IN FOCUS: BAE-EADS merger a 'test of national resolve to change'

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The decision by BAE Systems and EADS to abandon plans to merge their companies into the world's biggest aerospace and defence group, with revenues of some $100 billion, may have been inevitable in the face of overwhelming opposition from shareholders and severe misgivings in Berlin, Paris and London, but the deal's collapse casts a spotlight on a brewing crisis in the European defence industry landscape.

As Rand Corporation European defence analysts Matthew Bassford and James Gilbert put it, any analysis of the industry landscape shows "huge overcapacity" in fixed-wing military aircraft.

Even if defence budgets were rising it would be uneconomical to sustain the industrial base to build and support Saab's Gripen, Dassault's Rafale and the Eurofighter Typhoon, with its heavy involvement by BAE and EADS. But with defence budgets steady or falling sharply, they say, these companies and the governments keen to support them face stark choices as this decade rolls on towards a time when early conceptual work must begin to replace all of those aircraft by the 2030s.

The Rand view of the underlying imperative to rationalise Europe's defence industry has supporters on both sides of the Atlantic. Although talks over the merger never progressed beyond negotiations with the French, German and UK governments, all of which are understood to have been fearful that a BAE-EADS combination would put local jobs at risk, expectations that the US government might have scuppered a deal may have proved misguided.

During the past decade, BAE has built a US-based business that accounts for nearly half its revenue and is a trusted partner of the Pentagon. The concern had been that by merging with EADS, with large ownership stakes held directly or by proxy by Paris and Berlin, would put that relationship at risk - effectively undermining a big driver of the merger, to give EADS access to the US defence market.

However, some observers believe US authorities may have welcomed the creation of a globally competitive Europe-based aerospace group, as it would have provided the Pentagon with a competitive alternative, forcing the big US prime contractors to become more cost-conscious.

And, as the US Air Force's original selection of a Northrop Grumman-EADS bid to supply an Airbus A330-based aircraft for its $35 billion KC-X aerial refuelling tanker programme highlights, the Pentagon is not averse to buying European products when they represent well-tested technology. The fact that US domestic politics led to a re-run of that competition - won second time around by Boeing - is not regarded as evidence that EADS should abandon hope in the US market.

Joseph Lampel, professor of strategy at City University London’s Cass business school regards it as “structurally predictable” that there should be further European consolidation, which certainly aligns with the official ideology that wants to see the industry build enough critical mass to carry Europe’s burden in NATO. But his observation that national industrial policy often prevails has been confirmed by the failure of politicians to approve the BAE-EADS marriage.

Given the history of EADS’s creation from national aerospace champions in Germany, France and the UK – though BAE later chose to sell its stake in the Airbus-dominated company and focus on its defence business – it may be disappointing but shouldn’t be surprising that the political hurdle to a BAE-EADS union was too high to clear.

However, what probably sealed the deal’s fate was investor antagonism. Summing up much of the financial community’s opinion of the plan was investment fund Invesco – which is BAE’s biggest shareholder, owing some 13.3% of company. Days before the merger talks were called off it publicly declared the deal to be illogical and likely to damage BAE’s “unique and privileged position” in the US defence market. Noting that it did “not understand the strategic logic for the proposed combination”, Invesco went on to say it believed the level of state shareholdings in the combined group would have “heavily impair[ed] its commercial prospects”.

The irony of the deal's collapse is that in protecting shareholder and national interests, the investors and politicians may have shut the door on a great deal of commercial upside, which could more than offset any particular job losses that might arise from management decisions to close a factory here or end a programme there.

As Dean Gilmore, head of the UK aerospace practice at consultancy PwC, notes, while prospects for budget cuts, especially in the US, are well-documented, when the defence business globally is looked at broadly there is "compelling logic" for growth. Looking beyond struggling headline programmes such as combat aircraft, he says, demand for better electronics and sensors is solid, and in pan-European missiles maker MBDA there is precedent for success in cross-border mergers.

This merger proposal, he adds, "tested national resolves" for major change. And, it will probably have been merely the first such test case. Many smaller merger and acquisition deals are likely to follow and thus be more likely to succeed, particularly if they do not cross national borders. But, he adds: "The next big one will be interesting."