Vickers-BAe merger looks near

Arms firm's likely sale of medical systems division expected to pave the way for agreed link-up

Vickers is close to completing the long-awaited sale of its medical systems division in a move expected to lead to an agreed merger with British Aerospace.

The company, whose main businesses are making tanks, Rolls-Royce cars and Cosworth engines, is hoping to announce the sale of the division, which analysts have criticised for not delivering satisfactory growth or profits, when it publishes its half-year results in September.

In June it confirmed negotiations for the disposal of its Swedish medical subsidiary, S&W Medico Teknik, to Artema Medical. Since then observers have been expecting the sale of the remaining businesses, which make incubators and electronic monitoring equipment. The division is valued at pounds 85m-pounds 90m.

No deal has been concluded yet, but it is understood that one of the leading contenders for the division is Smiths Industries, which has extensive healthcare technology interests. A management buyout has also been considered. "The market is expecting to see a disposal of the medical business soon," said Daniel Bevan, engineering analyst at Credit Lyonnais Laing. "At the moment it looks like a division without a strategy." Vickers declined to comment.

Meanwhile, BAe is understood to have dusted off plans to make a takeover bid for Vickers, with a view to getting its hands on the armoured car and tank business to augment its "one-stop shop" strategy for arms export sales. It is understood to have instructed bankers Kleinwort Benson to put together proposals for a share-and-cash offer of about 240p a share, valuing the company at pounds 800m. On Friday, Vickers shares closed 3p lower at 199p, down from 300p last October, on continuing fears over its exposure to sterling; BAe was up 45p at 1486p.

BAe already has an agreement with Vickers to market the latter's Challenger tanks in the Middle East, where Qatar is planning a pounds 500m defence order for British equipment and BAe's close relationship with Saudi Arabia resulting from the Al Yamamah contracts could prove useful.

The companies are also collaborating with Lockheed Martin and General Dynamics of the US on a bid for the next generation of armoured reconnaissance vehicle, known as the Tracer or "battlefield taxi".

If BAe's approach leads to a full bid, the defence company would be unlikely to retain the Rolls-Royce car and Cosworth motor-racing engine businesses. The former might be sold to BMW, which has long expressed an interest in owning the prestige British marque and already supplies engines to Rolls-Royce.

Cosworth, which is expanding into engine manufacture for mainstream car makers, could be the subject of a management buyout.

BAe has also retained political lobbyists to liaise with the Government on the political implications of a merger. If BAe and Vickers were to combine operations, there would inevitably be rationalisations and job cuts. Vickers's two Challenger tank factories, one in Leeds and the other on Tyneside, are seen as particularly vulnerable. Even if the company is not taken over, one of the factories may have to close for lack of export orders for the Challenger after its MoD order is completed in 2001.

The timing for BAe is better than for Vickers. The latter's share price has been in the doldrums for nine months, driven lower by worries over its exposure to sterling and the profitability of Rolls-Royce, whose sales increased in the first half of the year but which is investing heavily in a new model, the first all-new Rolls in 15 years. Vickers warned in April that its half-year profits would not top last year's pounds 31.8m.

Sources within Vickers confirmed that it was seeking a long-term partner for its armoured vehicles division. Analysts believe it is keen to resist any takeover approaches until it can deal from a position of strength. It is still awaiting final testing approval on its Challenger 2 from the MoD, and every delay adds to the financial strain as it builds up stocks of the tank.