EADS-BAE Doubles Down On Missed Confidence: Real M&A

By merging to create the largest aerospace company, European Aeronautic, Defence & Space Co. (EAD) and BAE Systems Plc (BA/) will also be trying to improve the industry’s worst operating margin and a near record-low valuation.

The companies said this week that they are in talks, confirming a Bloomberg News report, to combine into what would be a European counterweight to challenge Boeing Co. (BA) When the discussions became serious in early June, Britain’s BAE was languishing at its all-time cheapest price-earnings ratio excluding the financial crisis, while EADS was grappling with operating margins that are less than a third of the industry median, according to data compiled by Bloomberg.

The new company would have a more balanced mix of sales from civil and defense operations, as well as a more global reach spanning Europe, the U.S. and Asia. For EADS, the deal would help reduce its reliance on Airbus commercial jets and gain higher-margin defense operations, while BAE would be less vulnerable to shrinking military budgets. With the stocks slumping yesterday on skepticism a combination would be able to deliver anticipated savings and penetrate the U.S. defense market, S&P Capital IQ says political complications could prevent a deal from happening anytime soon.

“For BAE, you can see they’re trying to diversify away from pure defense exposure,” Johnson Imode, a London-based equity analyst at S&P Capital, said in a telephone interview. “On the flipside, EADS is trying to build up their exposure to defense, which generally is more of a steady business than commercial aerospace and margins also tend to be higher.”

Deal Logic

“There is a logic for both sides of the deal, but actually getting it done isn’t going to be easy,” he said. “It is going to be a challenge in terms of the regulatory front.”

A spokesman for Toulouse, France-based EADS declined to comment. A spokesman for London-based BAE declined to comment on the company’s valuation.

EADS and BAE said on Sept. 12 that they’re in discussions to merge, a combination that would surpass Chicago-based Boeing to create the world’s largest aerospace company, with annual sales of almost $100 billion. EADS, which has helicopter, space and military operations in addition to its Airbus commercial-jet business, would own 60 percent of the new entity and BAE, Europe’s largest defense contractor, the rest, according to a joint statement issued in response to a Bloomberg News report that the companies are in talks.

A combination would create benefits including cost savings and new business opportunities, BAE and EADS said in the statement. The new company would have a combined market value of about $45 billion, compared with Boeing’s $54 billion.

Boeing ‘Clone’

“By putting these two together, you’re creating a clone of their biggest competitor,” Pete Sorrentino, a Cincinnati-based money manager who helps oversee $14.7 billion at Huntington Asset Advisors, said in a phone interview.

Preliminary talks between the companies took place in April, and by early June the two sides had engaged in more serious discussions about the merger, people with knowledge of the negotiations said this week.

Those more serious talks came as BAE’s stock fell to 7.3 times earnings on June 1, the company’s lowest price-earnings ratio since 2009 and the second-cheapest among 22 aerospace and defense firms with at least $5 billion in market value, data compiled by Bloomberg show. Excluding the period of the global financial crisis and its aftermath, BAE’s multiple was at its lowest on record, according to the data, which date back to 1999.

Defense Shield

Merging with EADS would shield BAE’s revenue from defense spending cuts in the U.S. after the nation ended its war in Iraq and the war in Afghanistan winds down, S&P Capital’s Imode said.

Sales at EADS are projected to climb 30 percent by the end of fiscal 2015 from last year, according to analysts’ estimates compiled by Bloomberg. BAE’s revenue may rise 7.6 percent over that span, the data show.

At the end of June, EADS’s order book was a record 551.7 billion euros ($716.7 billion), and the Airbus commercial airliner division had a backlog valued at 485.7 billion euros.

“BAE would gain exposure to the one part of the sector that’s still growing -- commercial aerospace,” Imode said. After the U.S. presidential election, “some decisions are going to be made on the U.S. overall budget, and defense spending is in the firing line.”

Low Valuation

EADS is probably looking to take advantage of BAE’s low valuation and even out its exposure to the military and commercial markets, said George Ferguson, a defense analyst at Bloomberg Industries in Skillman, New Jersey.

Tom Enders, on his first day as the new chief executive officer of EADS after five years of running Airbus, pledged at the company’s May 31 annual shareholders’ meeting to raise profitability.

