The Missing Piece In The BAE-EADS Merger Story: Subsidies

Merger discussions between BAE Systems and European aerospace giant EADS are rapidly approaching a climax. Despite weeks of intensive media coverage, though, one of the most important factors bearing upon the valuation of the two companies has barely been mentioned. That factor is commercial-transport subsidies. The World Trade Organization ruled in 2010 that the Airbus unit of EADS, which generates most of the parent company’s revenues, has benefited from a multi-decade pattern of improper subsidies that enabled it to rapidly gain global market share at the expense of U.S. producers. The WTO demanded that the use of banned subsidies end.

The WTO issued a similar ruling against Boeing, but the U.S. company’s improper subsidies were found to be much smaller in scale, and the largest such government benefit — favorable treatment of “foreign sales corporations” — has long since been abolished. European governments have continued to provide heavy subsidies to Airbus, even though the WTO reiterated in an appeal of its 2010 ruling that said subsidies are a market-distorting violation of trade treaties. To say these subsidies are detrimental to U.S. interests is an understatement. When Airbus first entered the market there were three U.S. producers of jetliners, and now there is one; that one (Boeing) has lost nearly half of its global market share to Airbus.

The reason why this issue has a bearing on the forward valuation of any BAE-EADS combination is that after decades of tolerating the illegal subsidies, the U.S. government has signaled that it is prepared to impose heavy penalties on European products if they continue. In fact, right now it is in the process of seeking WTO permission to levy many billions of dollars in tariffs to compensate for the losses caused by European commercial-aircraft subsidies. That means the business model that has brought Airbus success since its inception is now at risk, a fact which inevitably calls into question what that part of the business is really worth going forward.

EADS head Thomas Enders has repeatedly stated that he wants to reduce the role of the French and German governments in his company’s decisions, but I don’t recall him saying that he was willing to give up Airbus subsidies. He knows that the profitability of his whole enterprise depends on continuing to get “launch aid” — concessionary loans — for each new aircraft that Airbus develops, loans that don’t need to be paid back until the programs break even. However, there is now a bipartisan consensus in Washington that such aid must end, and European governments are so cash-strapped that even they are asking whether Airbus still needs handouts from taxpayers. So all those shareholders and stakeholders on the Continent who are grumbling that EADS is giving up too much in the proposed merger ought to take the deal while they can get it, because the future profit picture for BAE Systems may be rosier than that for EADS.