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Visitors look at an A350 aircraft miniature at the EADS booth during the ILA Berlin Air Show Sept. 13, 2012. Shares in EADS and Britains BAE Systems tumbled as investors feared a planned tie-up aimed at creating the world's biggest defence and aerospace group could run up against political and regulatory obstacles. (TOBIAS SCHWARZ/REUTERS)
Visitors look at an A350 aircraft miniature at the EADS booth during the ILA Berlin Air Show Sept. 13, 2012. Shares in EADS and Britains BAE Systems tumbled as investors feared a planned tie-up aimed at creating the world's biggest defence and aerospace group could run up against political and regulatory obstacles. (TOBIAS SCHWARZ/REUTERS)

EADS’s merger bid part of a long-term strategy to beat Boeing Add to ...

Even before EADS finally lost the $35-billion deal last year to supply the U.S. with air tankers, Tom Enders, then a senior executive at the European aerospace and defence group, expressed a startling opinion: Boeing had rigged the tender.

Mr. Enders told the American ambassador in Germany that his company believed U.S. rival Boeing had used political influence to design a contest that EADS could not win. The European group’s aerial refuelling aircraft was larger and therefore more expensive than Boeing’s – a big disadvantage in a tender process he said was based on a “price shoot-out,” according to diplomatic cables from 2009 obtained by WikiLeaks.

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Now Mr. Enders, a former German paratrooper, is chief executive of EADS and has a chance to get even. He is the driving force behind the €38-billion deal proposed on Wednesday to tie up EADS with BAE, Europe’s largest defence contractor and create the world’s biggest aerospace and defence company by revenue. Their combination would also give EADS a stronger presence in Boeing’s backyard.

If the deal goes through, Mr. Enders would not only complete his own near 15-year quest to consolidate Europe’s defence sector but also launch the biggest single European response to the power and influence of the U.S. defence industry.

Winning approval for the combination, however, will require Mr. Enders to convince a long list of governments and regulators of the merits of a highly contentious cross-border deal further complicated by its national security implications.

He will need to persuade London, Paris and Berlin – each with very different agendas – of the wisdom of his strategy.

Most of all, he will need to convince the Pentagon that the new company deserves a privileged slot in the U.S. defence market, the world’s largest. In particular, Mr. Enders will need to overcome two powerful Pentagon objections. The U.S. defence department is loath to see its range of suppliers shrink through consolidation. And it is reluctant to let foreign companies – especially those such as EADS with big government shareholders – into the most sensitive areas of the military equipment market.

“It is going to be a tough sell in the U.S. – that they should allow one of their top prime contractors [BAE] to be part of [an enlarged] European group, when one of their major sources of concern over the years has been about transfer of intellectual property,” says Nick Cunningham, an analyst at Agency Partners, a research group.

Should the tie-up gain approval, the business would have one of the aerospace and defence industry’s most varied production lines, spanning fighter jets, passenger aircraft and military and commercial helicopters, as well as frigates, satellites, ground combat vehicles, cyber and electronics. The diversified group would be better placed to withstand austerity-driven cuts in defence spending by western governments.

For EADS – formed in 2000 through the pooling of French, German and Spanish assets – the real attraction of the BAE deal is the ability to expand in the military market, which would provide it with additional revenue stability. The group’s main subsidiary, Airbus, entered the civil aerospace market much more recently than Boeing but since 2002 its annual deliveries of passenger aircraft to customers have outstripped those of its U.S. rival. However, the sector is highly cyclical, with airlines typically cutting their orders during economic downturns. Boeing, meanwhile, remains much bigger in the defence market. By combining with BAE, which has its roots in England’s first royal gunpowder factory, established in 1560, EADS should achieve its goal of creating a group with a 50-50 revenue split between civil aerospace and defence.

Mr. Enders’ big bet is that this deal will finally unlock the U.S. defence market. BAE has used acquisitions to build a U.S. business that includes electronic warfare systems, aircraft structures and land vehicles, while EADS has managed only a modest presence in the U.S., mainly selling helicopters.