EADS set a target when it was created in 2000 of eventually reporting operating profit of 10 percent of sales. The highest annual operating margin achieved since then was 8.16 percent in 2001, and the figure was 2.95 percent last year.

In the 12 months through June, EADS raised its margin to 3.61 percent, still the lowest of every aerospace and defense company globally with a market value higher than $5 billion, data compiled by Bloomberg show. EADS’s profitability is reduced by development costs at Airbus.

BAE’s margin of 10 percent is almost three times higher, and the industry median is 11 percent, the data show.

Less Vulnerable

Douglas Harned, an analyst at Sanford C. Bernstein & Co., said buying BAE would also help EADS reduce its vulnerability to swings in the commercial-aircraft cycle. EADS has said it plans to reduce its dependence on Airbus to 50 percent of total revenue by 2020, from about two-thirds last year.

“Combining EADS with BAE Systems’ large global defense business would achieve that goal,” the New York-based analyst said in a note to clients yesterday.

The rationale behind EADS’s motivation is less clear to Societe Generale SA’s Zafar Khan. While BAE will mean EADS can rely on Airbus less and increase U.S. sales, the analyst said he’s not convinced EADS needs the diversification right now. As the airline industry gets larger in Asia and the Middle East, and as more low-cost carriers emerge, Airbus is building a robust enough backlog that it won’t face the same business cycle pressures as it has in the past, he said.

“If you look at their backlog now, they’re geographically very well diversified,” Khan said in a phone interview from London. “The EADS shareholders will be scratching their heads, thinking why on earth have they given away this growth opportunity by merging with a company that is going to be low growth?”

‘Cheap Takeover’

After EADS shares fell 15 percent in the last two days, the company’s enterprise value is only 4.8 times its earnings before interest, taxes, depreciation and amortization for the last 12 months. With BAE trading at 5.2 times Ebitda, the two companies are less expensive than 90 percent of the industry, data compiled by Bloomberg show.

“The truth is, each of them may be looking at each other going, ‘Wow, this is a great, cheap takeover,’” said Bloomberg Industries’ Ferguson. “EADS is at the lower point of the valuation for commercial-aircraft manufacturers. And BAE’s at the bottom of the heap on the defense side.”

Both stocks dropped yesterday as investors became skeptical that the deal will deliver the revenue growth and cost-cutting opportunities that EADS and BAE may be envisioning. BAE slumped 7.3 percent yesterday, reducing its two-day gain to 2.6 percent and leaving its market value at 10.95 billion pounds ($17.7 billion). The two-day drop in EADS reduced its value to 20.8 billion euros ($27 billion).

Dead Money

Today, shares of BAE rose 2.9 percent to 347 pence. EADS gained 0.6 percent to 25.31 euros.

The companies forecast so-called synergies of as much as 850 million euros annually, mostly from cost savings, the Wall Street Journal reported yesterday, citing people familiar with the talks.

“This deal doesn’t strike the right notes with me, I don’t like it,” Brian Barish, who oversees $7 billion, including EADS shares, as president and chief investment officer at Denver- based Cambiar Investors LLC, said in an e-mail. “Obviously other investors have come to a similar conclusion, that this would be a dead-money stock. The combined group doesn’t offer cost or revenue synergies to offset the big-company disease in the way that a merger of this size should.”

The synergies will be limited because BAE will have to “ring fence” the U.S. businesses due to national security issues, Societe Generale’s Khan said.

Government Hurdles

Getting clearance from the governments involved will also be an obstacle, he said.

The French government owns 15 percent of EADS while German carmaker Daimler AG controls 22.5 percent, of which 7.5 percent is owned by German federal states and some banks, and the Spanish government owns 5.4 percent. The U.K.’s so-called golden share in BAE gives it veto power over any strategic moves.

The European governments’ main concern “will be ensuring that jobs are not lost,” Khan said. “The U.S. might give a grudging approval.”

A combination would also mean added political risk as the new entity bids for national military contracts, Huntington’s Sorrentino said.

“There’s an awful lot of governments involved,” S&P Capital’s Imode said. “This is the biggest problem really with the deal. More than the companies, I think it’s really the governments. With both stocks down, the market is perhaps thinking there’s an awful long way to go for this deal.”

To contact the reporter on this story: Tara Lachapelle in New York at tlachapelle@bloomberg.net.

To contact the editor responsible for this story: Sarah Rabil at srabil@bloomberg.net.

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