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Defense mega-merger might get derailed by politics

September 13, 2012: 11:26 AM ET

A combination of European aerospace giant EADS and British defense company BAE Systems looks like a no-brainer on the economic and financial front, but in defense, politics always rules.

By Cyrus Sanati

BAEFORTUNE -- The bold attempt by European aeronautics giant EADS to acquire British defense company BAE Systems is all about one thing: Pentagon access. After nearly a decade of trying in vain to tap the vast U.S. military industrial complex on its own, EADS, the parent company of jet-maker Airbus, is now trying to essentially buy its way into the canteen. If it is successful in snapping up BAE, EADS would automatically become one of the largest military contractors to the US Department of Defense, putting it in direct competition for contracts with U.S. aerospace giants Lockheed Martin (LMT), Northrup Grumman (NOC), and its commercial aviation archenemy, Boeing (BA).

But while such a tie-up looks like a no-brainer on the economic and financial front, it is bound to encounter stiff resistance on the political and regulatory front. You can bet that lawmakers that represent districts or states where defense is a major employer received more than their fair share of calls last night on this topic. That's because in the defense world, politics trumps economics every time as contracts are divvied up mostly to national champions with strong government connections. This deal will only go through if it is blessed, not just by the myriad of regulators, but by the U.S. defense contractors and their boosters in government. That seems like a tall order.

Wall Street seemed truly caught off guard yesterday when the news broke that EADS and BAE were in merger talks. The deal, which is still being negotiated and could collapse at any time, would create an aerospace juggernaut with true global reach. EADS has wanted to grow its defense business for a while now, but has had limited success. The potential acquisition of BAE gives EADS the defense business it always wanted, while also balancing the company's revenue stream. Airbus accounts for 66% of the company's earnings, with the other third coming from defense and space-related businesses. With the inclusion of BAE, where 98% of its earnings derive from defense-related businesses, the revenue mix for the combined company would be 50% Airbus and 50% defense and space, which would be nearly identical to how Boeing is divided.

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But this merger isn't just about gaining military contracts; it's about gaining the right kind of contracts – those wildly lucrative American contracts. While BAE is a British outfit and the largest defense company in the UK, it turns out that around 41% of its revenues come from the U.S. The company maintains a large office outside of Washington and actually employs more people in the U.S. than they do in the UK at around 34,000 employees.

EADS has bid on a number of U.S. military contracts over the years and while it wins small procurements here and there, it has had limited success in nabbing the big fish. Its Eurocopter division has been the best performer of the EADS family, winning a $2 billion contract in 2004 to build helicopters for the US Army and the Coast Guard. Building on its Eurocopter victory, EADS later challenged Boeing for a $40 billion contract to build refueling tanker aircraft for the US military. The battle between the two giants got very ugly. EADS ultimately lost out to Boeing in a multi-year drama that cost the company hundreds of millions of dollars.

EADS management must now believe that acquiring BAE is the easiest and most efficient way of securing those big US military contracts. But while the transaction achieves revenue balance and crucial U.S. access, there is concern as to why EADS would want to acquire a pure-play defense company now that governments around the world are cutting back on military spending. The market thought the same thing too, sending shares in EADS down 6% on Wednesday. Was EADS not aware of sequestration or the fiscal cliff? Why try to enter the U.S. market at a time when it could be possible that its military budget could get automatically cut by a whopping 5% to 10% in January of next year?

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Well, it is all perspective. For EADS, a piece of the US defense budget, even a small piece of a shrinking pie, is better than the markets back home in Europe. That's because, unlike in the U.S., when the Europeans want to cut defense spending, they actually do it. For example, Cassidia, the defense arm of EADS, had 8.3 billion euros in orders in 2009 before the euro crisis started to get bad. In 2010 and 2011, orders were sliced in half, with 4.3 billion euros in 2010 and 4.2 billion euros in 2011.

Now consider that the US military budget this year is $711 billion. Say that sequestration actually happens and the budget is cut by 15% in January from this year's level. That would mean that the defense budget would still be $604 billion – around five and half times what France and Germany's budget are this year, combined.

So it is pretty clear that even with the deepest cuts there is a lot of money out there. But can EADS ever grab a piece of that big American military pie? It is questionable as to whether the US military will be comfortable allowing a Franco-German conglomerate to take over one of its major suppliers. While BAE is a British firm, and clearly foreign, the US military has a much stronger relationship with the British Armed forces going back all the way to WWI. That relationship was cemented in WWII and has been relatively strong ever since, serving closely in both Afghanistan and Iraq. The US military just doesn't have that sort of relationship with the French or German military, despite the fact that they are all in NATO. EADS alluded in its release that it would take necessary steps to ring-fence BAE's operations in the US, but it's highly doubtful that would be enough for the US military to sign off on the agreement.

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But say the military does sign off; EADS would then have to sweet talk a lot of congressmen in a lot of districts where its competitors do business. It will need to convince lawmakers that it doesn't receive subsidies from the French and German governments, which would allow EADS to undercut US aerospace firms unfairly. Boeing clearly has no love for EADS given the blood feud between them in commercial aviation. Jim McNerney, Boeing's chief executive, told reporters yesterday that his company wasn't threatened by a potential EADS/BAE tie-up. While he might not be threatened, he most surely would like to avoid it if possible. Airbus is eating Boeing's lunch in both the superjumbo and single-aisle aircraft divisions – the last thing it needs is EADS taking swiping some of its big US military contracts.

It is unclear if any of the major constituencies involved in this deal are ready to give it the green light. The militaries of every major country that does business with either company will need to sign off on the deal, including, but not limited to, Saudi Arabia, Australia, Spain and, of course, the UK. EADS (hopefully) had already secured the support of the French and German governments before the deal was announced yesterday. But given how their stake in EADS would be diluted in the merger, it may be Paris and Berlin that end up crushing this deal before the US ever gets a chance to see it.

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