When 1 + 1 = 3
Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The United States’ two largest aerospace and defense contractors, Boeing (NYSE: BA) and Lockheed Martin (NYSE: LMT) have reason to worry. European Aeronautic Defense & Space Co. (NASDAQOTH: EADSY.PK), the parent of Airbus, and BAE Systems (NASDAQOTH: BAESY.PK) of Britain are working on a merger.
The EADS and BAE merger creates an aerospace and defense powerhouse. Lockheed Martin is the world’s largest defense company, boasting sales of $46.5 billion, cash flow from operations of $4.25 billion, and profits of $2.65 billion in 2011. But the merger would bump Lockheed Martin down to second place.
Last year Boeing reaped revenues of $68.7 billion, operating cash flow of $4 billion, and $4 billion in profits. However, the merger would place EADS and BAE - who would have earned a combined $90 billion in 2011 - above even Boeing.
EADS and BAE are no strangers to each other. They work together on a missile joint venture and also on the Eurofighter Typhoon. But working together comfortably is only a small reason for merging.
EADS longs to expand into defense, an area in which it has struggled. Moreover, Boeing and Lockheed Martin have a tight grip of the U.S. market, an area that EADS has long eyed.
Furthermore, EADS hopes to reduce its risks in Airbus. Airbus boomed in 2011, delivering more planes than ever before, but a number of its jets are over budget and running years behind schedule, a costly mistake in such a capital-intensive industry. EADS hopes that the move will streamline the Airbus unit – however, to me this sounds laughable. It may sound good in theory, but I can hardly think of a time when a merger actually streamlined anything. EADS: tread carefully.
BAE, on the other hand, is under pressure to find new markets. The company has a strong global reach, and it hopes that EADS existing businesses can allow it to expand its competencies in nations where it already has contracts.
When 1 +1 = 3
EADS and BAE hope to create several synergies from their proposed merger. The companies expect to achieve strong financial stability by joining forces, and they forecast budget savings of $1 billion annually.
For a firm that would have earned $90 billion in 2011 that savings represents a 1.1% savings that falls directly to the bottom line. The savings comes at a great time for the firms, who face margin difficulties compared to competitors.
Also, the new entity would be a formidable opponent to Boeing and Lockheed Martin. The aerospace and defense firms are competing for what is expected to be reduced spending from western governments but also large investments in the Middle East and Asia. No doubt the merger would expand the global reach of the two firms.
Finally, the proposed merger would smooth out the cyclicality of earnings. Defense and government contractors have a more smooth earnings trajectory than other firms, as evidenced by Lockheed Martin’s 4.3% dividend and Boeing’s 2.5% dividend.
Gluing the two companies together would create an entity where the larger defense earnings of BAE could, for example, offset a cyclical downturn for EADS’ Airbus jetliners, for example.
Overall, the merger is a bold move by two large firms who hope to completely overtake an industry. Boeing and Lockheed Martin are not likely shaking in their boots, but certainly they are preparing a competitive response to the merger.
First, two U.S. firms will likely try to stop the merger. But if that fails look for the companies to protect their own sales territories then try to protect their future interests by rapidly expanding into areas where the newly merged company would go after. We may just see the three biggest firms competing for a land grab – Lockheed Martin, the original Boeing, and the clone.
ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Lockheed Martin. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.