For BAE Systems Plc (BA/), a failed merger with European Aeronautic, Defence & Space Co. could be just the first attempted deal for the company’s defense contracts around the world.
After facing resistance from European governments, the combination that would have created the biggest aerospace and defense company was terminated yesterday. While BAE said it won’t look for another partner, the company may still be a takeover candidate as the industry consolidates to help weather any cuts to government defense budgets, said Huntington Asset Advisors. Espirito Santo Investment Bank said U.S. defense contractor General Dynamics Corp. (GD:US) now may be among the most logical acquirers of BAE, which makes everything from electronic warfare systems to submarines.
Potential buyers would get a company with a price-earnings ratio that’s cheaper than 89 percent of major defense companies and the second-highest free cash flow yield, according to data compiled by Bloomberg. With U.S. aerospace companies also likely to confront political hurdles to a deal, it may make more sense for BAE to break itself up, with the civil aviation business potentially luring a bid from Boeing Co. and its military aircraft unit possibly drawing Lockheed Martin Corp. (LMT:US), according to Christopher Street Capital.
“Once you’ve gone down that road, it’s now an open invitation,” Peter Sorrentino, a Cincinnati-based money manager who helps oversee $14.7 billion at Huntington, said in a telephone interview. Gaining more scale in the U.S. defense market “would certainly be a major motivator to anyone in that industry. The budgets are going to get smaller going forward, but the U.S. is still the biggest market. Given the expense of the programs and the risks involved, bigger players are more likely to weather any storm better. The prospects for a deal still hang out there.”
Today, shares of BAE rose 2.4 percent to 328.50 pence.
BAE confirmed a Bloomberg report in September that it was in talks with EADS, the Toulouse, France-based maker of Airbus commercial jets, to try and create the world’s largest aerospace and defense company by sales. The merger discussions, which would have given London-based BAE’s shareholders 40 percent of the combined business, collapsed yesterday after Germany refused to join France and the U.K. in backing the deal.
The merger was “a unique opportunity” for the companies, BAE Chief Executive Officer Ian King said in a statement announcing the termination of discussions.
“We are not casting around for another opportunity,” Chairman Dick Olver said on a conference call yesterday. King rejected the proposition that all or parts of the company were now in play.
A spokeswoman for BAE declined to comment further.
BAE, the maker of nuclear submarines, armored vehicles and fighter jets, had sales of 17.8 billion pounds ($28.5 billion) last year, with the Pentagon as its largest customer. With U.S. and European defense budgets in decline, the company has been focusing on trying to win business in growing markets.
BAE’s price-earnings ratio, after slipping to a three-year low in June, was 8.7 yesterday, the second-lowest among prime defense contractors with market capitalizations larger than $5 billion, according to data compiled by Bloomberg. Only Irkut Corp., a Russian state-controlled aircraft maker, is cheaper at 1.9 times trailing 12-month earnings, the data show.
The group, which includes General Dynamics and Lockheed, trades at a median price-earnings multiple of 14.4.
While political oversight would complicate a deal, BAE is attractive to buyers based on its balance sheet and cash flow, according to Chris Parkinson, a London-based analyst with Christopher Street Capital, a unit of GFI Group Inc.
BAE’s free cash flow yield, the measure of how much cash from operations a business generates after deducting capital expenses relative to its share price, was 10.1 percent yesterday, the highest after General Dynamics’s 12.3 percent, the data show.
“Certainly from a financing perspective, I think it’s an attractive company to take out,” Parkinson said in a phone interview. “They’re very cash generative.”
While BAE isn’t compelled to pursue a deal, the failed talks with EADS leaves the U.K. firm more vulnerable to a takeover by another company as contractors fight over less government defense spending, according to Edward Stacey, a London-based analyst with Espirito Santo.
“When the budgets are shrinking, then you think about the cost of running separate programs -- it’s expensive,” he said in a phone interview. “You need fewer, larger programs.”
The most logical buyer may be a U.S. company, such as Falls Church, Virginia-based General Dynamics, according to Stacey. General Dynamics may be lured by BAE’s combat vehicle production, which it could incorporate into its land-systems division, he said. General Dynamics’s land-systems unit makes armored trucks and amphibious bridge systems, while BAE produces the U.S. Army’s Bradley tanks. Any combination would have to receive antitrust approval.
Both companies also build ships. BAE is the U.S. Navy’s biggest contractor for non-nuclear ship repairs, and General Dynamics is the Defense Department’s No. 2 contractor for such repairs.
Still, a takeover of BAE would be a large transaction for General Dynamics, and may prove too costly for the contractor, Stacey said. General Dynamics had a market value of $23 billion yesterday, compared with BAE’s 10.4 billion pounds ($16.7 billion).
