Here's one defence secret BAE Systems isn't keeping: it wants to fly the Stars and Stripes

The arms and aerospace group could burn its European bridges if it succeeds in finding a US buyer. By Heather Tomlinson

At the Paris Air Show, which opens today, the talk will be less about the noisy aeroplanes overhead and more about the political upheavals dogging the global aerospace industry on the ground. The largest and most important trade exhibition of aircraft in the world, the Paris show is more than just a jolly for plane-spotters. Deals are discussed and partnerships sealed behind the scenes, as the executives of the aerospace and arms industries meet to eat and drink at each other's flashy chalets, rented at great expense. And this year, the company everyone will be watching is BAE Systems, the UK's biggest arms exporter, which is making no secret of the fact that it is looking to merge with one of its large foreign competitors.

But the transatlantic rift over the war in Iraq has made any deal involving BAE politically sensitive. Most American companies are scaling back their presence at the air show, following the lead of their government, which has been keen to prevent its senior armed forces personnel from coming to Paris to rub shoulders with the "cheese-eating surrender monkeys".

BAE's dilemma mirrors that of the UK Government. The defence contractor must keep one foot in the Pentagon and the other in Brussels. It has won substantial business in the US, which is now its largest market, but also has numerous joint ventures with the large European manufacturers, such as Thales and EADS.

But as the gulf between Europe and America widens, BAE will find it hard to carry on straddling the divide. So when it comes to its mega-merger, it is looking across the Atlantic rather than towards its peers on the Continent.

To emphasise the point, BAE's chief executive, Mike Turner, claimed last week that a bid from French defence company Thales had been rejected. Across the Channel, Thales denied that any such offer had been made, and it is understood that Mr Turner has already been on the phone to apologise to Thales' boss, Denis Ranque.

Instead, BAE is looking for a deal in the US, the biggest and fastest-growing market for tanks, bombs and other defence products. It appears undeterred by the fact that, with a market value of £4.3bn, it is much smaller than most of its potential partners in the US.

"We think a US merger is more likely [than a European one]," says Ben Fidler, a defence analyst at Deutsche Bank. "It would be consistent with BAE's historic strategy of focusing on the US market. The danger is, to do a deal in Europe would destroy its ability to grow in the US because of the current political relationship between the US and France."

Numerous American companies have been linked with BAE, particularly Boeing, whose chairman Phil Condit came to the UK in March, hinting he was interested in partnerships with British companies. However, detailed discussions with any American party are yet to take place. And some observers question why the US would find BAE's presence in Europe a desirable asset in any case. "There's no money in Europe," notes Francis Tusa, the editor of Defence Analysis, an industry newsletter. "Why would you want to increase exposure to an area that is spending bugger all on defence?"

He suspects bidders might be discouraged by last year's fiasco over the Ministry of Defence contracts to build the Nimrod spy plane and the nuclear-powered submarine Astute, which led to a £750m write-off by BAE. "Why would a US company want to buy a British company that potentially has major deficits on its books?" he asks.

A City analyst, who declined to be named, expresses further doubts. "I can't understand why the US would want to buy BAE," he says. "It doesn't bring technology, because the US has all the technology it needs. Most importantly, more than 50 per cent of group profit comes from a Saudi contract. With the US pulling out of Saudi Arabia because of anti-Western feeling, it seems strange that they would want to buy in there."

BAE wants to do a deal to gain access to US technology, but that will not be easy, since the US has strict rules on the transfer of technology outside its shores. The Prime Minister, Tony Blair, and President Bush are currently negotiating to relax the regulations, but an agreement could take a long time.

Added to that, BAE's unsubtle way of proposing a merger has not impressed its competitors in the US. "[Mike] Turner is like a bull in a china shop," says a source at one potential American bidder. "He keeps putting the ideas out there and everyone keeps laughing at them. The fact they are talking about it is baffling everyone - that's not the way you do things."

