Thursday, April 21, 2005

BAE Systems Opens Land Front in Assault on the Pentagon

BAE Systems’ recent 4 Billion $US proposed buyout of United Defense Industries signals the opening of a new front in BAE’s assault on the pentagon coffers. With this acquisition, BAE has solidified its position within the handful of defense companies that claim the majority of the Western defense pie. With 9 Billion $US in sales, BAE has now officially positioned itself to compete as the prime contractor against the likes of Boeing, Lockheed Martin, Northrop Grumman and Raytheon in delivering US defense systems.

This purchase is but the latest among 12 acquisitions that BAE has completed within the defense industry over the last few years. These acquisitions have allowed BAE to bid as a prime contractor in large US defense contracts. The market of small defense equipment manufacturers is fragmented and competitive, while the large contractors segment continues to be a historical oligopoly. This limited competition allows the prime contactors to benefit from lucrative cost-plus contracts that provide significant revenues and margins.

The increasing budget of the US department of defense as compared to the anemic European budgets makes the US defense market more attractive than ever. This has pulled many foreign defense contractors into targeting Uncle Sam as their most important customer. With the latest acquisition, BAE has significantly beefed-up its US operations and political ties, and has forced the Pentagon to look to the other side of the pond for much of its desired transformational technology. Even before the UDI acquisition, BAE’s North American arm operated with significant independence, led by its own autonomous management board overseeing more than 27,000 US-based employees. As if further evidence were needed, the acquisition signals industry confidence in the continued Bush-backed shopping spree required to support a carry a big-stick approach to foreign affairs.

The continuing strength of the Euro puts European companies in a solid position for making acquisitions. The other side of the coin is the increased costs the Europeans must swallow in delivering manufactured goods. The major European players, such as France's EADS and Italy's Finmeccanica, have yet to follow BAE’s lead in M&A strategy. BAE has been able to leverage both the strong Washington-London relationship and their private ownership structure (vs. government ownership of some of the other players) to position themselves as a trusted supplier. This strategy allows BAE to win more American projects than any of their European competitors.

Commenting on the proposed acquisition, Mike Turner, Chief Executive of BAE Systems, said: "The combination of UDI with our existing land systems and U.S. operations will create a world class business, better able to meet the ever more demanding requirements of our military customers.” As the acquisition is being reviewed by US regulators, BAE is publicizing its track record of stewardship of its acquired US businesses, having contributed to increased investment and job growth. BAE goes further in arguing that it shares with UDI a culture that fosters the creation of innovative capabilities, products and solutions, and that culturally the merger will be a great match due to “common values and a similar heritage, with long histories of innovation and commitment to national security."

BAE Systems, traditionally known for high-profile air and navel systems, will now have a land systems business “third leg”. With the UDI acquisition, BAE Systems inherits the U.S. Army's Future Combat System (FCS). This program represents a capstone of Rumsfeld’s much vaunted “transformation,” which will allow the US forces to become more versatile and mobile. By aiming at the brains of the transformation, BAE is positioning itself to win more R&D grants from the DoD and therefore share with the Pentagon significant development risk. This business is seen as particularly lucrative due to the army’s expanded use of lightweight troop transports that are replacing 40-ton Abraham’s tanks.

Officially, the merger still needs to pass muster with regulatory authorities in the US and EU, but this is believed to be largely a procedural matter, now that the US Committee on Foreign Investment has cleared the merger. With the US military’s increasing shift to land-based operations in engagements such as those in Iraq and Afghanistan, UDI continues to reap the benefits that will now flow to BAE.

The price premium BAE Systems paid for UDI reflects its expectations for robust future growth in the US defense market. While this might seem a solid bet, growth could slow if Afghanistan and Iraq cool down, and if further terrorist attacks on US soil fail to materialize. One worry is the fact that, based on stock performance since the announcement, the market seems to believe that BAE is overpaying. It is also possible that BAE systems could get burned by cozying up to Uncle Sam if the Chinese, Indian, or even Venezuelan markets heat up and start shopping abroad. This risk not withstanding, the safe money is on the US continuing to lead the race for military superiority and spending.

Ohad Reshef

John Rhoads

Leann Tchaikovsky

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