UK: UP IN THE AIR AT BRITISH AEROSPACE.

UK: UP IN THE AIR AT BRITISH AEROSPACE. - BAe has been battling since birth on two fronts: internally with its financial flaws and managerial failings; externally with persistent predators. The next two years will decide its fate. Andrew Lorenz

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Last Updated: 31 Aug 2010

BAe has been battling since birth on two fronts: internally with its financial flaws and managerial failings; externally with persistent predators. The next two years will decide its fate. Andrew Lorenz

For the best part of 17 years - almost from the moment it was created by the last Labour government's 1977 nationalisation of the UK's aircraft and shipbuilding industries - British Aerospace has been fighting a battle for survival.

The battle has been waged on two fronts: internally, as chairmen and chief executives have sought, with a general lack of success, conclusively to establish the unwieldy combine as a fully fledged corporate entity; and externally, against several predators of which the most persistent, and by far the most threatening, has been GEC and its legendary managing director, Lord Weinstock. Among the casualties have been two chairmen - Professor Sir Roland Smith and John Cahill - ousted when other directors rebelled against the way they were trying to resolve BAe's structural problems.

Now, the long battle for survival and the intense politicking that has accompanied it are both reaching a crescendo. Within the next two years, the destiny of BAe will be made manifest. Either it will give up its struggle and surrender to the vastly superior financial forces of GEC, or it will at last escape Weinstock's towering shadow and emerge as a key participant in the formation of a trans-European defence equipment superpower. The fact that the first outcome appears more likely than the second is due to a combination of financial flaws and managerial failings that have fed on each other throughout the company's short history.

BAe is a profoundly unstable company because, from the outset, it has been unable to reconcile a fundamental imbalance between its industrial scale and its financial weakness. This deep-seated fault was embedded in the flawed nationalisation which wrested BAe from two main entities: Hawker Siddeley Aviation, part of the Hawker Siddeley engineering group, and the British Aircraft Corporation, which contained the aerospace interests of its co-owners, GEC and Vickers. Keith Hayward notes in his book, The British Aircraft Industry, that nationalisation pre-empted the possibility of a BAC-Hawker Siddeley Aviation merger which 'would have retained the link between aerospace and wider manufacturing and the financial and commercial advantages which that brought'. As a result, Hayward writes: 'The creation of BAe severed the link between aerospace and other commercial activities which would leave it exposed when the company first returned to the private sector.' BAe's present bid to beat a rival offer by GEC and take over VSEL, the cash-rich, Barrow-based builder of submarines is the latest in a long line of attempts to put the company on a sound financial base by repairing its structural fault. It remains to be seen if the VSEL move - inspired by Dick Evans, BAe's chief executive, and Richard Lapthorne, its finance director - proves any more successful than the efforts of their predecessors. If BAe can complete the acquisition, it will have taken a significant step forward; if not, it will be more or less back to where it was under Sir Austin Pearce, the former head of Esso UK, who was called in in 1980 by the Thatcher government to privatise the company.

Pearce thought privatisation would solve BAe's problems. But while the act of floating 51.6% of the shares proceeded smoothly in February 1981, and profits from MoD cost-plus contracts continued to roll in thereafter, Pearce and his colleagues were still struggling to put BAe on a sound commercial footing three years later. The first man to propose that BAe's fundamental shortcomings be remedied by takeover was Peter Laister, the ambitious chairman of Thorn EMI - then a fast expanding military and civil electronics group. Laister's approach to the company and the Government in 1984 was immediately trumped by Weinstock, with a more potent offer that valued BAe at 420p a share but was never formally tabled. Pearce rejected it and the Thatcher government backed BAe.

The privatisation was completed the following February with the £363 million sale of the outstanding 48.4% of shares still held by the state. BAe took the opportunity to strengthen its underfunded balance sheet with a £187 million rights issue, but the beneficial effect of the cash was undermined by continued managerial failings. The retirement, shortly after the privatisation, of several long-established executives from the BAC and Hawker days - including Sir Freddie Page - left BAe struggling almost from its start as a public company to find top management talent.

