Foray into the sub culture: BAe may have made a winning play in its bid for VSEL, but rival Lord Weinstock of GEC (below) could still gain ground with a rival offer - win or lose. Richard Phillips explains why

THIS week's pounds 478.5m agreed offer for VSEL by British Aerospace brings to an end speculation over the continued independence of Britain's only nuclear submarine maker. Floated in 1986 after an interlude as a nationalised business, the company has been building submarines at its Barrow yards since 1886.

All that remains to be seen now is who will become VSEL's new owner - BAe, or its arch- rival, GEC.

This weekend, GEC officials have been weighing the merits of a higher counter-bid. Intervention from a foreign bidder is out of the question on grounds of national security.

BAe's bid reflects the shrinking pool of UK defence companies - a trend evident globally. There is also a paucity of options available to BAe and GEC. Constrained by the peculiarities of the defence market, they are unable to expand significantly in Europe. Their only choice is to buy British, and hope they can sell the acquisition's products into world export markets, where both companies are major players.

The commercial logic is straightforward. In GEC's case, it also owns the Yarrow shipyards, which would fit neatly with VSEL's Barrow-in-Furness yards.

BAe, by contrast, wants a presence in naval projects to complement its leadership in air and land systems. BAe is also known for its project management capability; much of its business is in lower-tech hardware rather than sophisticated electronic systems. Moreover, VSEL, which has relied in the past almost entirely on MoD contracts for the bulk of its business, hopes to piggy-back on BAe's expertise as an exporter to win overseas orders. As Chris Avery, defence analyst at Paribas Capital Markets, points out: 'VSEL on its own has no credibility overseas - under BAe it has unbelievable credibility.'

More compelling is the financial logic of the deal. VSEL brings with it an attractive dowry: a handsome pounds 288m net cash kitty, which would reduce the enlarged group's gearing from 39 per cent to 10 per cent. BAe can also benefit from attractive tax breaks which will shelter VSEL's profits and enhance BAe earnings per share. BAe's paper offer values VSEL at pounds 12.60 a share, or pounds 11.40 for those who opt for the cash alternative.

Sources close to VSEL admit the company did not see a long-term future for itself as an independent concern. Although pre-tax profits have shown a steady upwards trajectory over the last six years, from pounds 17.1m in 1989 to pounds 61m in the year to 31 March 1994, gains have been much lower in the underlying business. VSEL's figures have been boosted by changes in depreciation, and growing interest from its cash pile.

While the company has a secure cash flow at present from the construction of three Trident submarines, that business will have elapsed by the turn of the century. There are concerns the Batch 2 Trafalgar will come too late to ensure a smooth upward path in revenues. The remaining 6000- strong Barrow-in-Furness workforce would certainly be under threat.

Institutional investors look willing to accept the deal. It represents a 30 per cent premium over VSEL's share price of pounds 9.68 before it was announced.

'The terms seem right, and the bid is a step forward in BAe's aim to become an integrated defence contractor,' says David Rough, investment manager at insurance company Legal & General. He adds this deal is unlikely to be the last by the company in the sector.

BAe shares were up 3p at 470p on Friday, and have risen 11p since the deal was announced, buoyed by enthusiasm over the financial benefits it may generate.

But GEC is still lurking in the wings. The declaration by its managing director, Lord Weinstock, on Thursday under Stock Exchange rules of being a 'bona fide potential offerer' may not be all it seems.

Analysts are sceptical that GEC can enter the ring at this late stage - especially when the VSEL share price was as low as pounds 4 in 1992.

Observers believe Lord Weinstock's pronouncement is no more than a diversionary tactic. While VSEL management worry their time-consuming negotiations with BAe will come to nothing, Lord Weinstock can relish the turmoil he has unleashed. Nor will he come away empty handed. As a potential bidder, VSEL has to give GEC full access to all the information it supplied to BAe before the offer announcement. That includes management accounts, budget forecasts and cash flows over the coming years.

