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ANALYSIS

BAE merger collapse shifts focus to smaller deals

Washington, October 14, 2012

The collapse of the proposed merger between BAE Systems and EADS will shift the focus to smaller deals among global weapons makers as companies strive to keep revenue rising in the face of cuts in military spending by the United States and Europe.

Industry executives and bankers do not see other mega-deals on the horizon for now, after the $45 billion UK-French-German talks collapsed on Wednesday. The failure showed how easily a deal of that scale can be derailed by competing interests of different countries, despite commercial logic.

Instead, major defence companies likely will focus on possible combinations with smaller players such as Rockwell Collins, L-3 Communications Holdings, SAIC, ITT Exelis and Harris Corp, according to interviews with more than a dozen industry executives and bankers.

"None of the big players in the global defense industry seem inclined to do mega-mergers similar to the BAE-EADS proposal," said Loren Thompson, a Washington-based defense consultant who has advised BAE's US unit and its competitors.

"The American companies are all at a place where they're not eager to grow in defense and are basically trying to secure their base, while the overseas companies have been chastened in watching the BAE-EADS transaction falter."

It is also unlikely that big US prime defense contractors would bid for BAE Systems, even though the company is considered potentially "in play" after the failed merger, because of the potential complexity, these people said.

EADS said it would continue its aggressive hunt for takeover targets and alliances, especially with U.S. partners, though on a smaller scale than the BAE deal. EADS North America chief executive Sean O'Keefe said on Wednesday that EADS remained "undeterred" in its drive to increase its share of the US defense market.

BAE's US unit said it, too, would keep looking for possible mergers in the areas of cyber, intelligence, security, electronics and international businesses.

The scope of consolidation in the defense industry still hinges largely on how the US Congress deals with $1.2 billion in mandatory budget cuts slated to start in 2013. Half of those cuts are for defence, and as long as those reductions threaten, mergers and acquisitions are expected to remain slow.

Worldwide aerospace and defense deals have totaled $5 billion so far in 2012, compared with $27.5 billion in all of 2011, when United Technology's $16.5 billion takeover of Goodrich boosted the total. This year's total also appears low compared with $6.7 billion in deals in 2010.

The effort by BAE and EADS to create the world's biggest aerospace and defense group underscored the effect of shrinking markets on big weapons makers. Many other major companies are scrambling to move into adjacent civilian or commercial markets, or find smaller takeover targets to keep revenues growing, bankers and senior industry executives said.

"Second-tier consolidation is much easier because the Defense Department is not against it," said a banker who requested anonymity, because he is not authorized to speak to the media.

"Had the EADS-BAE deal gone through and created a stronger global entity, clearly it would have increased the likelihood of U.S. consolidation at the prime level," said the banker. "The chances seem lower in the absence of the deal."

The US Department of Defense has discouraged mergers among the leading U.S. prime contractors, but has said it is fully expecting takeovers, mergers and other actions among second- and third-tier suppliers, given the expected decline in defense spending in coming years.

A Pentagon official said last month that the department would have to rethink its views on top-tier mergers if Congress is unable to avert another $500 billion massive military spending cuts on top of the $487 billion in cuts already slated for the next decade.

Almost all prime US defense contractors considered merging with BAE Systems at various points in the past, and decided against it, several people familiar with the companies' thinking said.

Most were interested in BAE's North American operations and they remain wary of adding political risk that would come with being the UK government's prime contractor by pursuing the whole company, they said.

"There had been conversations for decades," said a senior industry adviser on condition of anonymity because he was not authorized to speak with the media. "But buying the whole BAE, with golden share and other things like dual-listing, dual-incorporation structure, US guys say it's not worth it."

For its part, BAE Systems has repeatedly said it has no intention of selling the US unit, which contributes more than half of the company's revenue.

BAE officials made clear in recent weeks that any move by the US government to require divestitures as a condition for approving a merger with EADS would have been a deal-breaker.

Some sources cautioned that a new round of merger considerations involving BAE cannot be ruled out, given the challenging defense environment.

But most potential US bidders have their own reasons for why the deal would not make sense right now.

Executives at Lockheed Martin Corp have said privately that they have no plans to pursue BAE, which is a key supplier on its troubled F-35 Joint Strike Fighter program. They say the company is squarely focused on its performance on the F-35, the Pentagon's largest weapons program, and does not need the distraction of integrating a major acquisition.

Boeing Co is more focused on its booming commercial business and expanding its position in the cyber and unmanned systems areas at the moment, according to company executives and analysts.

Raytheon Co's Chief Executive William Swanson has publicly discussed the immense challenges involved in absorbing such a large, complex company.

Northrop Grumman Corp just sold two units, including its lackluster shipbuilding business, to streamline the company, making an acquisition highly unlikely, according to company insiders.

Chief Executive Wes Bush is more focused on creating a high-performing defense company and maintaining profit margins, not acquiring a company whose revenues have been hard hit by the downturn in demand for ground combat vehicles, according to analysts and company executives.

Any combination with General Dynamics Corp could raise antitrust issues, since the General Dynamics and BAE both build the biggest US combat vehicles, and on a global scale, submarines.

General Dynamics also is changing management, with Phebe Novakovic slated to take over as chief executive in January. The company has highlighted the importance of its balanced portfolio of commercial and military businesses, and may be reluctant to add more defense activities to its portfolio at a time when military spending is declining, analysts said.

Pentagon officials were open to a possible merger of BAE and EADS because it would have created a stronger, sixth prime competitor. But the agency could be more wary of a deal that involved a combination with one of the existing primes, some industry executives said.-Reuters




Tags: EADS | US | Europe | merger | BAE | focus | Collapse |

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