The merger of British giant BAE Systems and EADS in Europe is likely to trigger further consolidation in aerospace companies globally.

In particular, it would put other top players such as Italy's Finmeccanica and France's Thales under pressure to react in an attempt to take on what would become the largest airspace company on the globe.

EADS and BAE Systems confirmed on Sept. 12 that they are talking about combining their businesses. EADS's existing shareholders would control 60% of the combined entity while BAE would account for the remaining 40%. “BAE Systems and EADS have a long history of collaboration and are currently partners in a number of important projects, including the Eurofighter and MBDA joint ventures,” BAE stated. “The potential combination would create a world-class international aerospace, defense and security group with substantial centers of manufacturing and technology excellence in France, Germany, Spain, the U.K. and the U.S.”

The new company would garner around $100 billion in annual revenues, compared with Boeing's $68 billion, making it by far the largest aerospace group (see page 14).

Boeing CEO Jim McNerney says the merger, if approved, is unlikely to “threaten us fundamentally,” though he acknowledges that the deal reshapes EADS's structure and holdings to more closely mirror those of Boeing in terms of a civil/defense balance.

According to senior EADS officials, the two entities will remain separate under a newly created holding structure. Golden shares for Germany, France and the U.K. are to ensure that the new group is protected against hostile takeovers and that strategically sensitive, often classified, programs are under firm control.

The proposed deal, however, is being met with criticism by some investors. EADS shares took a deep dive the morning after the plans became public. They were down 9% in early trading and BAE Systems dropped by 6% following an initial steep climb a day earlier. Citigroup downgraded its EADS guidance because it believes that synergies will be difficult to achieve.

“We doubt that doubling up on defense makes sense to shareholders,” RBC Capital Markets wrote in an investor note. “Equally for BAE, being acquired by a European company could limit its ability to work for the U.S. government in sensitive areas.” On the other hand, BAE has been struggling already because of its full dependence on largely declining defense markets, and the integration into a broader structure looks like it could give BAE more stability and better prospects.

Some in the financial community assert that operating margins for companies conducting business in the U.S. are peaking, indicating that the merger would take place at the financial apogee for BAE's U.S. activities. This is prompting questions about why EADS is pursuing the deal now. By next year, the U.S. Congress will have to address the question of sequestration—significant automatic cuts to defense that will be implemented unless lawmakers strike a compromise to handle the national debt. Additionally, the Pentagon will be forced to operate at 2012 funding levels even when fiscal 2013 starts in October because the legislature has failed once again to pass a budget on time.

“You could be looking at the most significant European consolidation that has yet been and probably [ever] will be,” says Douglas Barrie, a senior fellow for military aerospace at the International Institute for Strategic Studies. “This could create a genuine European powerhouse on the defense side.”

Barrie suggests that consolidation is inevitable in Europe, given the shrinking budgets around the continent. And it could prompt a reconciliation of some competing product lines into single, and potentially more globally competitive, designs. The area of UAVs, for example, has far more concepts in development than either appetite or budget from would-be customers. Such a merger could force the large aerospace companies in Europe to select specific designs not only aimed at European customers, but that will also have a better chance of competing with U.S., Israeli, Chinese and Russian options.

“If you look at the European market and what budgets can support, it is kind of inevitable,” says Barrie. “The debate becomes how many defense aerospace manufacturers can we credibly afford to support.”

For example, the deal would likely put an end to competing UAV projects in Europe, where BAE has been developing drone technology with French aerospace giant Dassault Aviation against rival efforts underway at EADS.

Earlier this year, U.K. Prime Minister David Cameron and then-French President Nicolas Sarkozy agreed to forge ahead with joint development of a medium-altitude, long-endurance (MALE) drone, part of a broader defense agreement that aims to boost the A&D sectors of both countries (see page 31). Since then, the new government of French President Francois Hollande has taken a fresh approach to the country's MALE strategy. In September, France's defense ministry unveiled plans to bring Germany into the mix.

In a joint declaration signed Sept. 12, the two countries agreed to strengthen cooperation in various sectors of armaments, including MALE platforms. In a communique issued by the French ministry late Sept. 12, both sides appeared to have devised a common set of operational requirements for a possible European MALE venture.

