French and Italians in talks to be €12.5bn allies

Defence marriage between Thales and Finmeccanica would challenge BAE Systems and present competition worries to MoD

Thales, the French arms and electronics company, has raised the prospect of a €12.5bn (£8.6bn) merger with its Italian rival Finmeccanica. This would create Europe's second- largest defence group and present a big challenge to BAE Systems.

Thales, the French arms and electronics company, has raised the prospect of a €12.5bn (£8.6bn) merger with its Italian rival Finmeccanica. This would create Europe's second- largest defence group and present a big challenge to BAE Systems.

Well-placed sources said that Thales executives had held discussions with their Italian counterparts over the past few weeks, but the talks were still at a "very informal stage".

The move follows the collapse of negotiations between Thales and EADS, Europe's largest defence group, last year following objections from the British and German governments.

Alex Dorrian, chief executive of Thales UK, said: "I suggest that it is time to look at [consolidation in] Europe. From Thales' point of view we will look at what opportunities there are and see if they fit in with our strategy. We will look at our relationship with Finmeccanica and see how that can develop. There are a number of opportunities going forward."

A tie-up between Thales and Finmeccanica would be controversial. Both companies have a significant presence in the UK market. Thales is involved in the Government's £3bn project to built two aircraft carriers and has bases in more than 60 locations. Meanwhile, Finmeccanica owns helicopter maker AgustaWestland and is in the process of buying BAE Systems' avionics business.

A combined Thales-Finmeccanica would employ 20,000 people in the UK and generate sales of nearly £3bn. This would create a company to rival BAE, which employs 40,000 people in the UK and last year generated sales of £6.2bn.

Defence industry sources said that as well as providing a threat to BAE, the UK Ministry of Defence might take a dim view of a Thales-Finmeccanica tie-up as this would reduce competition. The deal would also require the approval of the French and Italian governments. Just under a third of each company is owned by their respective governments.

Finmeccanica's chief executive, Pier Francesco Guarguaglini, is tomorrow expected to comment on the prospects for the European defence market when he presents the annual results and an outlook for 2005.

Separately, Thales is looking to increase its presence in the UK market, where it has built a strong relationship with the MoD. Mr Dorrian said: "We will certainly look for acquisition opportunities in the UK. We will look at companies in defence, security and service provision - anything that strengthens our ability to be a systems integrator in the UK."

Thales' position in the UK is underlined by its involvement in the project to build the aircraft carriers for the Royal Navy. BAE was originally selected by the MoD to lead the project ahead of Thales. But after considerable wrangling, the MoD has now set up an "alliance" in which BAE and Thales are equal partners.

However, in Freedom of Information disclosure, the MoD has revealed that Thales has so far been paid £96m for its work on the project compared to £86m to BAE.

An MoD spokesman said: "The payments reflect the work done so far in the alliance." A BAE spokesman said: "Although we have more people working in the alliance than Thales, the teams are completely integrated."

The MoD has also revealed that Kellogg Brown & Root, the subsidiary of US construction group Halliburton that was controversially hired in February to help manage the carriers project, will be paid £4m. Its contract will end in July 2005.

But there are fears that the aircraft carrier project is heading for more delays. Contracts are due to be signed in the autumn - in a process called "reaching main gate" - but insiders said that this would not happen until February at the earliest.