BAE and EADS Proposed Merger - Essay Example

? BAE & EADS Proposed Merger Contents •Introduction: •Strategy and motivation analysis •Stock market response analyses based on share movement and synergy multiples •Synergy analysis •Valuation •Corporate governance analysis •Conclusions Introduction EADS, which is the owner of Airbus and BAE system, which is the Britain’s largest manufacturing employer, announced their 29.8bn pound merger on 12th September 2012, a deal which could give Germany and France an interest in the UK’S major defense contractor. This deal could lead to employment of 220,000 people from across the world and generate about 60bn pounds revenue per year (BBC Monitoring European Germany, 2012). The deal could also lead to joint building of hi-tech equipment such as the A380 superjumbo. On the flip side, the deal would lead to political among other complexities. This report will give an analysis of the issues surrounding the proposal for merger of the two companies. Strategy and motivation analysis Invesco criticized the proposed deal citing poor terms, state interference and lack of strategic underlying principle. The problems that BAE has raised includes the share buyback programme , possible deviation from its generous dividend payout as well as the doubts imposed by inviting Germany and French stakeholders in the deal. The sharp cut in the defense spending by the U.S. is a big blow for EADS and BAE, but BAE is likely to suffer most because it is deeply exposed to the U.S. defense market. Furthermore, BAE is experiencing a serious reduction in the demand for the equipment it supplies for the US military, which are currently preparing to pull out from Afghanistan. Additionally, the firm is likely to suffer a big blow following the down-turn of the demand for the Eurofighter Typhoon fighter jet (Ranscombe, 2012). Figure 1: EADS DPS trend since 2007. As shown from figure 1 above, recently EADS has paid exceedingly high rate of dividends, which could be seen as a major motivation for BAE shareholders to enter the proposed merger (Le Figaro 2001). Stock market response analyses based on share movement and synergy multiples During the trading following the announcement on 12 September, the shares of BAE jumped by 10% to 336.1 pence ($5.41), as shown in figure 3 below. However, the shares of EADS plummeted by more than 10% following the announcement (shown in figure 2). Later, on 13 September, the shares of BAE fell back to just 2% above the level before the rumors emerged that the two companies were planning to merge (Norton-Taylor, 2012). Figure2: EADS share movement shortly before and shortly after the announcement Source: Thomson Reuters via FT Markets Data Figure 3: EADS share movement shortly before and shortly after the announcement Source: http://markets.ft.com When the reports hit news lines that there was a potential merger between the two companies, initially, the investors burst into a euphoria that affected the movement of the prices of the shares of the two companies. However, after uncertainty took shape, BAE’s shares drafted following a strong post-announcement rally, while the shares at EADS were moving lower (Petroff, 2012). On 12th September following the announcement, the shares of BAE were trading 1 percent lower at 338.90 pence, which was in line the decline in the wider market. As seen from figure 2 and 3 above, the investors’ reaction was swift, especially on Thursday when the shares of EADS fell by about 10 percent to €25.15, while those for BAE gained significantly on Wednesday following the news that the deal is simmering, going up to 337.10 pence in London. Synergy analysis The investors will have to ask themselves several questions in order to establish whether the merger is a good idea, including: (1) why is such a huge merger is the best means of solving the problems the individual companies are facing and also open opportunities for them? (2) Is BAE, which is a top US military contractor, the best company to help EAP achieve its desired growth in North America? and (3), is the 60/40 split terms in favor of EADS shareholders or will be attractive for investors from both ends? Strategising The most important issue is whether the merger will make any strategic synergy to benefit both EADS and BAE. The two firms could complement each other simply because there is little overlap of operations. There tends to be a balance between the military and civilian aerospace cycles that the two firms are exposed to. Besides, the merger could benefit from a significant transfer of skills, and technology. Operating