Why BAE-EADS merger is double trouble for Boeing

Fri Sep 21, 2012 7:36pm EDT

(Reuters) - At an awards ceremony in April, Boeing Co (BA.N) honored 14 "suppliers of the year." Prominent among them: BAE Systems Plc (BAES.L), the British arms maker now in talks to merge with Boeing's biggest civilian rival, EADS EAD.PA, maker of Airbus jets.

"We are grateful to have them as key members of our team," Boeing CEO Jim McNerney said of the contractors feted at the Field Museum in Chicago.

The potential pairing of a top Boeing partner with its fiercest competitor shows how deeply the deal could disrupt the complex relationships in the aerospace and defense industries, which account for hundreds of billions in sales a year.

The BAE-EADS merger would create the world's largest integrated defense and commercial aviation company with annual sales of $92.4 billion, topping Boeing by more than a third, based on 2011 figures.

Boeing initially said it did not see a big threat, but its top defense executive told Reuters this week the deal raised national security and industrial concerns that needed to be addressed.

Executives at companies that have close ties to BAE are alarmed that they may lose access to sensitive Pentagon documents, and potential future business, if the Pentagon clamps down on sharing certain information with BAE. The Pentagon might do that out of concerns that BAE's new partner, EADS, has German and French ownership. At present, BAE has a "special security agreement," or SSA, with the Pentagon that allows it to work as a subcontractor on classified contracts.

"BAE is an important defense player in the United States and their SSA has national security access. That's very unique," said one industry executive, who declined to speak publicly because it was unclear how the merger would be constructed.

"If they're part of a different company, does that eliminate them as a supplier?"

The powerful lobbying teams of the weapons makers have yet to go into battle on the issue, occupied as they are with budget gridlock in Congress that threatens overall U.S. defense spending.

But as Boeing's "supplier of the year" award shows, the merger could disrupt vast supply chains, given BAE's broad work as a supplier.

PARTNER, COMPETITOR

BAE's electronics and controls, for example, are installed on 6,343 Boeing jets in use by 181 major airlines. The British-owned company supplies more than 60,000 cockpit and cabin parts to Boeing a year. And it has been chosen to build a special touch-screen controller for the interior of Boeing's aerial refueling tanker, a $51.7 billion defense contract won by Boeing after years of competition with EADS.

BAE also works closely with most other big U.S. weapons makers. It is one of the major suppliers to Lockheed Martin Corp (LMT.N) on the F-35 Joint Strike Fighter, with work done by both its U.S. unit and the British parent. It also teams with Lockheed on a possible replacement for the U.S. Army's Humvee trucks.

EADS, for its part, recently partnered with General Dynamics Corp (GD.N) to compete for a border security contract.

Its biggest tie-up to date was with Northrop Grumman Corp (NOC.N) for the refueling tanker, a lucrative contract that saw the rival teams engage in a fierce lobbying battle. Their joint bid initially won the Air Force-led competition, but was later canceled after government auditors found errors in the selection process.

The merger talks clearly caught U.S. defense companies by surprise. Just a week earlier, Boeing's defense chief said he did not expect any mergers at the top of the weapons industry, citing the Pentagon's resistance.

Despite cautious public statements, Boeing and other companies recognize that the combined BAE-EADS will have more resources at its disposal - including larger research and development funding and ample cash flow - than either of the two separate companies now, which could put it in the running to bid for more ambitious projects in the future.

BAE's defense business would help offset cyclical downturns in EADS' Airbus jet business, and the combined firm could sink more money into new aircraft and weapons programs than Boeing, Lockheed and Northrop Grumman.

Some defense executives said they also see opportunity in the tie-up: While BAE and EADS are preoccupied with integration on a massive scale, they will likely be distracted from winning contracts.

GROWING CONCERN

Dennis Muilenburg, head of Boeing's defense division, said on Wednesday that the merger should be reviewed carefully by government regulators, but added it was difficult to comment further until the two companies released details of the proposed structure.

U.S. Air Force Secretary Michael Donley has said the Pentagon needs more details to be able to assess the security implications of a possible merger.

He said U.S. government had signed special security agreements with foreign-owned companies in the past that allowed them to work on sensitive military and intelligence contracts, but each of those deals was "very individual and very specific."

Like BAE, EADS also has a security agreement in place, and a merger would require approval by the United States.

"It's a big deal," said one senior U.S. government official. "We're in wait-and-see mode until we get a detailed proposal."

The merger may still fall apart, given the many conditions European governments are likely to impose. French President Francois Hollande and German Chancellor Angela Merkel will scrutinize the deal on Saturday, but are unlikely to give a final go-ahead to the merger.

U.S. regulators will review the deal carefully, but they are not expected to block it on security or antitrust grounds, according to people familiar with the matter, citing existing security agreements and preliminary discussions BAE and EADS have held with senior Pentagon officials. BAE has said it does not expect to make any divestments as part of the review.

Air Force Major General Christopher Bogdan told reporters on Monday that he did not anticipate major concerns about the impact of a BAE-EADS merger on the F-35 Joint Strike Fighter program, on which BAE is a key supplier to prime contractor Lockheed.

Lockheed Chief Executive Robert Stevens told analysts recently that his company - which acquired 30 companies over the past decade - was quite content to let EADS test the Pentagon's reluctance to approve top-tier consolidation.

He and William Swanson, the chief executive of Raytheon Co (RTN.N), both veterans of the massive consolidation among U.S. defense contractors in the 1990s, voiced concern about the immense challenges involved in integrating major companies.

Some expect more trouble. On Thursday, Greg Hayes, chief financial officer of United Technologies Corp (UTX.N), said the merger would likely face lengthy regulatory reviews, as did his company's recent acquisition of Goodrich. "It won't be an easy review. I think we saw that on Goodrich."

But few are venturing specifics, in large part because the details are still fuzzy, beyond plans for BAE Systems to own 40 percent of the merged company and EADS the remainder.

U.S. Rep. Buck McKeon, chairman of the House Armed Services Committee, noted that the companies will have to follow a set procedure to continue doing business with the government.

"We expect that procedure to be adhered to and that includes an opportunity for us to raise concerns," he said. "At this point we are just watching with interest."

(Reporting by Andrea Shalal-Esa in Washington and Alwyn Scott in New York; additional reporting by Marcus Stern in Atlanta; editing by Edward Tobin and Matthew Lewis)

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