BAe flies back to its future

For the first time, analysts see Britain's big aerospace conglomerate moving in a clear direction. David Bowen reports

ON TUESDAY, British Aerospace threw in the towel. It announced it was not going to top GEC's bid for the submarine and warship builder VSEL. It was an undramatic ending to what many assumed would be a nerve- tingling takeover battle. GEC had replied to BAe's pounds 16 offer with a pounds 21.50 bid, and the aerospace group's investors made clear they did not want their company to dilute their earnings with an even higher reply.

BAe's directors were disappointed - but did they shrug, or did they tear their hair out? How much does the failure really matter to the company? And where does it go now?

When BAe first tilted at VSEL last October, there was a feeling in the City that this was the move of a desperate management. BAe was struggling in a shrinking defence market, and its regional aircraft division was haemorrhaging cash. As VSEL had pounds 300m in the bank, this surely was no more than a disguised rights issue.

Then GEC pitched in, and for two months the companies leapfrogged each other with higher bids. The favoured theory then was that Lord Weinstock's aim was to force BAe to pay so much for VSEL that he would then be able to gobble his rival up at his leisure. But the theorists, as well as the two companies, were stymied when both bids were referred to the Office of Fair Trading.

They were cleared in May, and the gloves came off again for the final swift one-two. If BAe had been as wobbly as it was in October, its failure would have been bad news for the chief executive, Dick Evans, and his team. But it was not. "The circumstances have changed enormously since the beginning of the bid," says Peter Deighton, analyst with Smith New Court. The share price has risen from 457p to 571p, and analysts regard the company more benignly than they have for many years. Weinstock may still attempt to become British Defence plc by launching a bid for the group, but he has lost the chance of picking it up on the cheap. Most important, British Aerospace seems to be heading firmly in one direction for the first time in its 18-year life.

Mr Deighton says three factors have made the difference. First, BAe raised pounds 170m through a rights issue as part of its manoeuvrings during the first bid round. It was supposed to fund a VSEL takeover. Instead, it has been put in its piggy bank.

Second, BAe's figures, announced in March, were better than expected. Analysts were particularly impressed that it was making a profit on its 20 per cent stake in Airbus.

Most important by far, the company finally managed to find a home for its pet albatross - the commercial aircraft division, which makes a range of turboprops as well as the 146 jet (now known as the RJ). In the three years to 1994, the division lost pounds 1.79bn, mainly because it had huge liabilities on its leasing activities. It had tried to link up with Taiwan Aerospace, but talks had broken down in 1993. Then this January, it reached a marketing agreement with ATR, a joint venture between Alenia of Italy and the French Aerospatiale that would save money immediately. More important, analysts saw it as a forerunner for an Airbus-type consortium, nicknamed Minibus, making smaller aircraft.

All this means that the financial drive behind a VSEL purchase has flagged. But what about the industrial and strategic reasons, which BAe had always insisted were paramount? One of the group's main skills is as a prime defence contractor - assembling packages of equipment and organising back- up once it is in place. It could offer aircraft and missiles already - it reckoned it would make sense to have a shipbuilding capability as well.

There was another reason for building ships. Under new Ministry of Defence rules, whoever built the hull would also have responsibility for kitting it out with electronic systems. If BAe was a shipbuilder, it could install its own systems. More seriously, if GEC built the ships, BAe's share of the kitting-out would probably fall.

The City appreciates this potential, but is not too worried that it will now go by the board. "It would have been a big positive if it had got VSEL," says Nick Judge, analyst with NatWest Securities. "But it's not a negative that it hasn't." There will never be another Al-Yamamah, and the big defence buyers at the moment - notably South-East Asian countries - are buying their equipment piecemeal.

BAe could lose business on the kitting-out side - it is particularly strong on software such as command control systems. But, Mr Deighton says, this "wouldn't be tremendously significant". Electronic systems are much more important for GEC, which helps explain its knock-out offer.

The City may be sanguine, but BAe's management cannot be. The threat of a takeover by GEC is still real. The Government has lost interest in national competition between defence contractors and would be unlikely to block the creation of UK Defence plc. GEC is more committed than ever to defence, and has the financial firepower to gobble BAe. Thanks to its rising share price, BAe would be a bigger bite to swallow than it was - its market capitalisation is now pounds 2.4bn - but that is still only a quarter of GEC's.

British Aerospace's best chance of staying independent is by sticking to what it is good at - something it has been signally bad at. For the first 10 years after it was formed as the state-owned "national champion" in 1977, it was little more than a series of local baronies. Even in the mid-1980s, many managers said they worked for Hawker-Siddeley or BAC (two of the companies from which the group was formed) rather than British Aerospace.

Then Professor Roland Smith took over, and BAe headed off in several different directions at once. He bought a raft of companies, some of which, such as Rover, had little to gain from or give to the aerospace operations.

The end of the Cold War brought new pressures, and the collapse of the commercial aircraft business brought the company close to bankruptcy in 1992. But by then the management had at last decided to bring some order to the chaos.

BAe's sale of Rover last year was a big step forward, and other moves have gradually moulded the group. For the first time, analysts can say with some confidence exactly what BAe is. According to Mr Deighton: "It's a defence contractor with an equity interest in commercial aircraft."

To counter the shrinking defence market, BAe has been entering a series of joint ventures with other European companies. These include Eurocopter, a link with Saab to sell the Gripen fighter, and a tie-up with Matra on the missile side. In addition Airbus, for which it makes the wings, is becoming increasingly profitable.

Industrially, British Aerospace seems to make more sense now than it ever has, and the City seems to appreciate that.

"We feel there is quite a way to go with the share price," adds Mr Judge.