As a result, it acquired as managing director Sir Raymond Lygo, the former Royal Navy admiral who had joined the group's missiles division, Dynamics, in 1978. 'Lygo had no business experience when he joined BAe but he could be highly egotistical,' says one BAe expert. 'He and Pearce did not get on, and their disunity scarcely helped the company.' Lygo did make some progress in eliminating the group's various baronies by pushing through a reorganisation of the group into only two divisions, aircraft and dynamics. He also started the long-overdue job of streamlining the labour force and launched the expansion of BAe's product base with the £190 million purchase in April 1987 of Royal Ordnance, the state-owned munitions maker. But BAe's progress was hopelessly compromised by the deterioration in relations between Lygo and Pearce. In the end, they largely ceased to communicate with each other and bemused executives had to file identical reports to both chairman and managing director, since they knew that neither would show a report to the other. Lygo's falling-out with Pearce meant that, when the chairman stepped down in 1987, the 'Admiral' - as Lygo was nicknamed in BAe - did not get the top job. Instead, with the Government's approval, the board looked outside for a successor. And that was how BAe's eye alighted on Professor Roland Smith.

Smith's qualifications were dubious in the extreme. A professor of marketing at UMIST, the institute of science and technology in his beloved Manchester, he collected chairmanships the way other people collect stamps. As chairman of House of Fraser, his only association with the defence industry was his much-quoted instruction to Tiny Rowland at the height of Lonrho's battle to control the Harrods group. 'Get your tanks off my lawn,' he told Rowland. But his verbal bravado would have counted for little had Smith's candidacy for the BAe job not been endorsed by some powerful Thatcherites, including - reputedly - Lord King.

Where Pearce had believed that privatisation would be the making of BAe, Smith 'the Prof', as he was known, thought the solution to the group's problems lay in that vogue of the mid-to-late 1980s: diversification. This analysis was sound enough: the company was in two cash-hungry businesses - military and civil aircraft - which demanded huge capital commitments in the form of long-term investment and big customer guarantees. Yet BAe was chronically under-capitalised - net assets the year Smith joined were little more than £1 billion. What BAe needed, Smith knew, was more assets - lots more.

In this he was abetted by Lygo, and to fund their ambitions, they used the fruits of their most lucrative legacy: the Al Yamamah contract with Saudi Arabia under which BAe was supplying Tornado fighter-bombers and other equipment to the Gulf kingdom. Al Yamamah has consistently accounted for about half BAe's defence business - this year its contribution to BAe will be about £200 million in profits and £2 billion in sales, out of a group total of about £6 billion. In July 1988, BAe's Saudi inheritance was further enriched when Margaret Thatcher and King Fahd signed the £20 billion, 10-year Al Yamamah 2 deal for more Tornadoes, plus Hawk trainers and a host of support services. In the event, the aircraft orders outlined in the deal took years to materialise and have yet to be contracted for in full, but the City did not know that and BAe's share price took off like a Harrier jump-jet - vertically. In September 1989, the shares hit an all-time high of 733p.

By then, Smith had taken the biggest and most startling step in his diversification extravaganza: the acquisition of Rover. In one respect the acquisition - which was no acquisition at all, since the Government paid BAe almost £470 million to take Rover off its hands - made brilliant sense. Rover was barely profitable, but it constituted what Smith most wanted: a huge asset. Immediately after the transfer of ownership, he wrote up Rover's asset value from just over £400 million to £1.2 billion, almost doubling BAe's own capital base to £2.2 billion.

Hubris now took hold at BAe. It began to describe itself as Britain's largest manufacturer. Smith considered changing the name of the group to reflect its new, broad industrial spread. His quest for assets continued apace: he started talks about a possible merger with Edzard Reuter's Daimler-Benz to form what would have been Europe's largest industrial combine. But the idea collapsed when the demotic Smith and the cerebral Reuter failed to hit it off. 'Reuter wanted to play Smith some atonal music of his own composition; Smith was more interested in telling football jokes,' recalls a Daimler source.

Left to his own devices, Smith pushed on even more determinedly. In the late summer of 1989, he overrode the advice of Kleinwort Benson and paid £278 million for Arlington Properties, a successful property company with particular expertise in business parks. The rationale for the deal was fine in theory: BAe had extensive property assets which would be liberated by factory closures and streamlining. By developing those assets, BAe could self-fund the rationalisation and even generate a profit, strengthening its capital base. But in practice, the Arlington purchase - made at what proved to be the top of the property market - proved as disastrous as the Rover deal. Nemesis took two years to arrive, but then it struck with frightening speed. One minute - at BAe's annual meeting in May 1991 at London's Marriott Hotel off Grosvenor Square - all was sweetness and light. Not a single shareholder stood up to disturb the early summer afternoon. Yet barely five months later, Smith was out.

