BAE-EADS Merger ‘Illogical’ says Invesco

As BAE Systems and EADS approach a 10 October deadline for either announcing formal terms for their proposed merger, walking away or requesting an extension for further discussions, investment fund Invesco - which is BAE's biggest shareholder, owing some 13.3% of the UK-headquartered company - has poured cold water on a deal it believes to be illogical and likely to damage BAE's "unique and privileged position" in the US defence market.

Outlining its reservations about the merger proposed last month, Invesco in a statement says it "does not understand the strategic logic for the proposed combination". The only strategic benefit, it adds, was diversification, "which investors can achieve for themselves more cheaply and simply".

Invesco adds that it "believes the merger would materially jeopardize BAE's unique and privileged position in the United States defence market, and has been unable to identify any corresponding benefits to offset this".

Further concerns surround the level of state shareholdings in the combined group, which "heavily impair its commercial prospects - especially in the United States - and result in governance arrangements driven more by political considerations than shareholder value creation". France and Germany each control nearly 22.5% of EADS, a legacy of the Airbus parent's creation from national aerospace companies. Spain owns 5.45%.

And, Invesco also doubts the feasibility of the expected dual-listing of the combined group's shares, maintaining both BAE's London and EADS's Netherlands listings: "The proposed dual-listed (DLC) structure perpetuates the predecessor company identities and thus impedes synergies. It also divides share trading between two markets and therefore deprives the enlarged group of the benefits of a single deep pool of liquidity. This is why most of the recent DLC's have been subsequently dissolved."

Further, says Invesco, the deal would be costly for BAE shareholders, as the UK company pays twice the dividends and generates more cash than EADS, and also has a higher-quality earnings stream "derived from the length and nature of its customer contracts".

In summary, says Invesco, in anticipation of discussions with the BAE board and other shareholders: "[We believe] BAE is a strong business with distinctive positions in the global defence market (especially in the US and UK) and good stand-alone prospects."

Separately, a research note from aerospace and defence sector analysts at Société Générale also sees few synergies in the merger which it describes as "a radical proposal, but the wrong deal at the wrong time".

BAE would benefit from the tie-up, says Société Générale - with 40% of the group, its shareholders would come out ahead and the defence-focussed partner would also get a lift by linking to Airbus's strong civil market growth prospects.

However, argues Société Générale, Airbus's "geographically well-diversified order backlog of eight years" suggests it is "significantly less cyclical than previously feared".

Thus, say the analysts, "merging with BAE at this point in the civil cycle gives away a lot of this upside".

Société Générale nevertheless rates EADS a "buy" and has uprated BAE from "sell" to "hold".