European Aeronautic, Defence & Space Co. (EAD) and BAE Systems Plc (BA/), a week into announcing plans for a $45 billion combination, are starting to canvass investors who are doubtful a merger adds any value to what they have now.
The two companies have started briefing select groups of non-government shareholders to convince them of the merits of a deal, people familiar with the talks said. EADS Chief Executive Officer Tom Enders, in a message to employees, acknowledged yesterday the announcement may have caught some shareholders off guard on Sept. 12, causing a 12 percent stock drop since.
EADS and BAE are seeking to harmonize the interests of the U.K., Germany, France and Spain, and to avoid alienating the U.S. Department of Defense, the biggest source of BAE’s sales. BAE investors get higher dividends than those at EADS, and the company has a more focused portfolio with no government involvement beyond the U.K.’s passive veto share, clouding the appeal of joining forces with Toulouse, France-based EADS.
“Long-term investors and hedge funds are scratching their heads a bit because it is not immediately clear what the benefits of this merger are,” said Robert Stallard, an analyst at RBC Capital in London.
Shares of BAE traded 1 percent lower at 338.90 pence in London as of 8:11 a.m., in line with a wider decline in markets. EADS was little changed in Paris trading.
Among BAE’s biggest shareholders is Invesco Ltd. (IVZ), with a stake of 13.25 percent, while Blackrock Inc. and Axa SA each own just below 5 percent, the latest filings show. EADS has three main investors, with Daimler AG (DAI), Lagardere SCA, and the French government controlling a combined 44 percent of the company, while the rest of its stock is freely traded.
Beyond a basic structure giving EADS investors 60 percent of the new company and those of London-based BAE the rest, details of the combined entity remain unclear. Under U.K. regulations, the companies have until Oct. 10 to work out how to formalise their merger. An EADS spokesman said he had no immediate comment. A spokeswoman for BAE said the company has been in touch with investors since the announcement.
Saying he was encouraged with progress on the plan, Enders called EADS and BAE a “a perfect fit” in a letter to employees yesterday. A merger would let EADS reach its goal of balancing its portfolio between defense and civil aerospace much sooner than its original target of 2020, while flushing out a pact that retains equal control between the main shareholders, he said.
“Despite some initial critical reactions, word will soon go around that this deal makes good business sense,” he said.
Ratio of Power
One area of contention is the ratio of power within the combined company. While EADS is more than twice the size of BAE in terms of revenue, the U.K. company will have 40 percent of the combined business. In terms of market value, EADS is a third larger than BAE, a relation that was inverse three years ago, when BAE’s value trumped that of EADS.
“BAE management is effectively selling at precisely the wrong time,” said Nick Cunningham, an analyst Agency Partners in London.
A change in the merger ratio is not being considered, said a person close to negotiations. EADS said last week that it would pay shareholders 200 million pounds ($324 million) to make up for the lower dividend. EADS has a 12-month dividend yield of 1.8 percent, compared with 5.5 percent at BAE. EADS scrapped its payout altogether in 2010, the first time since the company was created a decade earlier, because of cost overruns and delays.
BAE shares, which initially surged 12 percent on Sept. 12, the day Bloomberg News first reported the plan, slumped 7.3 percent the following day and have lost 7.2 percent in total since the news broke. The company has a market value of 11 billion pounds, compared with 21.2 billion euros for EADS.
EADS in particular has focused its initial campaign to win followers at governments, with Germany and France the two sides that need to find common ground. While France owns a direct stake of 15 percent, Germany is home to some of the biggest production sites. The U.K. has a so-called golden share in BAE that can block takeovers, and the companies said they would hand out special government shares under the new group.
Enders, who has been critical of government meddling in EADS, has made the unraveling of the state shareholdings a cornerstone of his endeavor to pair with BAE. In his letter to employees, Enders said that failure to establish “good governance” that limits governments’ role would derail a deal.
Among concerns voiced by BAE investors is how the U.S. business will guard its independence. The BAE Systems Inc. subsidiary, run by Linda Hudson, now operates under a so-called special security arrangement that gives it clearance to handle sensitive contracts with the Pentagon. EADS and BAE have said they would keep the asset “ring-fenced,” without elaborating.
The U.S. government may require asset disposals after a merger plan is subjected to security review. A BAE Systems spokesman said existing mechanisms to address the Pentagon’s security concerns should accommodate a new ownership structure. There are no plans to divest any of the business in the U.S. as part of a combination with EADS, he said.
EADS and BAE have promised cost savings without providing details on their scale or how they may be generated. Among possible opportunities is the ability to generate more sales as BAE’s ties in export markets such as Saudi Arabia, India and Australia open the door to EADS units.
Enders said the benefits will go beyond broadening market access, and that the companies will “go for real operational and industrial synergies across all combined businesses.” While Enders voiced optimism that talks are progressing and that the companies would be able to present a plan soon, some past deals point to the drawn-out nature of negotiations.
United Technologies Corp. (UTX) required 10 months to complete the purchase of Goodrich Corp., a deal that lacked the complexities in the multinational EADS-BAE tie-up.
Now both EADS and BAE need to convince their shareholders that what they get under the united group is better than what they signed up for as shareholders of either separate entity. Given the make-up of the new company, whose name has yet to be disclosed, will be unrecognizable from the former companies, some investors may balk at the prospect of a merged group.
“Most of the people that were in EADS wanted to invest in the positive civil aerospace cycle and the margins potential at Airbus,” said Stephan Boehm, a Frankfurt-based analyst at Commerzbank AG. “Long-term investors that wanted to invest in civil aerospace might now consider looking for alternative investments within the European commercial aerospace sector.”
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