GE's Proposed Deal For Smiths Aerospace Gets Warm Response

Defense Daily, Jan 17, 2007

By Calvin Biesecker

Wall Street analysts are generally applauding General Electric's [GE] proposed $4.8 billion cash deal for the Aerospace division of Britain's Smiths Group, despite the relatively high price versus future earnings given that GE will have an opportunity to improve profit margins in the Smiths business while expanding its offerings in the aviation sector.

"This aerospace transaction had been talked about for years in the aerospace industry and, in our view, makes good sense," Bear Stearns analysts said yesterday. Morgan Stanley analysts agreed, citing the strategic importance and the "ample room for margin improvement to justify the rather healthy premium."

GE Aviation touts margins of about 20 percent compared to Smiths Aerospace's 11 percent.

A sidebar to the pending deal, which the companies expect to close toward the end of the second quarter, is the establishment of a joint venture between Smiths' and GE's respective detection and homeland security businesses. The creation of Smiths GE Detection, comprised of 64 percent ownership by Smiths and 36 percent by GE, is contingent upon closing the aerospace agreement.

GE's aerospace business, which is mainly based on the development and production of engines for commercial and military aircraft, has been looking for a while to "move beyond the engine," as company officials say. The company made a failed attempt to purchase Honeywell [HON] for $45 billion in 2001 after European Union (EU) anti-trust regulators nixed the deal citing reduced competition in the aerospace industry that would result from the merger. Honeywell also makes engines for small aircraft and helicopters.

Most analysts believe the acquisition of Smiths Aerospace is unlikely to be turned down by EU authorities given it has fewer aerospace revenues than Honeywell and that the deal is complementary for GE, meaning there is little overlap between both companies' product portfolios. However, UBS analysts wouldn't rule out an anti-trust investigation by the EU, noting regulators' concerns that the Honeywell deal would have allowed GE to bundle its engine and avionics offerings to "gain an advantage against other competitors."

GE Chairman and CEO Jeff Immelt said he doesn't foresee obstacles to the acquisition and pointed out that his company has had 16 deals approved in Europe since 2001.

Smiths Aerospace, which had $2.4 billion in sales last year, is a first and second tier supplier of cockpit avionics, electrical power systems, aircraft mechanical systems and engine components. Over half of its business is with military customers. Key aircraft platforms include the F-22, F/A-18, F-35, Apache Longbow and Eurofighter Typhoon on the military side and the Airbus A380, A320, Boeing [BA] 737, 787 and 767 Tanker aircraft on the commercial side. GE Aviation had $13.2 billion in sales last year.

Smiths Aerospace's main competitors in the aerospace market include Goodrich [GR], Honeywell, Rockwell Collins [COL], France's Thales, and United Technologies [UTX] Hamilton Sundstrand division.

Smiths Group cited several reasons for divesting its Aerospace business including the increasing need for more capital to compete in the industry and the growing importance of "supplier scale" to prime integrators. Another reason for exiting the business is the increased risk suppliers are being asked to take on in the development of new aircraft, UBS analysts said.

For GE, the deal would not only expand its product offerings but also give it scale across the aviation portfolio.

"We think there could be future synergy as GE is able to boost expenditures for R&D (research and development) and offer a more complete package of aviation products and services including leveraging GE's aircraft leasing business' global relationships (GE is the largest aircraft lessor in the world)," Merrill Lynch analysts said. About 25 percent of Smiths Aerospace revenues are from the military and commercial aftermarkets.

If the deal is approved, about two-thirds of Smiths Group will be comprised of its Medical business and the Smiths GE Detection JV. Smiths plans to return about $4.1 billion of the net proceeds of the sale to its shareholders.

Smiths GE Detection would be the largest security detection business globally at over $1.1 billion in annual sales. Smiths Detection, which has a slew of products it sells in the United States and internationally, had about $808 million in sales last year compared to the $330 million of GE's Homeland Protection business. However, GE's business has superior earnings performance as a percentage of sales, as its contribution to the joint venture had $110 million in earnings before interest, taxes, depreciation and amortization compared to Smiths' $167 million.

GE's primary contribution to the joint venture would be its Computed Tomography (CT)-based Explosives Detection Systems for checked baggage at airports in the United States and internationally. GE competes against L-3 Communications [LLL] both domestically and globally and against Reveal Imaging Systems domestically in this market. Smiths Detection doesn't offer a CT-based X-ray system and has probably been eyeing a way to snare capability here.