The recession destroyed Smith's grandiose design as surely as it undermined many other groups which had embarked on breakneck expansion in the go-go 1980s. Slumping consumer demand pitched the British car industry into the most precipitate decline in its history. Property values collapsed, undermining Smith's Arlington strategy. But the greatest damage was inflicted on BAe's regional aircraft and turbo-prop operations. Not only did sales collapse, but so - crucially - did residual values. The vast majority of the BAe 146 regional jets and the Jetstream turbo-props had been leased rather than sold, so the potential loss to the company, now that the aircraft were flooding back to BAe, was hideous.

With cash pouring out of the company and the balance sheet in peril, Smith played two desperate cards. First, he started talks about a merger with Trafalgar House, the construction engineering and property group. 'If that had succeeded, it would have bankrupted both companies,' commented one leading British fund manager later. Fortunately for BAe, the talks broke down. Next Smith turned to his last resort: GEC. Weinstock was delighted at the approach. The same could not be said for the BAe board, which ordered that the talks be aborted as soon as it found out about them. BAe was forced in September 1991 to make a £432 million distress rights issue. The combination of the clandestine approach to GEC and the financial debacle meant the end for Smith: he was ousted and replaced by Rover's chairman, Sir Graham Day.

Considering he was only in charge for six months, Day made a significant contribution to steadying BAe's sinking ship. In particular, he repulsed a further advance from GEC. So frenzied was the atmosphere at that time - with a nebulous City consortium trying to engineer a takeover of BAe - that the BBC even reported that Weinstock was about to move for BAe. The bid failed to materialise and when Weinstock called him, Day riposted: 'You only want us so that you can solve your succession problem.' The GEC chief was not amused.

But for the first time since 1984, industry and the City had been reminded of Weinstock's long-standing ambition to merge Marconi with BAe's defence business. He had no interest in the rest of the group, including its 20% stake in the Airbus consortium. His whole concern was to cajole or manoeuvre BAe into a position where it would be prepared to play ball with its defence operation.

John Cahill, the former BTR chief executive head-hunted to succeed Day in April 1992, initially viewed Weinstock with suspicion. He changed his mind for two reasons: first, Cahill realised the recovery of BAe was going to be a harder and longer task than he had anticipated. And secondly, he encountered considerable resistance, at both board and subsidiary level, to his efforts to penetrate the impermeable BAe corporate culture.

So Cahill turned to GEC. In the autumn of 1992, around the time he unveiled a near-£1 billion half-year loss, had to delay payment of the interim dividend, and saw the share price touch an all time low of 98p, he deputed George Simpson (then deputy chief executive) to set up a framework for negotiation with GEC on the possible merger of the two companies' defence operations. It took the best part of nine months but eventually a deal emerged. In return for receiving confidential financial data on BAe, GEC accepted a two-year standstill under which it agreed not to use the data for a hostile takeover bid. Unfortunately for Cahill, no sooner had the pre-negotiation terms been signed than news of the merger talks were leaked to the Sunday Times. GEC and Cahill wanted to go on, but the leak gave anti-GEC hawks on the BAe board, led by Lapthorne, the chance to force through termination of the discussions. Most people, including Weinstock and several BAe directors, assumed that the negotiations would restart after a decent interval. But then, in January 1994, BAe agreed to sell Rover to BMW for a net £529 million. This deal freed BAe from a tightening financial stranglehold which was threatening to force it back to the negotiating table with the cash-rich GEC. Without Rover, BAe was not exactly liberated - a fact the City soon recognised, when the BAe share price fell back from its post-Rover high of 5781/2p to well below 500p - but it could at least breathe again. It no longer needed GEC.

