MD writes:
On 7 March BAe announced the purchase for cash of United Defense Industries (UDI) of the US for $4.1bn (£2.1bn), maintaining the USA-centric policy of chief executive Mike Turner. Fears that BAe are neglecting their European market continue.

UDI were known as United Defense, LP until 1997 when venture capitalists The Carlyle Group (profile here of this, ah, interesting outfit) took them private. Carlyle then unleashed the new UDI by IPO in 2001, taking a final payment of $3m in 2002 for "services rendered". They no longer have a direct interest.

Carlyle may have made a good profit on the 2001 IPO, but they missed the post-9/11 surge in defense company stock prices. Viewed thus, the proposed BAe offer looks expensive - a 29% premium price at or near the top of a sector fiscally-primed by US government defense spending. Analysts suggest that UDI will have to grow by circa 15% annually for the next 3 years to justify the price. Good luck.

Financials:
UDI turned over $2.2bn in 2004 and made 7.5% on that ($166m) at the net income level. Not sparkling. Sales are skewed heavily to the US government agencies (81% according to UDI's 2004 10-K) so any squeeze of the defense budget will hurt.

On the UDI balance sheet it's noticeable that goodwill was $356m at the last count, not subject to amortisation and up from $343m in 2003. It was tested for impairment at year-end with the conclusion that there wasn't any (Ok guys, we believe you). Also, pension scheme obligations are increasing fast: they exceed assets, yet company contribution levels are alarmingly low. Rates of return assumptions are heroic at 8.5%.

Prized product: the Bradley
In terms of product, UDI's portfolio is diverse but the jewel is probably the Bradley fighting vehicle, a design over 25 years old but still a cash cow. The company has produced over 7,250 Bradleys and believes it's funded until about mid 2007. It is the company's single biggest programme and will now compete with the arguably better BAe Warrior fighting vehicle (spot the logic, but fortunately one of few overlaps between the companies).

Though there may yet be life in Bradley from ongoing maintenance and upgrade activities, the future may well not be as bright as BAe believe. UDI's most recent 10-K suggests (fairly) that the US Army's Future Combat Systems (FCS) programme is an opportunity. But the threat to the locked-in Bradley franchise from the FCS should also be recognised: the Army want a new wheeled, not tracked, manned ground vehicle. Not an area of proven UDI expertise.

Conclusion:
BAe look to be significantly overpaying in a toppy sector. UDI's own advisors, Lehman Brothers and JP Morgan, happily signed off a "fairness opinion" on the price offered. That would give pause for thought to some. But in any case, it is very hard to rationalise the twenty times net income of the $75/share acquisition price. Equally, there are the uncertainties over elements of the balance sheet to consider. And finally, paying for the whole deal with cash is stupendously foolish. No wonder the advising investment bankers to UDI must have smiled.

BAe shareholders should vote against this deal. UDI shareholders should hope they don't.

[Editor's 2nd opinion] The 9/11 atrocity has driven US Department of Defense budget increases of at least 10% per annum in recent years. Defense stocks have benefited accordingly.

Regression to historical valuations is likely to be hastened by the combination of:

1) considerations of how to battle the non-traditional threat of small terrorist cells. Resulting shifts in military priorities will likely come at the expense of the traditional big ticket items; and

2) growing political pressure to reduce the US federal deficit. That part of the US defense budget spent on "traditional" weapons systems will do well to beat inflation plus a couple of points.
BAe/UDI combo is sound business logic; but questionable timing and price.

[Writer nor editor hold an interest in BAe or UDI.]

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