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Arms maker BAE fights for growth after merger shot down

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* Saudi deal now tops to-do list

* Dividend levels seen at risk without new cash

* Merger alerts would-be suitors

By Jason Neely

LONDON, Oct 11 (Reuters) - Its $45 billion merger plan shotdown, BAE Systems must now hunt growth elsewhere if theBritish arms maker is to find the cash needed to sustain bigdividends and avert the possibility of a break-up.

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

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

Net debt at Europe's biggest arms maker is mounting, andthere are ominous signs from the massive U.S. defence marketthat has powered recent revenues.

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

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

Armoured vehicles used in wars in Afghanistan and Iraq aswell as warships and fighter jets for Europe have fuelled BAE'sgrowth and profits. It has extended its reach with deals inSaudi Arabia and Australia.

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

"BAE shareholders, they need to ask management where they gofrom here because clearly in agreeing to do this merger therewas an implicit admission that maybe their focus on defence wasperhaps a failed strategy," Societe Generale analyst Zafar Khantold Reuters.

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

SAUDI LIFELINE

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

"BAE really needs the cash from renegotiating Typhoonpricing with Saudi Arabia. Without it total gearing remains highto 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 analystsestimate as much as 600 million pounds in cash this year.

Without it, dividends that have grown by 10 percent a yearcould be in trouble in the near future. Even with it, growthhopes are modest.

CEO King highlighted the programme, and a campaign to sellwarplanes to Oman, on a call with reporters on Wednesday.

"We have real key prospects in Saudi, in Oman and in otherterritories," King said, while Chairman Dick Olver said currentdividend plans remain unchanged.

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

SWINGEING CUTS

BAE's push into the United States has been the mostsuccessful of any European defence firm. Few analysts questionsetting up shop in a market four times the size of Britain,Germany and France combined.

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

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

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

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

Wednesday's collapse of the mooted EADS-BAE merger wasblamed on the German, French and UK governments failing to agreeterms.

BAE shareholders speaking to Reuters on Thursday werewilling to give management time to recover from the affair, butanalysts did not discount the possibility of shareholderslooking for value through a break-up.

Most said BAE getting taken over in its entirety wasunlikely given its size and tough competition rules in theUnited States where its most likely suitors operate.

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

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

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

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

Better cash inflow could come this year, management promisedin an interim statement on Thursday, but linked this to securingthe Saudi deal. Modest growth in 2012 underlying earnings pershare 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)

((jason.neely@thomsonreuters.com)(0207 542 8825)(ReutersMessaging: jason.neely.reuters.com@reuters.net))

Keywords: BAE GROWTH/