Despite the hype, BAE is still working with its European peers. For example, it is in the midst of discussions with Italy's Finmeccanica over a new joint venture in avionics and radar. It already has a joint venture with the company with revenues of €1.2bn (£840m), and is in talks to expand this figure to €3.5bn.

A merger with a company in the US could also lead to huge political repercussions on the Continent. "It's a dilemma: if the UK Government allows BAE to be taken over, it indicates the UK is prepared to buy much more US product, which means it will buy less from Europe, which will upset the Continent," says one City analyst. He adds that European projects like the A400M military transport plane and the Eurofighter could be threatened. "The UK is the biggest buyer of product like the Eurofighter. In [the case of] a number of different contracts, if Europe takes the UK out of the equation, either the unit costs will go up or the project won't go ahead."

Mr Blair is believed to have given initial approval for a takeover of BAE by an American company, but satisfying all Britain's allies and interested parties could prove as difficult as agreeing a Security Council resolution in the United Nations. And BAE needs to "sex up" its proposition before it has any deal to offer.

Potential suitors but no clear path to the altar

EADS

An amalgam of French, German and Spanish defence businesses, EADS has several joint ventures with BAE, including Airbus, MBDA and the Eurofighter. The group is developing the M-51 nuclear warhead for France, and working on a European version of a missile defence system.

EADS tried to merge with BAE in 1999 but failed. With management from three different countries, it already pulls off a delicate balancing act, and a merger with a rival from the UK could upset the apple cart. EADS owns 80 per cent of Airbus, which generates all its profits; BAE holds the remaining stake.

Thales

Thales is a thoroughly French company, although it has succeeded in charming the UK Ministry of Defence after its £1.3bn purchase of Racal Electronics in 2000. Thirteen per cent of its €11.1bn (£7.8bn) revenues now come from the UK, and it only just missed out as the main contractor for the MoD's new aircraft carrier, a project it will share with BAE.

Last week BAE claimed Thales had proposed a merger, but after the French company's unequivocal denial, there were red faces all round.

Boeing

Unashamedly American, Boeing is best known for commercial aircraft such as the 747, but it also makes air traffic control equipment, manages the US missile defence programme, makes the Chinook helicopter and has a large division involved in space technology.

There is some prospect of a deal between BAE and Boeing, although Boeing is so big that BAE wouldn't be much more than its UK division. There would also be political hurdles to jump. The companies' commercial aircraft businesses would present major competition problems - BAE would have to sell its stake in Airbus, which is arguably growing faster than the business of its American rival.

Last week Boeing issued a public apology over a scandal in which its employees stole documents from competitor Lockheed Martin in order to win a contract.

Lockheed Martin

This US colossus runs the contract to make the Joint Strike Fighter, which will be a strong rival to the Eurofighter and to the Gripen fighter aircraft, both projects BAE is currently involved in. A BAE link-up is possible, although Lockheed does not appear to be receptive to the idea, and the two companies have significant interests in fighter aircraft, so some disposals would be likely.

General Dynamics

Based in Virginia, General Dynamics makes Gulfstream aircraft, ships and tanks, and also works on several of BAE's projects, such as the Hawk trainer aircraft, the Eurofighter and the British Army's new communications system, Bowman. Also tipped as a potential bidder for BAE, General Dynamics has just snapped up IT networks company Veridian in a $1.5bn (£898m) deal, so it might not have the immediate appetite for another big deal.

Raytheon

This US company is fresh from winning a $175m contract from the MoD to manufacture a precision-guided bomb. It makes the Tomahawk cruise missile, among others. A merger with Raytheon would probably force BAE to sell off its stake in the European MBDA missile company. Analysts also doubt it has the financial firepower for a deal.

Northrop Grumman

Northrop has deals in the UK for a fingerprint identification service and to network the radio communications of the emergency services, but it is primarily an American defence contractor. It has been deal-hungry recently, and the large acquisition of a rival defence engineer, TRW, could leave the management suffering from indigestion if they made another purchase just now.