Berlin – In what would be the biggest step in aerospace consolidation since the 1997 Boeing /McDonnell Douglas combination, EADS and BAE Systems are exploring a “combination of their businesses.” The implications for both the European and U.S. aerospace sectors would likely be significant: The combination would be certain to up the pressure on further global consolidation efforts.

EADS and BAE Systems confirmed Wednesday that they are talking about combining their businesses. If completed, the merger would enable EADS to achieve the duel goals of balancing out revenues from Airbus with more military sales and greatly expanding its presence in the large U.S. defense market.

The proposed merger would also create by far the world’s largest aerospace and defense company. In 2011, the two companies had combined revenues of $96.8 billion.

EADS’ existing shareholders would control 60% of the combined entity while BAE Systems would account for the remaining 40%. The company would have a dual listing, but “there would be a unified board and management structure,” BAE Systems said in a statement. “ 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 said. “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 USA.”

EADS said that among others, the transaction still needs the approval of EADS ’ board of directors, and that it is uncertain the talks will lead to a deal. The two sides will have to reach an agreement by Oct. 10 or state that they will no longer pursue it, according to the City Code on Takeovers and Mergers. However, BAE Systems has already pointed out that it intends to request a deadline extension if the two companies are still in discussions by then.

“You could be looking at the most significant European consolidation that has yet been and probably 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 unmanned aerial vehicles, for example, has far more concepts in the works than appetite or budget of would-be customers. Such a merger could force Europe’s large aerospace companies to select specific designs not only for European customers, but also those that would have a better chance of competing with U.S., Israeli, Chinese and Russian options.

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

On the defense side, the merger, if approved, would clearly provide EADS penetration into the U.S. market by way of BAE’s substantial defense business, much of which is in the ground vehicles area. Likewise, EADS has a substantially better presence in the defense markets of Latin America and the Middle East.

“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 merger, 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 antitrust issue in the U.S. military market,” says Loren Thompson, chief operating officer of the Lexington Institute, a Washington-based think tank. Thompson is also a consultant for BAE.

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

What would probably be the most delicate part of the entire transaction is European government participation. 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. Germany’s aerospace coordinator, State Secretary Peter Hintze, said Tuesday that the German government still plans to buy holdings in EADS as a shareholder before the end of the year. But that was before the EADS /BAE merger talks were confirmed.

According to BAE Systems, “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 .” It was not immediately clear whether and when the French government intends to sell its stake or if Germany’s now obsolete move in would still happen. Daimler said it still intends to reduce its stake.

EADS management has been trying for years to get rid of government shareholders in an effort to establish the group as a purely private company. That effort has failed so far, mainly because France did not seem to be willing to sell down its stake. The German side therefore decided to buy into EADS, but that was declared to be an interim step that would enable the two sides to sell down in parallel and guarantee that no shift in the group’s balance was taking place. The two private shareholders, Lagardère and Daimler, have stated their interest in selling their stakes eventually, but had not yet put a firm timeline on their intentions.

EADS has been trying to become less dependent on its Airbus business, which contributes the vast majority of its revenues and profits. As part of its Vision 2020 strategy, EADS planned to grow its non-Airbus revenues to around 50% within the next eight years. But with Airbus booming and defense budgets stagnating at best, that goal seemed ever more unrealistic to achieve.