, France and Germany could be regarded as an indication that there are no fundamental objections to the merger. Indeed it is hard to believe that the companies did not get preliminary nods from European officials before going public.
As the planned transaction would also be linked to a possible dissolution of the shareholder pact, German car maker Daimler, who holds 15 per cent in EADS (which presents 22.5 percent voting rights), could in principle sell its stake on the open market, instead of selling half of it to the German government via state-owned bank KfW. The opportunity avoid such a financial commitment in times of austerity could be seen as an incentive by the German government to support the merger. In any case, approvals by the various stakeholders in Europe, the US and other big markets like Saudi Arabia are likely to delay the proceeding of the merger significantly.
Even, if in the end the BAES-EADS merger does not fly, it seems fair to conclude that the race is on for far reaching consolidation in the European defence market. The increasing market pressures have caused industry to review its current positioning in the market and to resume the initiative to restructure the market, thereby getting even further ahead of politicians in order to succeed in the global environment. This move could be labelled an act of 'smart industry'. It remains to be seen if policy makers in London, Paris, Berlin and Washington will play a constructive role in this process, thereby complying with their own requirements of 'smart defence'. In the end, 'smart defence' requires 'smart industry' and vice a versa.