Argonaut has been an investor in EADS since 2009 when the shares traded at €13, compared to €30 before the proposed merger with BAE was announced yesterday. Our investment rationale has been based around the attractiveness of the Airbus franchise which today accounts for over half of all new civil aeroplanes sold each year. Civil aerospace is an attractive industry with demand driven by emerging market passenger growth and the replacement of ageing aircraft with more fuel efficient planes. Over the last decade revenues at EADS have doubled from €29bn to €57bn driven by Airbus sales, confirming EADS’ status as a growth stock. There is no reason to suspect that future growth will be any less impressive.
Civil aerospace is also an industry where scale and technological leadership have created significant barriers to new entrants and where the only serious competitor is Boeing. One of the reasons for this is the enormous cost and time required to develop new plane projects. Airbus has already sunk billons of Euros into developing new plane projects like the A380 superjumbo which are only now beginning to generate sufficient sales to break even. In fact, Airbus is thought to currently make all of its profit on the A320 short-haul aircraft which was developed two decades ago. It has three new plane projects (A380, A350, A440) which currently contribute no profits, but which have an estimated combined sunk cost of around €28bn, which is more than the market capitalisation of EADS today (€21bn). As sales from new plane projects ramp up, loss making projects will become profitable and will significantly drive up overall profitability at EADS. Indeed EADS management have confirmed that it should be possible for the company to generate a 10% operating profit margin, a significant improvement on the 4% forecast by analysts for this year.
So with EADS shareholders finally seeing the benefit of the company’s ambitious recent Airbus investments its shareholders are rightly angry that these are now being shared with the shareholders of BAE, whose own business, being wholly exposed to government defence budgets would seem to have limited short term growth prospects. It is also doubtful whether the combination of the two company’s defence assets will bring any meaningful cost synergies or accrue any competitive advantage. Indeed, any merger is likely to be fraught with political sensitivities and distract EADS management from executing on the new Airbus projects. EADS also has a significant cash balance of €11bn on its balance sheet which will now be shared with BAE, which itself has in comparison has £1bn of net debt. EADS shareholders are understandably angry.
But does a bad deal for EADS shareholders make a good deal for those of BAE? The answer is no. The exchange ratio has already been fixed at 60% EADS/40% BAE. Share price weakness at EADS will be immediately reflected in a sell-off in BAE shares. BAE shareholders will soon be no better off than before the deal was announced. This is a deal without logic and without winners. The whole of the proposed combination is inferior to the sum of the parts. Whilst it is possible that EADS’ controlling shareholders may stubbornly attempt to push through the deal, BAE, by virtue of their superior corporate governance, need 75% of their investors to agree. Ironically, it is BAE shareholders who are likely to end up saving the EADS share price.
Founding Partner & Fund Manager
September 13th 2012
*Source: Internal, Argonaut/Starmine – September 2012