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BAE May Make Purchases as U.S. Cuts Spur Defense Companies to Widen Reach

U.S. budget cuts may spur a spending spree at BAE Systems Plc (BA/) and other European companies reliant on the world’s biggest defense market as they rush to expand in military technologies best-placed to dodge the contraction.

BAE, Europe’s biggest weapons-maker, Chemring Group Plc (CHG) and Ultra Electronics Holdings Plc (ULE) say they’re seeking opportunities in electronic warfare and intelligence gathering, while Meggitt Plc (MGGT), a maker of wheels, brakes and controls for fighter jets, is chasing energy-industry deals to offset the defense-side slump.

“That’s more the area we would look at until uncertainties in the defense markets have resolved themselves,” Terry Twigger, chief executive officer of Christchurch, England-based Meggitt, said in an interview. “We’re unclear quite what the implications are of the recent discussions in Washington.”

BAE, which exited airliner production in 2006 with the sale of its Airbus SAS stake, derived $16 billion in sales from the U.S. last year, twice the revenue from its home U.K. market and almost 50 percent of the global total. Smaller European players are even more exposed, with Cobham Plc (COB) deriving almost 61 percent of business from the world’s No. 1 economy and Meggitt more than 54 percent, including civil work for Boeing Co. (BA)

U.S. Targets

West European companies have made 360 aerospace and defense purchases worth $52 billion over the past five years, according to Bloomberg data, of which almost 40 percent by value have been in the U.S. Just over half of the buyers have been British, with 20 percent French, 13 percent Italian and 11 percent German.

President Barack Obama’s Aug. 2 accord cutting U.S. spending by $2.4 trillion over the next decade calls for a $325 billion reduction in the defense budget. Another $500 billion in military cuts could follow next decade if a special committee of lawmakers can’t agree on $1.2 trillion in savings by November.

“Transactions in the broader defense industry may pause until there is more clarity about the U.S. defense budget, but niche sectors such as cyber-warfare will attract strong interest,” said Paul Edwards, managing director for aerospace and defense investment banking at Jefferies International.

Europe spending is also under pressure. Britain is slashing military budgets 8 percent over four years, scrapping a contract for BAE reconnaissance aircraft, cutting tank orders, delaying submarine replacement and opting for fewer, cheaper planes for two aircraft carriers, one of which may be sold. Italy passed an austerity package featuring defense cuts last month, Germany is moving from a conscript army to a smaller professional force and France is shaving $1.8 billion from its military in three years.

Energy Push

Meggitt, which also makes engine-monitoring systems, would consider spending as much as 400 million pounds over the next 12 months to expand an energy business that includes heat exchangers and sensors, CEO Twigger said on Aug. 2.

BAE is targeting “modest” acquisitions, CEO Ian King said when reporting half-year results on July 28. The London-based company has expanded in the non-military sphere via the purchases of Norkom Group Plc, an Irish provider of anti-money- laundering technology, for $290 million this year and Detica Group Plc, a U.K. maker of software to support counter-terrorism and tax-fraud detection, for 531 million pounds in 2008.

European Aeronautic, Defence & Space Co., which already gets two-thirds of sales from jetliner maker Airbus, has made four services-related purchases this year including Vizada, a provider of satellite communications for the media, ships and the Pentagon, which it agreed to buy Aug. 1 for $960 million.

Fareham, England-based Chemring is looking at a single purchase of about 200 million pounds, it said July 23, while London-based Ultra is budgeting for more than 100 million pounds of acquisitions this year in areas including nuclear and cyber security, CEO Rakesh Sharma said Aug. 1 on a conference call.

Streamlined

European companies that streamlined early in anticipation of U.S. and European cuts could become targets for bigger players eager to diversify, Goldman Sachs Inc. said Aug. 8 in a note to clients, among them Ultra and Cobham, a maker of aerial refueling systems that has made purchases in homeland security while closing one redundant site and integrating three others,

Goldman analyst David Perry upgraded both companies to “buy” from “neutral,” saying they have diverse contracts, strong balance sheets to fund bolt-on purchases in non-military markets, and niche positions that would make them attractive acquisitions for global contractors.

Still, U.S. defense cuts may not result in a merger surge to match that which followed the end of the Cold War, Edwards said, given the degree of uncertainty over the scope of the budget reductions that U.S. Defense Secretary Leon Panetta has called a “doomsday mechanism” that could do permanent damage.

F-35 Doubts

Disposals and takeovers involving companies with “significant exposure” to newly vulnerable major programs such as Lockheed Martin Corp. (LMT)’s F-35 Joint Strike Fighter could become much tougher, Edwards said. The largest U.S. military program at $382 billion, the F-35 is the subject of several deficit-reduction studies, none with Defense Department backing.

Neither does the Pentagon favor consolidation among the top five or six contractors -- which include BAE -- it said earlier this year. BAE’s King said speculation about a possible bid from that Boeing Co. is unfounded, as far as he is aware.

“Companies won’t make purchases if the seller is unable to provide at least a three-year growth plan, and right now given the defense budget uncertainty, that is difficult,” Edwards said. “So it’s going to become more challenging to close deals.”

That might stymie new Finmeccanica SpA (FNC) CEO Giuseppe Orsi’s plans to exit unviable products, restructure an aeronautical unit that’s a major partner in the Eurofighter warplane and makes components for the F-35, and sell $600 million of assets at U.S.-based defense-electronics unit DRS Technologies Inc.

Seeking Clarity

BAE in January abandoned a four-month push to sell its Platform Solutions business after failing to find a buyer for the maker of hybrid propulsion systems for trucks and buses and flight controls for warplanes and jetliners. The unit, valued at $2 billion, needed high levels of investment, it had said.

Cobham may also struggle to dispose of Analytic Solutions, a Washington-based defense-intelligence specialist bought in 2008 for $407 million and offered for sale in May, and CEO Andy Stevens said the U.S. needs to refine its spending plans as soon as possible to help contractors deal with the implications.

“The shape of the budget is starting to emerge and that will eventually flow down to programs and platforms,” Stevens said Aug. 3. “I think then the industry will be able to understand it and respond. Our hope is that certainty and clarity will return as we go through the end of the year.”

To contact the reporter on this story: Sabine Pirone in London at spirone@bloomberg.net

To contact the editor responsible for this story: Benedikt Kammel at bkammel@bloomberg.net

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