in only a non-commercial aerospace would expose BAE’s to significant risk, and hence its merger with EADS would help reduce this risk. Model behaviour Merging of the two companies is seemingly a strategic move; however, this does not guarantee success. For a case in point, Boeing’s 1997 purchase of McDonnell Douglas was apparently successful as it reaped $16bn from its defense , security and space operations, in its total first-half 2012. However, it should be kept in mind that the Boeing model was a creation of US defense and aerospace consolidation in the 1990s, which took place when a military boom was starting (Le Figaro 2001). Is BAE the right partner for EADS BAE invested heavily in the US military after selling its Airbus stake. Currently, more than 40 percent of its revenues come from the US. However, some perspective is needed here. BAE’s share relatively highly priced and its first-half 2012 revenues went down by 10 percent compared to the same period in 2011. However, since, for now, the defense department has expressed disinterest for merger and acquisitions among its top contractors, and a transatlantic combination would be especially difficult, this could be the only reason why EADS want to merge with BAE; not because it is the best choice but because there seems to be no other better strategy (Feinstein, 2012). Split the difference The question of the terms brings in the issue of the proposed split. The companies have agreed a 60/40 split, with an EADS bagging bigger share than BAE. This means a premium of 12 percent for BAE following the merger. However, this premium has since been brown out of proportion as investors believe that the deal will not materialize; but it can resurface if the deal is reignited. Nevertheless, only the shareholders of EADS seem to get sense out of the deal; that is, if the capitalised value of possible synergies outweighs the premium offered to BAE. Unfortunately there is no much hope considering that the possible overlap is very little (Bawden, and Leftly, 2012). Figure 4: Revenues synergy Figure 5: Sales synergy Valuation models Synergy valuation model The interactive calculator is used to estimate the value of the annual synergies, which covers the premium paid to the target company, which in this case is BAE (Milmo, 2012). The Net Present Value of synergies is got from the estimates of annual synergies, synergy multiples and tax rate. It is then, assumed that, if this NPV is higher than the bid premium, then the deal is viable as it adds value for EADS shareholders, but if it is lower it does not add any value. The synergy that needs to be generated in this case should help reach the valuation of € 35bn. As shown in the appendices, the combined company has to generate €13.3767bn synergy. Comparison between pre and post combined market capitalization shows that the merger has to generate € 1.32bn. Ideally, it is clear that the value of synergies (€13.3767bn) does not cover the premium paid to BAE, and hence this deal is not fare for EADS (Boland and Kirk, 2012). This model is advantageous as it enables estimation of whether it is worth to enter into a deal using quantifiable values, but it is disadvantaged because it uses assumptions which sometimes are unrealistic. Dividend growth model Using the dividend growth model, BAE valuation is ?23.8bn, while that of EADS is -?5212 million, meaning that BAE will lose if it merges with EADS, but EADs will gain. This model is easy to understand, but it has several disadvantages, including: It is not applicable to companies which are not paying dividends; if dividends are not growing at a realistically constant rate, it is not suitable; it is highly responsive to the estimated growth rate; and, it does not put risk into consideration. Earnings-based model According to FT and Morningstar, the P/E of BAE is 7.12 while that of EADs is 17.56. The P/E for EADs has increased at a higher rate than that of BAE. This means that the market is in favour of EADS and hence justifying the 60/40 ownership structure. In other words, this means that BAE will bring business opportunity which is of less magnitude than that of EADS and hence the ownership should be in the favour of EADS. This also, means that BAE may not really deserve a premium from EADS. Residual income model This valuation model adjusts a company’s future earnings estimates, to give back to the equity place and cost a more precise worth to an entity. In calculating the value of a firm using this method, the most important aspect is to calculate the firm’s equity charge, which is basically a