Then Cahill was ousted by a boardroom coup led by Evans, and backed by Lapthorne. His departure - he was succeeded by Bob Bauman, former chief executive of SmithKline Beecham - removed GEC's biggest friend in the BAe boardroom, particularly as Evans, who had always got on well with Weinstock, now took a tougher line against a defence merger with Marconi. Instead of the vertically integrated British national champion that a Marconi deal would create, he now argued for horizontal integration with a European combat aircraft maker and prime contractor. Only that, he maintained, could enable Europe to resist the increased competitive pressure that would be exerted by giant American groups which had consolidated rapidly to counter swingeing US defence spending cuts. 'The horizontal moves that are available today will be very major and time-consuming,' Evans said in October. 'The one thing that we cannot allow to happen is for BAe to be marginalised in our core businesses.' BAe believes that its most suitable partner would be the French group Dassault, maker of the Mirage and the Rafale. Critics, such as Weinstock, argue that the fierce independence of the Dassault chief Serge Dassault, and opposition from the French government, would make such an alliance pie in the sky. Still, it is not beyond the bounds of possibility: BAe and Dassault are already working together on the next-generation fighter that will follow France's Rafale and Eurofighter, the four-nation aircraft programme in which Britain holds a one-third stake. And moves by the British and French governments to fuse some of their airforce operations could facilitate BAe-Dassault links. If, as some analysts expect, Dassault and its state-owned rival, Aerospatiale, eventually join forces, then BAe will be even closer to their orbit because of its partnership in Airbus with Aerospatiale. Despite BAe's avowed determination to retain its 20% stake in Airbus, reckoned to be worth more than £1 billion, some close followers of the company believe that, if it ever has to choose between staying in Airbus and establishing itself beyond doubt as one of the global leaders in military aerospace, BAe will have no hesitation in exiting from the commercial jet consortium.

First, however, it will probably have to make a final decision on whether to turn its back on GEC. Many BAe shareholders, let alone members of the UK defence community, have long assumed that a BAe-GEC link-up was only a matter of time. The main significance of the battle for control of VSEL is that, if Evans and Co win, they will be in a stronger position either to resist GEC or to demand a high price from Weinstock for agreeing an alliance.

The timing of the battle heightens its pivotal significance. For the first time, BAe has reasonable hopes of attaining its corporate objective of stripping back to its defence interests and Airbus. Turbo-props are close to an Airbus-style alliance with the Franco-Italian group ATR; regional jets could be injected later this year into Fokker, now owned by Daimler-Benz; Dynamics is on the verge of a joint venture with Matra; and Royal Ordnance will be sold to Giat of France or piecemeal to others. That will only leave BAe's 30% stake in Hutchinson Telecom's Orange mobile-phone business, and Arlington, whose portfolio should be liquidated over time. Internally, BAe is putting the final touches to a sweeping reorganisation which will integrate the group's manufacturing operations into a single, aerostructures unit, and create a springboard for expanding the product base.

Can the new executive team - Evans, Lapthorne, John Weston, head of BAe's defence side, and Mike Turner, close to Evans personally and head of the civil aircraft interests - bring all this off and beat GEC to VSEL? Cynics point out that no BAe management has ever succeeded in its aims. And although his stock is now rising to the point where the City would probably accept him as Bauman's successor, few see Evans as a hard-driving chief executive. 'Dick is a consummate politician, great at the wheeling and dealing and glad-handing that you need in the aerospace industry, with an amazing contacts book of Saudi names and numbers,' says one industrialist who knows him well. 'He would probably make a better chairman than chief executive.' Weston has long been seen as Evans' most likely successor, although neither Turner nor Lapthorne should be discounted.

But none of them stand to exert as much influence over BAe as Weinstock. Whether he gets VSEL or not, GEC will retain abundant firepower to take out BAe. The only question is whether Weinstock has the will to use it. His sole objective is the military aircraft business. But if BAe will not do a deal, or insists on a price Weinstock regards as unacceptable, or starts to make progress with a European counterpart, will Weinstock jettison his innate caution and simply table a full bid? He might not have the field to himself - GKN is one possible rival - but his vast cash resources would make him the prime contender. 'If Arnold sees himself being pushed into a corner by BAe, then he might launch a bid,' says one former BAe manager.

British Aerospace comes of age this year - its 18th. But its destiny still lies in the hands of others - of the British government, of Saudi Arabia, of Lord Weinstock and GEC. The period between now and its 21st birthday in 1998 will almost certainly determine whether this underdeveloped company can ever master its troubled universe.

Andrew Lorenz is deputy business editor of the Sunday Times.

BAe: FINANCIAL FACTS

Sales/profit* (£m)

Sales Profit

Defence 3,963 345

Commercial aircraft 1,580 (162)

Motor vehicles 4,301 56

Property development 166 (17)

Other businesses/HQ 347 (13)

Construction (discontinued) 947 28

Intra-group trading (544) -

Exceptional items - (288)

Interest - (186)

Total 10,760 (237)

Sales by geographical market*(£m)

UK 3,720

Rest of Europe 2,963

Middle East 2,566

US and Canada 635

Far East 539

Australasia & Pacific 169

Africa, Central and S. America 168

Total 10,760

No. of employees 87,400

Shareholders' funds (£m) 1,510

* for year to 31 December 1993.

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