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:: September 2012 Letter ::

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Dear Fellow Innocents Abroad,

The Berlin Air Show has much in common with the Teal Group: it’s low-key, kind of quirky, and beer is frequently served. Since the mid ‘90s we’ve regarded ILA as a great opportunity for a company off-site meeting. It’s much less frantic than Le Bourget and Farnborough, yet there’s still lots of people to meet. But on day two of this year’s show, I got a call from my friend Andrea Rothman at Bloomberg asking if I’d heard anything about a BAE/EADS merger. Minutes later the story broke, leaving show attendees stunned at their beer taps. Thus endeth my relaxing week.

So, BEADS (as it really should be called) looks set to belatedly re-start the European aerospace integration process. It’s been 12 years since there’s been any progress with this process; you can catch up with the last installment with my April 2000 newsletter. Since the new merger has already been covered to death by the time you read this, I’ll confine this note to a list of seven things I like about the merger and four potential obstacles. First, the positives:

1. If done correctly, it could sidestep the toxic Franco-German national control dynamic. BEADS, after all, would be French/German/Spanish/UK/US, or better still completely “multi-domestic.”

2. There’s not much overlap. Almost all their businesses are nicely complementary, and allow greater coordination over MBDA, Eurofighter, the A400M, and other pan-national ventures. This would be a relatively “clean” merger.

3. It gives BAE access to commercial jetliner revenue. BAE sold its Airbus share to EADS in 2006, becoming a pure-play defense company with a particular focus on US military vehicles as a growth driver. That worked well as long as Iraq and Afghanistan were the center of the US strategic world. But these days, jetliners are outperforming anything the military world offers.

4. It gives EADS access to the US defense market, which they’ve wanted for years. That market may be declining, but it isn’t self-destructing, like Europe’s. Former EC Trade Commissioner Pascal Lamy once said Britain risked being “drowned in mid-Atlantic.” Turns out they were merely the first to get to the lifeboats.

5. It gives EADS access to a cash from a company that has actually learned how to make money from military programs (through some secret alchemical process). That means instead of EADS’s lightly profitable jetliner side and marginally profitable military side, BEADS will have a lightly profitable jetliner side and a profitable military side that can actually contribute cash for new jetliner product development. If done quickly enough, that’s good news for the A350XWB.

6. It’s a rational response to shrinking home markets. This merger would essentially be a defensive move. French President Francois Hollande and his pals might not grasp the fundamentals of a market economy, but if demand shrinks, it’s logical for the number of suppliers to shrink too.

7. It creates a European aerospace powerhouse with Boeing’s size, clout, and commercial-military synergy. It would also be the largest defense company in the world.

What could stop the merger?

1. Investor reaction. The two companies’ shares took double-digit hits. This may have been investors confronted by new challenges: BAE investors haven’t needed to think about commercial jetliner cycles; EADS investors haven’t needed to think about US sequestration. But if their share prices follow Facebook’s trajectory, the stocks may become a thumbs-down referendum on the virtues of a merger.

2. The national interest question. You now have three countries that wish to protect their national interests. Lawmakers in Britain and France have expressed unease about the merger and what it could mean for ownership, technology, and most of all jobs. The more each government interferes with the way the company is structured and run (in the name of national interests), the less flexibility the company will have. A company needs the freedom to rationalize operations and to share technology between business units. The UK has already requested that the company’s military HQ be located in the UK. And national interests can get quite broad: one UK lawmaker has already cited Kraft’s takeover of Cadbury as a negative precedent. Damn foreigners. Stealing our strategic milk chocolate business.

Also, there’s a paradox: Germany is leading the charge for globalization and getting around national political interference. Thus, the other Europeans see this merger (and any effort to sidestep national agendas) as the German national agenda. Right after the merger was announced, a spokesman for Angela Merkel’s party helpfully stated that Tom Enders would be the logical choice for BEADS CEO. He would indeed be the logical choice. But in a continent that’s concerned about German economic and political dominance, this assertion may not have been a politically correct move.

3. US regulatory issues. The UK has been allowed to buy some of the most sensitive industry assets, including Sanders, the world’s most capable electronic warfare house. A Franco-German company would have had serious problems acquiring this. They may need to divest this unit if they can't persuade the US Government that firewalls will keep this technology separated. One job US regulators have will be to look for conflicts of interest. If the merger is approved, the owners of 80% of Eurofighter (and a 46% financial stake in Rafale) would have a major stake in the F-35. Some might regard this as an issue. In fact, there may be some US politicians who now regard BAE in North America as a Trojan Horse. Or a sleeper cell.

4. Execution and integration issues. Mergers create headaches, particularly in our industry. In terms of execution, the aftermath of the Last Supper in the US saw 80% of mergers give the other 20% a bad name. Cross-border political and cultural issues, which weren’t issues in the US, won’t make this an easy one. Byzantine ownership issues (EADS has direct ownership shares from two governments, government proxy stakes through other entities, and BAE has its UK Government golden share) will make integration even more fiendishly complicated.

So, what’s the Bottom Line? Well, seven good and four bad…I’d give this merger a 60% chance of succeeding. The French and UK voices that have already indicated interference in the process hardly encourage confidence, even if many of the drivers behind the merger are sound.

Teal updates this month include the Rafale, C-17, F-2, AH-1, Tiger, Ching Kuo, Super Puma, and Avanti. Have a great month.

Yours, ‘Til The BEADS Chalet At ILA Starts Serving British Beer,
Richard Aboulafia
 

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