A U.S. defense contractor “still could swallow the whole, but it’s easier to think of finding homes for all the bits of it separately,” he said. “Management has said they’re not considering that. The question is will shareholders apply a lot more pressure to consider something more radical.”
Rob Doolittle, a spokesman for General Dynamics, declined to comment.
While BAE could get acquired by a U.S. defense contractor, concerns about military budgets and the outcome of the U.S. presidential election will determine the timing, as well as which companies emerge as potential buyers, Huntington’s Sorrentino said.
The U.S. faces $1.2 trillion in automatic budget cuts that will begin Jan. 2 unless Congress and the White House agree on a way to avert the so-called sequestration. Military spending would be reduced by as much as $500 billion over the next decade, including as much as $54.7 billion in fiscal 2013.
While interest from U.S. companies to buy all of BAE may be limited, some BAE assets -- if they were to be put up for sale - - would be “snapped up immediately,” particularly the U.S. defense electronics operation, Sash Tusa, a London-based analyst at Echelon Research & Advisory LLP, said in an interview.
For shareholders, a divided BAE may be more valuable, according to Christopher Street’s Parkinson.
“A lot of the businesses aren’t getting the economies of scale” from being part of a large conglomerate, Parkinson said in a phone interview. “They’re being weighed down by being in such a slow-moving, tanker-like business.”
Splitting the company into parts could also make it easier for BAE to sell itself, he said. While political complications could deter Boeing (BA:US) from bidding for BAE as a whole, it may be more willing to buy the company’s civil aviation unit, Parkinson said. Boeing, the world’s biggest aerospace company, gets more than half its revenue from selling commercial airplanes.
In January 2011, BAE abandoned a four-month attempt to sell its unit that makes components for aircraft and hybrid vehicles, including flight controls used by Boeing and Airbus.
Lockheed, which already collaborates with BAE on its F-35 Joint Strike Fighter, the Pentagon’s costliest weapons program, may also be interested in the company to help consolidate production, Stacey said. Buying BAE’s military aircraft businesses, specifically, may be attractive to Lockheed, Christopher Street’s Parkinson said.
John Dern, a Boeing spokesman at the company’s Chicago headquarters, declined to comment, as did Jennifer Allen, a spokeswoman for Bethesda, Maryland-based Lockheed.
A better option for BAE may be to spin off its North American business into a separate publicly traded entity, said Brian Barish, who oversees about $7 billion, including EADS shares, as president and chief investment officer at Denver-based Cambiar Investors LLC. The combined company isn’t trading at a stock price that recognizes its earnings power and the amount of cash it throws off for investors, he said.
“The more probable route for those guys would be to break the company up,” Barish said in a phone interview. “You could get some valuation uptick from doing that. BAE does trade at a pretty low valuation currently.”
Parts of BAE, such as its electronic warfare systems, “are coveted by U.S. companies” and combining with one would create a “powerhouse” in certain markets, Peter Arment, an analyst at Sterne Agee & Leach Inc., wrote in a note to clients yesterday.
Still, BAE is unlikely to sell or spin off those “crown jewel” pieces of its business, he said.
David Pearl, co-chief investment officer at Epoch Investment Partners Inc. in New York, who helps manage $24 billion, including Boeing shares, said a proposed BAE tie-up with a large U.S. defense contractor such as Boeing probably wouldn’t gain approval from the Pentagon.
“BAE could combine with another company, but it’s unlikely it would be a U.S. company,” Pearl said.
Robert Stallard, an analyst at Royal Bank of Canada, also said in a note yesterday that BAE is unlikely to draw bids from primary U.S. defense companies. Those firms will be deterred because U.S. defense spending is uncertain, U.S. companies don’t want the political risk of being the U.K.’s prime contractor, and deals for assets such as the electronic warfare systems will be limited by competition, he wrote.
While the Defense Department has encouraged consolidation among smaller companies to boost efficiency amid cuts to U.S. defense spending, it also has said it wouldn’t allow transactions that lead to fewer major U.S. defense contractors.
An acquirer of the full company would also have to cope with BAE’s pension deficit of more than $7 billion and the U.K. government’s so-called golden share that allows it to block any foreign takeover of the strategic business.
Still, BAE will be compelled to do something to boost its stock and competitive position after the attempted merger with EADS fell through, said Zafar Khan, an analyst at Societe Generale SA in London. BAE should even weigh the disposal of its U.S. business, he said.
“The BAE strategy has failed,” Khan said in an e-mail. “BAE should explore all options to maximize value for shareholders.”
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