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LONDON (Reuters) - BAE Systems (BAES.L) needs its proposed merger with Airbus parent EADS EAD.PA to succeed if it is to avoid being cast adrift as a company without a clear strategy in a shrinking industry or a takeover target for predatory U.S. rivals.
If the planned $45 billion merger between the British defense group and the European aerospace giant does not go ahead, BAE could look to do a deal with a U.S. group, sell off its standalone U.S. business or remain alone trying to squeeze growth from the contracting global defense sector.
Europe's biggest defense deal in a decade faces many hurdles, including a row over the proposed 60/40 EADS-BAE ratio, how to ringfence top-secret projects and how to satisfy governments keen to safeguard EADS operations in France and Germany.
"BAE see their defense earnings going down, what do they do about it? They either get into bed with someone going up like EADS or they team up with someone who can help them rip a load of costs out and get economies of scale like a Rockwell Collins (COL.N), a General Dynamics (GD.N) or a Lockheed Martin (LMT.N)," said an equities manager at a British investment house holding a stake in BAE.
"The conspiracy theorists say BAE are hoping to flush out a bid from one of the U.S. prime contractors."
Such plans could, however, be scuppered because of the U.S. government's reluctance to see more consolidation among their prime contractors and competition reduced. Some analysts believe this attitude could change given that BAE is one of the biggest foreign suppliers of weapons to the Pentagon.
"BAE's strategy has taken it deep into UK and U.S. defense but both of those markets are in deep trouble over the medium-term but at the moment doing nothing is not really an option for BAE," said Societe Generale defense analyst Zafar Khan.
If the merger falls foul of the many political and regulatory obstacles in its way, BAE will be left stranded and Ian King, its chief executive of four years, will face tough questions about his vision for the company, both past and present.
"BAE doesn't have a 'Plan B' as such, it's the deal with EADS or back to trying to drive growth from defense and cyber, which is pretty limited," said a source close to the British contractor.
In its most recent annual report BAE Chairman Dick Olver said the group's main strategic aims included developing its export business, building on its large geographic footprint and pushing growth at its cyber security arm.
"BAE Systems maintains a well-defined strategy with a defense focus at its core, but with the flexibility to adapt to changes in the business landscape," wrote Olver.
"BAE Systems will continue to keep its strategy under review and will move to adjust its portfolio of businesses where it is in the interests of shareholders to do so."
BAE is precluded from making statements that relate to the proposed EADS merger because of UK takeover panel rules.
In 2006, BAE sold its remaining 20 percent stake in Airbus for $3.5 billion to fund its big move into the then booming U.S. defense industry.
It had created a standalone U.S. business, BAE Inc, a year earlier which has since become one of the largest suppliers of weapons to the United States.
BAE Inc has grown through acquisitions and now competes toe-to-toe with prime U.S. contractors such as Lockheed, Northrop Grumman (NOC.N) and Boeing (BA.N). It reported revenues of $14.4 billion last year - around half of BAE total group sales.
"If a merger doesn't happen BAE are basically in play and a U.S. tie-up is possible but in that scenario I think BAE should sell its U.S. business," said Societe Generale's Khan, who believes that BAE Inc could fetch up to 10 billion pounds ($16.20 billion) on a debt free basis.
BAE Systems has a market capitalization of 10.7 billion pounds and debt of 1.23 billion pounds as of June 2012.
BAE Inc, however, expects U.S. defense spending cuts to hit its business in the coming years so any sale would need to happen sooner rather than later.
The United States, by far the largest market for weapons, already has plans in place to cut $487 billion from its defense budget over the next decade, while Congress could also make a further $500 billion in military spending cuts in January under a process known as sequestration.
EADS is keen on a deal to balance its civil aviation exposure with more defense work, while BAE would gain access to planemaker Airbus, allowing it to diversify at a time when defense budgets around the world are contracting.
In recent years BAE has been throwing cash into its cyber security business, Detica, to help offset budget cuts and contract losses across its more lucrative traditional business of fighter jets and warships. This has failed to plug the hole.
BAE bought Detica in 2008 and has since pushed the cyber crime-fighting business into the commercial arena. It handles data and national security information for governments and is expanding further into telecoms, media and financial services.
Part of the Eurofighter consortium that lost out on the sale of 126 jets to India earlier this year, BAE expects to deliver only modest growth in 2012 - and that hinges on talks to renegotiate a jets deal with Saudi Arabia - one of its five 'home markets'.
BAE has cut thousands of jobs in recent years to combat spending cuts. Headcount at its land and armaments business, where sales fell 40 percent last year reflecting the end of a key vehicle program and reduced military operations, has halved since 2009. It plans to cut at least 2,000 jobs as Typhoon orders slow.
"By considering this deal, has BAE admitted that focusing on U.S. defense and cyber security was flawed and won't deliver real growth in the medium term? It looks like it," said a fund manager holding BAE stock, who wished to remain anonymous.
If the deal with EADS goes through, BAE's past forays into the automotive, construction and support services sectors in search of growth and reduced reliance on the defense sector will become a distant memory.
Since its privatization in the 1980s, British Aerospace, as BAE was then, has bought and sold mass market UK carmaker Rover, Dutch construction firm Ballast Nedam, German naval systems business Atlas Elektronik and its own aerostructures arm.
BAE is still chopping and changing today. It has hired consultancy firm LEK to review options for its British shipbuilding business including the possible closure or sale of one of its three shipyards in Scotland and southern England.
The British government holds a ‘golden share' in BAE, granting it the right to block any deal, although Prime Minister David Cameron has made positive noises about the merger. If a U.S. suitor made a play for BAE Cameron would be unlikely to block a deal because such a deal would only strengthen Britain's ‘special relationship' with the United States.
In a column in Britain's Daily Telegraph newspaper senior Conservative MP Bernard Jenkin urged the British government to "use its golden share to force the break-up of BAE, to ensure that key assets are owned by UK companies, and to create a more fragmented, entrepreneurial and creative set of businesses, to serve our interests and to export to the world."
Espirito Santo analyst Ed Stacey believes it would be difficult for King, who has a strained relationship with many of BAE's top shareholders, to remain as CEO if the EADS deal fails.
"It would be tough for King to go out on a roadshow saying he is completely committed to his strategy and is happy with his portfolio if the EADS deal doesn't happen," he said.
BAE's shares are at 321.30 pence, back below their price when news of the deal was leaked. They initially jumped but fell back on concern about political and regulatory barriers.
The main hurdle for King, though, is just getting the deal done one way or another.
"The risk is that everyone walks away and BAE is left like the emperor with no clothes. If they do a deal with EADS, King has won them a massive get-out-of-jail card. If they don't, the company is very exposed," said the BAE investor and equity manager.
($1 = 0.6174 British pounds)
Additional reporting by Sinead Cruise and Chris Vellacott