firm’s total equity multiplied by the required rate of return. Then, the equity charge is subtracted from the company’s income to get the residual income. This method makes use of data that is readily available from the firm’s financial statements and can be used to estimate the value of firms that do not pay dividends. However, this method relies on forward looking estimates hence leaving forecasts exposed to misrepresentations or psychological biases of a firm’s financial statements. Discounted cash flow model (DFC) This model is used to estimate the value of the company using the concepts of time value of money. To find the present values of all future cash flows, these cash flows are discounted using time value of money concept. The company with the highest value is considered to have more synergy. This method is advantageous because it produces an accurate picture of a company’s true value. However, its limitation is that the estimates are based on predictions rather than concrete data (Ciaran, J. 2012). Corporate governance BAE system is having a hard time trying to uphold their 35bn Euros merger. This is because the governments of French, German, and British are wrangling over the plan. In this merger, BAE is the major shareholder with 13.3% of the shares. Some sources maintained that the deal is opportunistic rather than motivated by necessity and hence BAE and added that BAE could survive alone (Dan, Jill and Kate, 2012). However, BAE blamed the wrangling governments as the source of the problems facing the proposed merger. Sources from BAE also indicated that the interests of the party’s government were hard to be reconciled with each other with the objectives that the two companies had in mind when proposing the merger. As such, it appeared very hard to this wrangle because the government shareholders seemed to have hijacked the whole process hence denying the rest of the shareholders their right to decide their fate in regards to the proposed merger (Michaels, 2012). Conclusion If successful, the merger between EADS and BAE could result in the creation of a world’s major employer and also bring a balance between military and civilian airlines. However, the deal is feared that it could lead to political among other complexities. Yet still, the proponents of the merger argue that it could lead to diversification and creation of synergy when the two companies come together. Despite the benefits that are expected to be realised from this merger, there are strong political and influential stakeholders, who are likely to make this merger a futile because of their divergent interest. This particularly includes different governments that think that the merger could be to their disadvantage. Nevertheless, with interest of individual parties puts aside, there appears to be a lot of benefits that the two companies may not enjoy if they do not merge, hence the merger could be better tried than shelved. References Bawden, T. and Leftly, M., 2012. In A Tailspin: Where Will BAE's Pounds 30bn Defence Merger With Eads Land?, London (UK): United Kingdom. BBC Monitoring European Germany, 2012. France, UK blame each other for breakdown of EADS-BAE merger talks. London: BBC Worldwide Limited. Boland, V. and Kirk, S. 2012. EADS-BAE – decision [Online] Available from: http://www.ft.com/intl/cms/s/2/afd4b6ce-0f08-11e2-9343- 00144feabdc0.html#axzz2CnrLxCkjLex%20in%20Depth%20EADS-BAE [Accessed 10 December 2012] Ciaran, J. 2012. Advantages & Disadvantages of a Discounted Cash Flow [Online] Available from: [Accessed 10 December 2012] Dan, M. Jill, T. and Kate, C., 2012. BAE and EADS: Where's the logic? Merger plan trashed by investor: Invesco, 13% owner of British firm, savages move as governments try, and fail, to agree. London: Guardian Newspapers Limited. Feinstein, A. 2012. Comment: The devil's in the deal: The collapse of the BAE-EADS merger reveals the dangers of an arms trade too close to the state. London (UK): United Kingdom, London (UK). Le Figaro: Rainer Hertrich Rules Out Merger between EASs and BAE’s Systems (Rainer Hertrich Exclut Une Fusion Eads-Bae Systems) 2001. The Financial Times Limited. London: United Kingdom, London. Michaels, D., 2012. Corporate news: Defense deal's political hurdles --- merger negotiations between EADS and BAE need to satisfy five governments, as well as investors. Wall Street Journal. [online] Available from: http://search.proquest.com/docview/1040772638?accountid=145382 [Accessed 10 December 2012] Milmo, D., 2012. Business: BAE and EADS - a merger still very much up in the air. London (UK): United Kingdom, London (UK). Norton-Taylor, R.., 2012. BAE/EADS merger 'will create company beyond law': European partner scores badly in corruption index call for independent board to avoid bribery risk. The Guardian [Online] Available from: [Accessed 10 December 2012] Petroff, A., 2012. Reaction to the EADS-BAE Merger Talk [online] Available from: http://www.morningstar.co.uk/uk/news/81314/Reaction-to-the-EADS-BAE- Merger-Talk.aspx%20Reaction%20to%20the%20EADS- BAE%20Merger%20Talk> (Accessed 10th December 2012). Ranscombe, P. 2012. BAE confirms talks on EADS merger to create defence giant. Edinburgh (UK): United Kingdom, Edinburgh (UK). Appendices Synergy valuation model – answer to question 1 What synergy needs to be generated to reach the valuation of € 35bn the premium for potential success •The equation solves for the minimum required synergy: •Pre-merger value of both firms+synergy = pre-merger stock price Post-merger number of shares Let S=Synergy Data: on Sept 11 (announcement made on Sept 12, 2012), EDAS share was: €29.30, number of shares outstanding at 31.Dec 2011= 8.21bn Pre-merger value of EADS: € 26bn http://markets.ft.com/research/Markets/Tearsheets/Summary?s=EADA:FRA on Sept 11 (announcement made on Sept 12, 2012), BAE share was ?4.12 or € 4.75 (4.12X € 1.153) Number of shares outstanding 3.59bn, pre-merger value of BAE: € 4.75X3.59bn= € 17.05bn, exchange rate at ?/ €1.153 http://markets.ft.com/research/Markets/Tearsheets/Financials?s=BA.:LSE&subview=Overview Assuming pre – merger stock price = average pre-merger prices of EADS+BAE (26+17.05)/(3.59+8.21) +S =( 29.3+ 4.75)/2, 43.05/11.80+S =17.025 3.6483+S=17.025 S=13.3767bn The combined company has to generate €13.3767bn synergy Information: Market capitalisation of BAE at Dec 4, 2012 = ?10.64bn, 10.64X1.153 = € 12.27bn http://citywire.co.uk/money/share-prices-and-performance/share-factsheet.aspx?InstrumentID=499 Comparison between pre and post combined market capitalisation •Pre- merger capitalisation of both companies compared with €35bn post merger valuation •BAE pre-merger cap = ? 10.64bn at the exchange rate ?/ €=1.153 •10.64X1.153= € 12.268 •EADs pre-merger cap = €21.46 •€35 –(12.268+21.46) = € 1.32bn •Merger has to generate € 1.32bn. •What would be the problem with such pre and post merger cap comparison? Asset based valuation model •Asset based: •Combine the Book value EADS and BAE = total assets •Re 2011 b/s: •Total assets/total combined common shares outstanding •EADS total assets 2011 € 88.4bn/8.15 = € 10.85 •BAE total assets 2011 €26.52/3.59 = € 7.387 •(10.85+7.387)/2= € 9.12 •Compared with 35bn/total combined shares •35/(8.27+3.59) = €2.95 Dividend growth model - BAe •Assuming Yo= Dec 30, 2011 •Po=Do(1+G)/(R-G) •Po= share price •Do = dividend in Y0 per share 20p •G= expected rate of growth in dividend (10.72%) assuming same growth rate in the future •R = cost of equity capital (14.06%) assuming it is the required rate of return (5 yr average ROE from Morningstar) •Po = 20p (1+0.1072)/(0.1406 -0.1072) = 20p X (1.1072/0.0334) •=20p x 33.15 = 663p (compared with pre merger 412p) •Using this model, BAE valuation should be 663pX3.59bn shares outstanding (see slides 31) =?23.8bn, twice of the market cap ?10.64bn •Assuming Yo= Dec 30, 2011 •Po=Do(1+G)/(R-G) •Po= share price •Do = dividend in Y0 per share 20p •G= expected rate of growth in dividend (10.72%) assuming same growth rate in the future •R = cost of equity capital (14.06%) assuming it is the required rate of return (5 yr average ROE from Morningstar) •Po = 20p (1+0.1072)/(0.1406 -0.1072) = 20p X (1.1072/0.0334) •=20p x 33.15 = 663p (compared with pre merger 412p) •Using this model, BAE valuation should be 663pX3.59bn shares outstanding (see slides 31) =?23.8bn, twice of the market cap ?10.64bn •You may calculate the EADS share price using the same model •You may comment on the fact that BAE’s dividend payout is much higher than EADS, how to resolve this ‘BAE shareholder incentive’ problem? •Second, would the high dividend growth potential justify Bae’s 40% share in the new company? EADS Valuation •Assuming Yo= Dec 30, 2011 •Po=Do(1+G)/(R-G) •Po= share price •Do = dividend in Y0 per share 0.45p •G= expected rate of growth in dividend (35.56%) assuming same growth rate in the future •R = cost of equity capital (14.06%) assuming it is the required rate of return (5 yr average ROE from Morningstar) •Po = 0.45p (1+0.3556)/(0.1406 -0.3556) = 0.45p X (1.3556/-0.215) •=-5212 million •Using this model, BAE valuation should be -6.3051pX827.37m shares outstanding (see slides 31) =?23.8bn, twice of the market cap ?10.64bn Read More