Arms maker BAE fights for growth after merger shot down

Its $45 billion merger plan shot down, BAE Systems must now hunt growth elsewhere if the British arms maker is to find the cash needed to sustain big dividends and avert the possibility of a break-up.

CEO Ian King is under pressure to spur the search for new business with a lucrative deal in Saudi Arabia now seen as crucial to bolster the balance sheet.

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The warning signs for the maker of Astute nuclear submarines and Challenger tanks are clear.

Net debt at Europe's biggest arms maker is mounting, and there are ominous signs from the massive U.S. defense market that has powered recent revenues.

The fact it considered a merger with Airbus parent EADS , a company in which it sold a stake in 2006 having balked at a full merger several years earlier, showed how wide-ranging BAE's search for a new strategy has become.

"The genie is out of the bottle now and they cannot put it back," one of the top 30 shareholders in BAE told Reuters.

Armored vehicles used in wars in Afghanistan and Iraq as well as warships and fighter jets for Europe have fuelled BAE's growth and profits. It has extended its reach with deals in Saudi Arabia and Australia.

But Europe's arms purchases are drying up and U.S. and British troops in Afghanistan are heading home, meaning the outlook for BAE, formed in 1999 with the merger of Marconi Electric Systems and British Aerospace, is dimming.

"BAE shareholders, they need to ask management where they go from here because clearly in agreeing to do this merger there was an implicit admission that maybe their focus on defense was perhaps a failed strategy," Societe Generale analyst Zafar Khan told Reuters.

Troops in Afghanistan will go home in 2014 when BAE's last Type 45 destroyer for the Royal Navy is also due to set sail.


Weak prospects for a "big win" to offset slowdowns in such programs are worries for both the company and investors, and analysts agree a upgrading a contract on Typhoon fighter jets for Saudi Arabia must now be at the top of BAE's to-do list.

"BAE really needs the cash from renegotiating Typhoon pricing with Saudi Arabia. Without it total gearing remains high to 2015 (and) we see a decreased possibility of share buybacks," said analyst Sash Tusa at Echelon Research and Advisory.

The deal is worth more than 7 billion pounds and analysts estimate as much as 600 million pounds in cash this year.

Without it, dividends that have grown by 10 percent a year could be in trouble in the near future. Even with it, growth hopes are modest.

CEO King highlighted the program, and a campaign to sell warplanes to Oman, on a call with reporters on Wednesday.

"We have real key prospects in Saudi, in Oman and in other territories," King said, while Chairman Dick Olver said current dividend plans remain unchanged.

But beyond 2012 some see trouble. Bank of America analysts on Thursday cut estimates on BAE's stock price and the dividends it is likely to deliver in 2013 and 2014.


BAE's push into the United States has been the most successful of any European defense firm. Few analysts question setting up shop in a market four times the size of Britain, Germany and France combined.

But that exposure now leaves BAE vulnerable, as the Pentagon lines up $487 billion in spending cuts over the next decade.

Worse, there is a major risk of the figure doubling unless Washington swiftly gets its finances in order.

"BAE are left in a tricky position, closely linked to defense spending with U.S. budget cuts likely and the threat of (further cuts under U.S. budgetary) sequestration looming," said a second BAE shareholder.

"Consolidation would seem sensible in the face of such difficulties, but as we have seen, this is not going to be easy to achieve," he said of the EADS escapade.

Wednesday's collapse of the mooted EADS-BAE merger was blamed on the German, French and UK governments failing to agree terms.

BAE shareholders speaking to Reuters on Thursday were willing to give management time to recover from the affair, but analysts did not discount the possibility of shareholders looking for value through a break-up.

Most said BAE getting taken over in its entirety was unlikely given its size and tough competition rules in the United States where its most likely suitors operate.

But some saw a chance of a buyer looking at parts of the business. "We see a greater likelihood in one of the U.S. groups making an offer for (U.S.-based unit) BAE Inc," said Societe Generale's Khan.

"We believe that BAE should explore all options to maximize value for shareholders, including the disposal of the U.S. business."

Management's more mundane challenges also linger, including BAE's retirement funding shortfall and rising net debt pile.

Net debt of 1.44 billion pounds in 2011 was six times the figure from the year before, while the funding gap jumped by more than 1 billion pounds.

Better cash inflow could come this year, management promised in an interim statement on Thursday, but linked this to securing the Saudi deal. Modest growth in 2012 underlying earnings per share would also hinge on that deal getting done.

(Additional reporting by Kate Holton, Paul Sandle, Sarah Young, Sinead Cruise and Chris Vellacott; Editing by Giles Elgood)