Buying Boeing Against a European Merger
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As more discussion of the potential mega-merger between Europe’s two largest defense contractors continues, Boeing (NYSE: BA) continues to look like the best play in defense for your core portfolio. While the newly formed competitor will rival Boeing in both size and reach, Boeing continues to have sufficient positives to warrant its inclusion in your portfolio. As many industry insiders note that the contraction in defense spending is inevitable, Boeing’s diversification in commercial aircraft, amongst other areas, remains an important element of risk mitigation for the company. This is not to say that the merger poses no threat to Boeing, but the company’s overall position looks strong.
The Merger
The combination of BAE Systems and European Aeronautic Defense and Space (EADS) will form a defense contractor similar in size to Boeing. The new entity is expected to have a market value of nearly $50 billion and generate $90 billion in annual revenues. EADS, which operates Airbus, is one of Boeing’s largest competitors in the commercial aircraft space, but the company lacks serious muscle in the defense sector. BAE is far more established in defense, particularly in the critical U.S. market. EADS recently lost a bid to Boeing to build a new refueling tanker to be used by the U.S. Air Force. The contract was worth $35 billion. Additionally, BAE has ten times the U.S.-based workforce as EADS.
In the commercial sector, Airbus had a huge year, selling the most aircraft ever recorded by any company in a single year, but its backlog is significant. Furthermore, with Boeing rolling out its efficiency MAX line, Airbus is in jeopardy of losing the top spot it just grabbed. The merger will give BAE access to new markets as well, unlocking critical synergies that the two firms believe can result in cost savings of as much as $1 billion annually.
Another goal of the merger is to restore greater control to the company’s management. Currently, the French, Spanish and German governments all have interests in the company that are manifested in decision making influence. The new company will issue special, non-voting shares to its government shareholders and ban them from holding positions on the Board of Directors. The increased control is also expected to improve the combined company’s standing with U.S. regulators.
The Impact to U.S. Defense
Jim McNerney, Boeing’s CEO, dismissed the merger as a significant threat to Boeing: "I have a pretty deep and abiding faith in our company's strength, so I don't think this is going to threaten us fundamentally." Executives from competitors Lockheed Martin (NYSE: LMT) and United Technologies (NYSE: UTX) also downplayed the threat, focusing on shrinking defense budgets being a catalyst for consolidation. Each of these companies is facing significant pressure as the U.S. Congress continues to negotiate budget cuts under the threat of sequestration set to go into effect in January.
Shareholders of the two European interests seem to have agreed with the U.S. executives as both stocks were down sharply on the news. European analysts downplayed the available cost savings across the two companies and pointed out that the merger would preclude BAE from working on U.S. contracts in sensitive areas. While the specifics will likely play out as the merger is better understood, the news is of sufficient importance to consider the U.S. defense names in your portfolio.
The Trade
While a contraction in defense spending, particularly under the sequestration plan, is a real concern for the major players in the space, Boeing’s diversification in commercial aircraft gives the company a significant amount of cover. Even during the recession, Boeing achieved annualized EPS growth of 13.4% over the last five years. This figure is projected at 20.6% moving forward. This growth is largely fueled by significant growth in foreign markets for its commercial aircraft. The ongoing development of more fuel efficient aircraft is also expected to push growth.
During a period in which defense spending is contracting, it is difficult to predict which companies will be most impacted by cuts. To that end, Boeing looks like the strongest player in the space because such a significant portion of not only its revenue, but its expected growth, comes from its commercial aircraft division. Based on this strength, Boeing is a buy at current levels.
Mr. Ehrman 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.
