WRAPUP 3-Investors see obstacles; rivals gain in BAE-EADS tie-up

Fri Sep 14, 2012 4:33am IST

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* Raytheon sees potential gains as merger distracts BAE-EADS

* Deal could speed up Lagardere, Daimler stake sales

* EADS and BAE shares down as obstacles feared

By Andrea Shalal-Esa and James Regan and Alwyn Scott

WASHINGTON/PARIS, Sept 13 (Reuters) - Even as it creates the world's biggest aerospace company, the proposed merger of Europe's defense and aviation giants may help U.S. rivals win defense contracts, at least in the short-term, experts said Thursday.

The combination of Airbus parent EADS and Britain's BAE Systems could embroil them in a lengthy complex integration that would limit their ability to win new business.

"We'll probably increase Raytheon's market share," said William Swanson, chief executive of Raytheon Co, which makes missile defense systems and other defense technology.

"When you put companies together in a contracting marketplace, your team has their head down, trying to figure out how to make things work rather than looking up and figuring out how to make an opportunity out of the situation," he said.

Swanson, who helped Raytheon integrate its own complex acquisitions during the last big wave of consolidation in the 1990s, was among those questioning whether the blockbuster deal would yield the synergies, savings and scope its proponents envision.

To be sure, EADS and BAE Systems would have $93 billion in sales and 220,000 employees, based on 2011 numbers, exceeding Boeing Co's $68.7 billion. And it would combine BAE's deep connection in the U.S. defense market with Airbus' growing U.S. presence in the commercial jet business, symbolized by its plans to build a plant in Alabama.

The plant "is not going to have a material effect on Boeing's ability to sell 737 maxes," said Alex Pietsch, director of the Governor's office of Aerospace for the state of Washington, referring to Boeing's next generation single-aisle jet.

"But if they start doing military work there and do other programs there and are successful in convincing the politicians that they're buying American, it might be able to get a military contract" that it wouldn't otherwise be given.

LIMITED UPSIDE

Still, the deal's many other questions loomed large Thursday, helping to drive shares of EADS and BAE Systems sharply lower in Europe, as investors grew concerned the tie-up could hit political obstacles and may lack benefits for the companies.

Given that the shares had rallied this year "and the potential for some near-term challenges (both logistical and political) in the deal closure process, we see limited upside at current levels," Barclays analyst Carter Copeland said in a note suggesting investors scale back holdings in both companies.

Rob Stallard of RBC Capital Markets said he was not convinced the deal made strategic sense, and said the companies needed to provide more details on cost savings and new business opportunities to stem further losses in their shares.

Jay Johnson, CEO of General Dynamics Corp, said he did not expect the deal to trigger a spate of top-tier mergers in the weapons business. Consolidation would be focused mainly on small to medium-sized companies, not the big prime contractors, he said, and only once the outlook for the U.S. defense budget became more certain.

If talks unveiled Wednesday culminate in a deal, BAE shareholders would hold 40 percent and EADS investors 60 percent in a giant with products ranging from Airbus commercial planes to Typhoon warplanes and BAE's Astute-class nuclear-powered submarines.

The deal is being driven in large part by the need of U.S. and European defense firms to offset the impact of shrinking national military budgets with more revenues from the commercial sector.

STRONGER AIRBUS

But the accord will need the political backing of Germany and France to unravel the 12-year-old shareholder pact underpinning the strategic European aerospace champion, while the enlarged group must win the trust needed to deal with security-minded customers from the Pentagon to the Gulf.

Pressed for comment, Chancellor Angela Merkel told reporters only that the deal was being checked by Berlin. With European politicians wary of the impact on jobs - especially in France where unemployment has hit 13-year highs - the head of EADS' Airbus unit sought to reassure staff on the deal.

"Such a combination would strengthen EADS and BAE Systems - thereby making Airbus part of a stronger company overall," Fabrice Bregier said in a letter to employees, adding that any deal would not affect Airbus' organisation, product plans, manufacturing or future strategies.

EADS' shares fell more than 10 percent to 25.15 euros and BAE shares dropped 7 percent to 338.8 pence as investors acknowledged the logic of the move but fretted that shareholders would lose out.

"A merger would allow EADS to achieve its aim of balancing civil aerospace ... with non-Airbus activities," Citigroup analysts said in a note.

"However, we believe that achieving merger synergies for the combined entity could be difficult, particularly given the need to ring-fence certain strategically sensitive activities," they added, downgrading EADS' shares to "neutral" from "buy".

Ratings agency Fitch said the tie-up had "sound industrial logic" but added: "Considering the complexity and security sensitivity of some defense contracts, this may prove to be a long and arduous process."

In the U.S., rating agency Standard and Poor's said the deal would not hurt the credit standings of defense competitors.

"The BAE/EADS combination is not likely to change the competitive environment in the U.S. significantly," S&P said.

RETHINKING GROWTH

Western defense spending is under severe pressure from public finances on both sides of the Atlantic, forcing Europe's two largest defense companies to rethink strategies for growth.

"I think it is now recognised that you can't sustain a global defense company off the budget of a medium-sized or even large-sized European country," said Nick Witney, senior research at the European Council on Foreign Relations.

BAE will regain a foothold in the commercial aircraft business through Airbus, undoing its decision to exit in 2006 and giving up a pure-play defense strategy.

EADS will absorb the consequences of failing to win a huge contract to sell tankers to the U.S. Air Force last year and give up trying to conquer the world's largest arms market alone.

Yet one investor who bought into EADS in 2009 at less than half its price before the talks announcement fretted that the deal would dilute EADS' existing attractions and so ultimately turn sour for both sets of shareholders.

"This is a deal without logic and without winners. The whole of the proposed combination is inferior to the sum of the parts," said Barry Norris of UK-based Argonaut Capital Partners, holder of 500,000 EADS shares.

The deal would unpick the ownership pact agreed for EADS since its creation in a 2000 merger. French media-to-aerospace group Lagardere owns 7.5 percent of EADS, with the French state holding 15 percent. German car maker Daimler holds 15 percent, with 22.5 percent voting rights.

The current status quo could be replaced by special shares for all three governments that would give them the power to veto any hostile takeover bid.

DAIMLER EXIT?

A Daimler spokesman said on Thursday that a merger could allow it to exit its stakeholding. Germany had already agreed, via state-owned bank KfW, to buy half of Daimler's stake to ensure the Franco-German balance.

"Since the planned transaction would also be linked to a possible dissolution of the shareholder pact, all options would be open to us in principle - including the possibility of selling our stake on the open market," he said by email.

The political implications are equally complex.

Rather than making BAE more European, the deal appears designed to make EADS more American - potentially to the chagrin of the French government and other French aerospace companies.

Until now, EADS has sat uncomfortably at the middle of a triangle of misaligned political and economic relationships.

While France and Germany underpin both the euro and EADS politically, France and Britain are Europe's biggest military powers and Germany and Britain dominate its defense industry. None of these pairings alone has generated adequate business.

German sources told Reuters the German government had yet to approve the merger, while France said it would wait before commenting. Yet one industry source said there were encouraging signs from both countries involved that a merger could go ahead.

French Industry Minister Arnaud Montebourg told France Inter radio he could not comment on the deal because of "reasons of confidentiality", but added that "this is a very important strategic, geo-strategic negotiation".

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