One CEO of a major European aerospace supplier says the proposed deal will definitely trigger another wave of consolidation. Even now, the pressure to expand and move into a position to be able to self-fund more development programs has grown to an extent that many second- and third-tier suppliers are thinking about exiting the market, he points out. However, melding the biggest European aerospace and defense (A&D) companies into one entity would give it considerably more market power—particularly on the defense side—when it comes to negotiating with their suppliers.

The executive highlights, however, that the number of original equipment manufacturers (OEMs) is actually rising in spite of the proposed deal. The growing clout of aerospace industries elsewhere—in China, Russia, Brazil, India and South Korea—is giving suppliers new business opportunities beyond EADS and BAE. Margins are almost definitely going to be higher there, but so will the risk, he concedes.

On the defense side, the merger, if approved, would clearly give EADS penetration into the U.S. market by way of BAE's substantial Pentagon business, much of which is in the ground vehicles area. Likewise, EADS has a substantially better presence in the defense market in Latin America and the Middle East. BAE CEO Linda Hudson told employees in a memo last week that the product lines are “highly complementary” between the two companies, and that the merger will strengthen their presence in the U.S. market.

“This would raise a question for Dassault, Saab and Finmeccanica about how they react to this kind of merger,” Barrie notes, adding that a merger as large as BAE and EADS could spark further market shifts in Europe.

While European regulatory agencies could raise red flags about the plan, there is little chance of the U.S. government standing in the way of the deal. “This is basically a European transaction that raises no anti-trust issue in the U.S. military market,” says Loren Thompson, chief operating officer of the Lexington Institute, a Washington-based think tank. Thompson is a also a consultant for BAE.

Though there are some fairly immediate gains to be had from the merger—reducing administrative staff and taking advantage of each other's supply lines, for example—a BAE official says it is too early to tell if there will be an impact on any major near-term business pursuits.

“A merger may not signal a major strengthening of the combined firms' defense operations,” Capital Alpha Partners wrote. “There might me some savings from consolidation of overhead and possibly larger supply agreements, but the politics of the location and employment in defense facilities in the U.K., France and Germany suggests to us that savings from consolidation will take years to materialize and lots of political work to achieve.”

If the deal goes ahead, the new group will own the overwhelming share in the Eurofighter program. EADS will add BAE's 33% share in Eurofighter to its 46% (it earlier added Spain's 13% to its own 33%) for a total of 79% of the program. Italy's Finmeccanica owns the remaining 21%.

One of the key challenges until the deal can be closed will be convincing the shareholders, says one official. In his view, governments are not necessarily the ones that need the most persuading. In fact, it was Arnaud Lagardere—chairman of the Lagardere Group that owns 7.5% of EADS and the aerospace company's current chairman—who indicated in an initial reaction to the proposal that the EADS board had not yet been informed. Lagardere went on to say that he would recommend approval only after the full consequences of the proposed combination become clear.

One of the most delicate and significant parts of the entire transaction will center on how European government participation in the industry will shift. The British government has a special share in BAE Systems because of the company's involvement in so many crucial defense programs. The situation on the EADS side is even more complex: The French government currently owns 15% of the company and Germany is on its way to buying up to a 15% stake from Daimler and a consortium of banks, to balance state ownership. Industry sources believe that Germany will now no longer buy, because there is no added value for the country if it already has the necessary control through its new golden share.

According to BAE, “the parties envisage issuing special shares in BAE Systems and EADS to each of the French, German and U.K. governments to replace the existing government share in BAE Systems and the stakeholder concert party arrangements in EADS.” The concert party refers to the so-called shareholder pact that regulates the balance of power among core investors.

EADS management has been trying for years to shed government shareholders in order to establish the group as a purely private company. That effort has failed so far, mainly because France was unwilling to reduce its stake. The two private shareholders, Lagardere and Daimler, have stated their interest to sell their stakes eventually, but have not put a firm timeline on their intentions.

France's 15% stake in EADS would be watered down to 10%, and Lagardere's 7.5% would be diluted to 5% if the merger is approved. Spain's 4% would also be reduced.

EADS has been trying to become less dependent on its Airbus business, which contributes the majority of revenues. EADS planned to grow the non-Airbus revenues to around 50% within the next eight years. But with Airbus booming and military budgets stagnating at best, that goal seemed ever more unrealistic to achieve. Combining with BAE would bring the larger group instantly to about a 50/50 civil/military split, analysts estimate. One of the ironies of the proposed deal is that six years after the U.K. industry effectively exited the civil OEM business through the sale of its 20% stake in Airbus, it will now be back in that market again.