A Massive Shake-Up in Europe's Defense Industry

Super-sized mergers and acquisitions hold a lot of water for companies and their investors. Though history shows most companies overpay for their big purchases, the moves can also lead to increased economies of scale, supreme market position, and improved efficiencies once overlaps are removed. Yesterday, two of the biggest aerospace and defense companies in Europe announced talks of a merger. The move could put the European defense industry, and the American one as well, on its toes.

Legacy makers
When we get on a plane these days, chances are it's made by the duopoly that runs commercial jet production -- Boeing (NYSE: BA  ) and EADS (NASDAQOTH: EADSF.PK). EADS is the company responsible for Airbus, and is the largest European defense company. One of its closest competitors, besides Boeing, is BAE Systems (NASDAQOTH: BAESY.PK). BAE's focus is more on military applications while Airbus is, obviously, a commercial jetliner maker. Now, EADS and BAE are in talks to combine and create a defense company with $90-plus billion in annual revenues.

The move is very similar to Boeing's acquisition of McDonnell Douglas a few years back. Boeing was looking to increase its exposure to military and defense sectors due to the volatile nature of the passenger plane business. While then the United States and other western nations were only increasing defense budgets, especially after 9/11, now the story is reversed. Shrinking defense budgets around the globe have many of the defense contractors seeking alternative forms of revenue. This gives EADS an opportunity to snap up BAE for what is likely a lower price than what it could fetch in military boom times.

Long flight
The merger would create an absolute monster of a company, and one that Boeing and other defense companies, such as Lockheed Martin (NYSE: LMT  ) , may grow nervous of. A combination of the two companies would create a near even split for EADS for commercial and military production -- smoothing out the boom and bust cycles of both business lines.

It would be a massive restructuring that would take years to fully implement -- making the true value of the merger a difficult one to pin down any time soon. But, on the surface, it looks like the resulting company would be the biggest, most well positioned aerospace and defense company on the planet.

The ownership structures create complications as well. France, Spain, and German conglomerate Daimler own substantial portions of each company, making a merger difficult to process. The United States has already weighed in on the subject, saying it would not stand in the way of a merger even though BAE's military electronics segment, Sanders, was originally a Lockheed division and could be subject to trade regulations.

Defense contracting is all about the sell. Sure, technology wavers from company to company, and each organization has its own advantages and disadvantages. But, for the big sources of revenue (i.e. governments), it's about who has the best lobbying power and who can undercut the other one at the last second.

Boeing and EADS are pros at this game in the U.S. market. The two have battled incessantly for government contracts, with Lockheed Martin and other contractors in the mix as well. A combination of EADS and BAE, though, would create a company with immense bargaining power, and could be serious threat to Boeing's future contracts.

Investors say "eh"
Learning from history, investors are often weary of major deal-making from big companies. Today, both BAE and EADS are plunging in stock price, as investors just don't seem too turned on by the prospect of the deal. Will it be enough to crush the merger -- who knows? If the management teams are strong enough in their belief that the merger would enhance value, they may go ahead with the deal, barring any shareholder activism. But, with all the expense associated with the deal, and with BAE and EADS trading down nearly 9% and 14%, respectively, this merger may die before it ever gets going.

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Fool contributor Michael Lewis owns none of the stocks mentioned above. You can follow him on Twitter @MikeyLewy. The Motley Fool owns shares of Lockheed Martin. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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Michael Lewis

Michael is a value-oriented investment analyst with a specific interest in retail and media businesses. Before coming to the Fool, Michael worked with private investment funds focusing on deep value and special situations. Currently living in the media capital of the world--Los Angeles, California.

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