Defunct BAE-EADS Merger Leaves BAE Heavily Reliant On U.S. Defense

That may be why the €34 billion (US $43.8 billion) merger of European Aeronautic, Defence & Space Co. (EPA: EAD) and BAE Systems PLC (LON: BA) collapsed on Wednesday.

It couldn't even pass the first hurdle: getting the three key government stakeholders, the U.K., France and Germany, to a agree to move forward.

A business combination would have created a more integrated European aerospace industry giant that, like its U.S. competitor, Boeing Co. (NYSE: BA), would have had two robust segments: one civilian and the other military.

The bigger pan-European company would have had $96 billion in annual revenue and 220,000 employees. By contrast, Boeing reported $69 billion in annual revenue from about 160,000 workers.

Currently BAE, of London, acts as wholly an air, land and sea defense contractor while EADS, based in Toulouse, France, is primarily vested in civilian aircraft through Airbus. Both companies would have benefitted from what the other does:

BAE would have benefited from greater exposure to the civilian aircraft market. EADS might have gotten a fothold into the U.S. defense industry. BAE had the most to gain and is now left to figure out how to deal with sizeable decreases in the U.S. defense budget in the coming years.

Just hours before a deadline set by British financial regulators, Germany was still reticent even after EADS CEO Tom Enders and BAE CEO Ian King succeeded getting France and the U.K. to agree to move forward with certain guarantees on jobs and voting rights.“Enders and EADS have a much less demanding short-term outlook with an excellent revenue stream from their commercial aircraft businesses,” said David Reeths, consulting director at IHS Jane’s, which follows the defense industry.

“For Ian King, the short-term challenges facing him both personally and professionally are much more significant. While BAE’s long-term prospects could still be quite excellent, the failed merger will leave the firm much more exposed to uncertain factors beyond its control, such as major declines in the US defense budget and potential loses in an increasingly competitive international defense market,” Reeths added.

Indeed, how much Americans will spend on weapons development in the coming years is a major consideration for BAE. Its Pentagon contracts were a major sticking point for at least one major company shareholder, Invesco Perpetual Select Trust Plc (LON: IVPU), a London-based global investor that owns 13.3 percent of BAE.

Invesco managers worried that BAE’s subcontracting work for the U.S. government would have been harmed once it joined up with EADS, a major civilian-aircraft competitor to U.S. aerospace companies.

BAE sold its stake in EADS in 2006 and focused on grabbing a share of the massive U.S. defense budget during the wars with Iraq and Afghanistan. But now that budget is being cut by $600 billion over the next decade and BAE has no civilian aircraft division to fall back on other than the components it makes for Airbus.

There are precedents for this concern – in 2005 a contract between EADS and the U.S. government to build aircraft tankers was cancelled and given to Boeing, of Chicago, after Sen. John McCain, R-Ariz., and others criticized the deal as wasteful.

“A dark day for European defense,” said Robert Staffard, defense analyst with RBC Capital, describing the breakdown in merger talks. “We always believed that this deal was in the best interest of European defense, which remains relatively fragmented and with significantly less budget resources versus the U.S.”

Now questions remain: are there potentially other European technology partners willing to merge with either party? Perhaps an engineering and technology giant like Swiss-based ABB Inc. (NYSE: ABB) might be interested, although with its base outside the European Community, EADS shareholders might frown.

Philips Electronics NV (NYSE: PHG) is the Dutch electronics champion, which supplies aerospace but doesn't have direct aerospace or defense experience and has sold off several of its units, including its semiconductor business, over the past 15 years.

Lacking a huge pan-European company, perhaps one party or the other might turn to a European-based private equity fund, such as London-based Permira, Apax Partners or CVC Capital Partners.

Even then, governments might be wary of handing over assets to private companies without ensuring national goals: selling top-rated European aerospace products designed and manufactured by Europeans.

Shares of BAE Systems fell 2.5 percent in London, to close at 317.29 pence (US $5.08) while those of EADS rose 5 percent to €27.48.