Last year’s air tanker deal, which Boeing has said was fairly awarded based on affordability, ended a decade-long contest. It was an example of the obstacles EADS faces. Boeing lost the contract twice, only for the Pentagon to rerun the competition. On the third try, the U.S. company won. A group of lawmakers, including President Barack Obama and secretary of state Hillary Clinton, both then senators, had argued strongly against EADS making the tankers. Some said the Pentagon should support domestic jobs by choosing Boeing, and highlighted how Airbus benefited from state subsidies. Others went further, saying giving the contract to EADS could jeopardize national security, with Paris and Berlin in effect controlling EADS through their 22.5-per-cent stakes in the group, held via a mix of direct and indirect shareholdings.

Mr. Enders, a public critic of these shareholdings, wants to use the deal with BAE to end state interference. EADS is proposing for the stakes to be cut to 9 per cent each in the combined entity, say two people familiar with the details. The French, German and U.K. governments would all hold golden shares enabling them to prevent hostile takeovers but without additional veto rights or the ability to nominate board members.

Such changes could ensure the group functioned as a normal company, free from political interference, and put it in a position to compete head-to-head in Boeing’s home market. One person close to EADS says: “We are in the negotiation phase but our proposal is very clear. The governments’ rights will be reduced, and must be reduced.”

But Mr. Enders is some way from achieving that aim. Paris, in particular, represents a serious potential hurdle. The deal would have been impossible under former president Nicolas Sarkozy, who had a close relationship with Dassault – BAE and EADS’s biggest French rival. The election this year of François Hollande improves the chances of approval, but it remains far from certain.

Meanwhile, the U.K. would be likely to object to any deal that did not put the defence headquarters of the enlarged group in London and minimize the influence Paris and Berlin wield at EADS. “BAE will not be forced into a corner and the U.K. government will support it in that position,” says one person close to the deal.

The politics are even more complex in the U.S. For a start, there is opposition to more consolidation. Cost overruns on ongoing programs, notably U.S. group Lockheed Martin’s F-35 fighter jet, have reinforced the Pentagon’s reluctance to see its supplier base dwindle. That reluctance was particularly strong as defence spending mushroomed in the aftermath of the terrorist attacks of Sept. 11 2001, followed by the wars in Afghanistan and Iraq.

But spending has peaked. The focus is now on cuts, which have become a pawn in the highly politicized debate about how to address the U.S. budget deficit. The good news for EADS and BAE is that opposition to industry consolidation might be weakening, precisely because of the cuts. Recent comments by Pentagon officials indicate they realize a new round of mergers might be inevitable as companies adapt to reduced spending.

Mr. Enders will also need to navigate suspicion about foreign defence companies. Helped by the close security ties between the U.S. and the U.K., BAE has managed to become the Pentagon’s favoured foreign supplier. But the Pentagon has been less keen on EADS and its backers, especially France. Despite allowing French defence companies a presence, it is so concerned about them stealing technical know-how that it limits the number of jets it parades at the Paris air show every two years.

Washington insists foreign companies completely ring-fence their U.S. operations. Ian King, BAE chief executive, is not privy to some of the work the company’s U.S. operations does for the Pentagon, and leaves the management of sensitive programs to American colleagues.

The most extreme potential demand from U.S. regulators would be for BAE to spin off its defence business. Analysts think it more likely that the enlarged group could win approval by agreeing to even more rigorous safeguards to prevent sensitive technologies being transferred back to Europe.

The other crucial factor will be how Boeing responds. It is already braced for a new onslaught from EADS after Airbus announced plans in July to create 1,000 jobs by opening a $600-million factory in Mobile, Alabama, to build narrow-body passenger aircraft. Airbus hopes the move will enable it to secure a bigger share of the U.S. market, which is expected to be the second most valuable by sales over the next two decades.

If Mr. Enders’ suspicions on the tanker deal are correct, however, Boeing could use politics to influence EADS’s chances of gaining ground in the U.S. through the BAE tie-up. People close to BAE believe Boeing could even make a counter-offer for the U.K. group. But before then, Boeing, EADS, BAE and everyone else in the industry will be waiting to see what sort of reception the planned combination receives in Washington.

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