Beyond BAE-EADS: What’s Next? Who’s Vulnerable?

[Corrected at 4:50 pm to fix misquotation; see note below] With today’s spectacular but not unanticipated collapse of the mega-merger between Airbus parent company EADS and British armsmaker BAE, what’s next? The conventional wisdom is that BAE, the smaller of the two firms, is now vulnerable. But top analysts tell Breaking Defense that, in many ways, the reaction against the deal by both the German government and the stock market is a bigger rebuff for EADS. Here’s the conventional wisdom in a capsule: “There will almost certainly be greater pressure on BAE Systems than EADS to reveal a plan B strategy as soon as possible,” wrote IHS Jane’s analyst Guy Anderson in a widely distributed email. “[T]he company has put itself firmly out on the field in terms of merger discussions….Investors are unlikely to be satisfied with business as usual.” But wait a minute, said Robbin Laird, a defense analyst and member of Breaking Defense’s Board of Contributors. “At the end of the day it’s still a solid company with solid growth,” he said. Laird is hardly a BAE booster: “BAE management’s been very short-sighted,” he grumbled, especially by over-investing in armored trucks and other ground vehicles for which demand is now dropping as the post-9/11 wars wind down and the Army downsizes. But when people call BAE’s situation dire or desperate, Laird said, “I think that’s tremendously overstated.” Fellow Board of Contributors member Loren Thompson, a consultant to BAE, was outright bullish. “They have not shown the slightest indication to panic,” he said. In fact, BAE pays a dividend of 5.9 percent, “almost twice what companies like General Dynamics and Northrop Grumman are paying,” he argued. “The dividend is so high compared to other military contractors that it’s hard to see why the company could be in play. Why would investors sell?” By contrast, “I’m not all that favorably disposed to EADS,” Thompson went on. “I think people underestimated how vulnerable EADS is going to be once the US brings full pressure to bear on its unfair subsidies.” “The Airbus part of EADS that provides two-thirds of the parent company’s revenue is one big market distortion,” Thompson argued. “The WTO has said that without illegal subsidies, none of the products Airbus currently has on the market could have been developed and marketed when they were, not one of them….The US Trade Representative right now is seeking permission to impose billions of dollars of penalties on the Europeans for their continued use of illegal subsidies. This could either force EADS to abandon its current business model or to accept a smaller market share as their ability to sell into the US is constrained.” Other analysts were less grim about EADS but still saw the deal’s implosion as a sharp rebuke to CEO Tom Enders — not just in this instance, but over EADS’s entire long-term strategy of diversifying beyond Airbus. Commercial airliner sales are going gangbusters now, but they have a history of gut-wrenching ups and downs, so EADS management had sought to build up their defense business, which tends to be more stable and even counter-cyclical. But when EADS stock dropped in recent weeks, only to recover on this morning’s “bad” news, said Capital Alpha analyst Byron Callan, “one of the clear signals that came from their shareholders is ‘we like the fact that you’re a commercial aerospace company and don’t go mucking it up with a big defense deal.'” Now EADS must revise a strategy it has pursued for years. “It’s not just Enders,” said Laird. “[Even] the management before Enders, which was headed by Louis Gallois, had this ‘2020 strategy’ where they wanted to grow in services and defense.” Now, instead of taking a great leap forward towards that goal by merging with BAE, “maybe you’re going to go back to the drawing board and evolve to greater capacity” through a series of smaller deals, Laird said. “Unlike BAE systems, they have a lot of cash, so they can buy.” But buy whom? “Finnmeccanica may be very attractive to them,” Laird said. The Italian-based firm has longstanding relationships with the French part of EADS, the former Aerospatiale. And when BAE decided to emphasize manufacturing ground vehicles in North America — which Laird thinks was a mistake — it sold off a lot of its electronics business in the Continent, which Finnmeccanica snatched up. The Italian company is not as good a match for EADS as BAE would have been, particularly because its helicopter division, AgustaWestland, duplicates capabilities EADS already has with its subsidiary Eurocopter. But various deals with Finmeccanica and smaller companies are definitely an option. Callan sees some opportunities for BAE in the US. “They’ve been out of the picture for a couple of years after they bought Armor Holdings and United Defense, but they can be back in,” he said. In particular, smaller companies in defense-related services and electronics are both areas “where you could see them make deals without causing a lot of waves or consternation at the DoD.” But a BAE merger with almost any major American US defense company would raise red flags by reducing competition. (For example, a deal with General Dynamics would leave only one US manufacturer of tracked armored vehicles.) That limits BAE’s options but also limits its exposure to an unwanted takeover. That said, Callan went on, “I wouldn’t be surprised at all to see BAE systems back in the M&A [mergers and acquisitions] market in 2013-2014, particularly in the US,” where there are lots of smaller companies to buy up. In general, “there’s going to be further consolidation in global defense markets,” Callan said. For now, the pressure’s off all the companies that were looking at their strategic options to counter the new giant that the BAE-EADS deal would have created. But with shrinking budgets on both sides of the Atlantic and deep uncertainty in the big-spending Middle East, the defense industry still needs to think about hunkering down. Edited at 4:50 pm to correct a misquotation of Byron Callan; an earlier version of this story incorrectly quoted him as referring to merger and acquisition opportunities in the United States for EADS, when he was in fact referring to opportunities for BAE.

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