It is not unknown for rivals to gain knowledge of their competitors' activities through the pretext of seeking information to weigh up a bid. What is highly unusual in this case is that GEC is also a rival bidder for the Batch 2 Trafalgar submarine contract, worth up to pounds 2.5bn.

The information could provide GEC with an unrivalled insight into how to structure its bid financially. GEC refuses to comment on the potential conflict of interest. VSEL's advisers say GEC will not be provided with confidential information. But the suspicion remains that whatever GEC obtains, it can but help its cause.

Batch 2 Trafalgar is Britain's hunter-killer nuclear submarine. It is an improved version of the Batch 1, the last of which was commissioned in 1991.

Batch 2 will be vital to VSEL's revenues into the next century. It is also a mainspring for Aerospace's commercial thinking behind its offer. In June the Ministry of Defence invited four companies to tender for the post of project manager for the design and build of the new submarines. They were Vickers, GEC Marconi, BAe and VSEL. The contract will be awarded in 1996, with the first deliveries due by 2000.

VSEL, as the builder of the Batch 1 Trafalgars, is almost certain to secure the majority of the construction work, and much of the design work, regardless of whether it wins the overall project manager role. Its status as the only authorised nuclear-powered submarine maker virtually guarantees this.

GEC's knowledge of how VSEL - which boasts far more expertise and experience in submarines than any of the other companies - sees the contract's profitability work out may be enough to give it the edge when tenders are submitted in mid-1995.

It is an irony not lost on VSEL management which, following GEC's arrival on the scene, has imposed a blanket embargo on further comment, given what it calls the 'sensitivity' of this latest twist. A London fund manager said of GEC's potential conflict: 'It's a weird and wonderful world.'

GEC faces a tricky balancing act if it is to emerge with its reputation intact. On the one hand it must avoid endangering its relationship with BAe, one of its more important suppliers. On the other, it is hard for it to ignore this opportunity.

The MoD's position in all this is difficult to ascertain. It refuses to comment on hypothetical outcomes. The disappearance of VSEL as an independent company and thus from the tender list is understood to have the Ministry's blessing. Its waiver of the Government's golden share in VSEL to allow the takeover to proceed acknowledges that further savings can be had, despite a shorter tender list. Whether GEC would actually be allowed to proceed with a bid will be decided by the Secretary of State for Defence, Malcolm Rifkind, and the Cabinet.

The Ministry's decision in June to invite tenders for a project manager on the Trafalgar contract continues its recent practice of squeezing more out of suppliers and creating greater competition.

By appointing one company not only does it expect to see savings, but the contractor also shares in the risk - and responsibility - for other suppliers' work.

The MoD's increased cost- consciousness is itself a major factor driving the further consolidation of the UK defence industry. Reflecting this reduction, over the last year alone GKN has swallowed Westland Helicopters, while GEC has mopped up Ferranti. Last week saw the demise of Swan Hunter shipyards, as the group went into receivership, while GKN Defence bought up Hampshire- based Glover Webb, a maker of light armoured vehicles with a pounds 10m turnover. Further out, the UK's two other main defence contractors, Rolls-Royce and Vickers, must now be increasingly under the microscope of unfriendly predators.

Defence businesses worldwide have been hurriedly seeking partners and acquisitions. The mood in the industry is less gloomy than at the fall of the Berlin Wall, when pundits decreed defence spending an anachronism. The reality of President Clinton's New World Order and recent events in Iraq have renewed investors' faith in the sector, and defence stocks have been good performers over the last 18 months.

Nevertheless, the current consolidation emphasises that defence is no longer the pot of gold it once was. Further contraction is inevitable. BAe and GEC are already the UK's two defence titans. Only this year they confirmed they had been in discussions about potential joint ventures. This latest event underlines how both are, to a great extent, operating with one arm tied behind their backs. Next step: a GEC Aerospace merger?

(Photograph omitted)