BAE is staring down a barrel

As deals backfire, Heather Tomlinson asks if casualties may be claimed at the defence giant

The Ministry of Defence are bastards," whispers a City analyst, referring to the MoD's negotiating tactics when buying arms, warships and tanks. "They drive a hard bargain and drive down costs. But it is good news for taxpayers."

It isn't quite so good for the pension funds and individuals who hold shares in BAE Systems, the UK's largest arms manufacturer. Last week the share price dived towards a nine-year low when the company announced that two of its key contracts with the MoD would cost more and take longer to fulfil than it had expected. The problems threaten the future of one of Britain's largest employers.

One of the projects, to build new versions of Nimrod surveillance aircraft, has already cost the company £300m more than it had budgeted for. The other troublesome contract is to build three Astute nuclear submarines for the Navy. BAE was scant on detail on why the delays have occurred or by how much its profits will be hit.

As the MoD is encouraging foreign companies to compete for its billion-pound orders, it is suggested that BAE might have been too keen to win.

"They have been over-ambitious in their bids. I believe they were so eager for contracts they have been prepared to cut things to the bone," says Mike Witt, the deputy editor of "Defence Analysis", an industry newsletter.

Investment bank Goldman Sachs describes the Nimrod fiasco as "alarming" and estimates that BAE could have to fork out a further £800m for the two contracts and halve its dividend to shareholders. Goldman talks of a lack of confidence in the management and predicts that £1.5bn of cash will leave the company between now and 1995. It has called for radical action to stem the outflow.

The bleed of cash could be connected to well-publicised problems with some of BAE's products. The British Army's SA80 rifle malfunctioned in desert conditions and required an expensive overhaul. There have also been delays in the delivery of new Storm Shadow long-range missiles, Sting Ray torpedoes and Type 45 destroyers. The last two of these, along with Astute, were deals that BAE took on when it bought GEC Marconi in 1999.

These problems may weigh on the minds of ministers when they decide who will win a £10bn contract to build two enormous aircraft carriers for the Royal Navy. BAE is head-to-head with Thales, a French defence company, for the lucrative deal, and the competition is fierce. BAE declares that its ships will be better and that it will secure British jobs. But Thales says it will be able to do the job more efficiently, and claims it will also build the craft entirely in the UK.

Alongside these negotiations, BAE and the MoD will be talking about how to alleviate the financial problems of Nimrod, so the reminder of BAE's poor performance may further focus the minds of government advisers.

Although the problems faced by BAE are principally in the UK, the company is now a global arms supplier. It sells more goods to the US than it does to the UK. The Middle East as a whole and Europe also spend more on BAE goods than the UK Government. In fact, Saudi Arabia was a significant factor in the rescue of British Aerospace, as BAE was known in the early 1990s. The company avoided going bust by a whisker, and needed £432m from investors to stay afloat. It was helped in this by a deal to sell King Fahd £5bn worth of Tornado aircraft – a contract personally brokered by the then Prime Minster John Major in 1993.

But now the cash flows from the lucrative contract are drying up, and New Labour, despite its "ethical foreign policy", has taken up the mantle of international arms dealer. Tony Blair himself has tried to encourage India to buy BAE's Hawk jets, despite loud protests about the morals of selling arms to a country at risk of war with its neighbour, Pakistan. The defence minister Lewis Moonie said earlier this month: "I can assure ... that we are working hard, as we have done continuously, to try to help BAE to secure orders for Hawk abroad."

Shareholders can't change the Government's ministerial sales people. However, they can change the management of BAE. John Weston was dumped as chief executive in March this year. And if the new man, Mike Turner, and the former chief executive and current chairman, Sir Richard Evans, are seen to be responsible for this new trauma, more scalps could be taken.

The sense of fury in the City can be gleaned from the tough talk of investment bank analysts, who are usually very backwards in coming forwards with their views. But French bank BNP Paribas described BAE's contract execution as "disastrous", while Goldman Sachs states: "We believe that it is now appropriate to assess BAE both with far more radical management options and, potentially, under new management and or ownership."

Investors might hope for a bid but the only possible buyers will be foreign and require the Government's approval. According to Mr Witt at "Defence Analysis", two potential bidders are the US companies Boeing and General Dynamics. "That's the only way out I can see," he says.

A rescue by the Americans might be embarrassing for the Government, which could have to fall back on increasing the political sales patter. In these times of high political tension around the world, that could be both difficult and highly controversial.

BAE's problem projects

Sting Ray torpedo

A contract to increase the capability and length of service for the lightweight torpedo was won in 1996. However, the original cost of £147m has ballooned to £190m, and delivery is delayed.

Storm Shadow missile

The new long-range bombs were due in service in August, ready for any action in Iraq, but the delivery has been delayed until November next year. A BAE engineer tried to sell its secrets to the Russians but was trapped in an MI5 sting.

Nimrod aircraft

BAE won the £2.8bn contract to upgrade the Nimrod surveillance aircraft in 1996. It has already cost BAE £300m and will cost more. It was originally to be delivered in April but is now unlikely to be completed before 2006.

Astute submarines

In 1997 GEC Marconi won the contract to build three new nuclear-powered subs for £2.7bn. Last week BAE said they would be delayed in delivery and cost more, but it is not known by how much.

Eurofighter

BAE is one of the contractors on the project. The plane's original delivery date was the end of 1998, but the Royal Air Force has yet to receive them.

Future aircraft carriers

Fighting French group Thales for a £10bn deal, BAE fears the problems on Nimrod and Astute will encourage the MoD to look across the Channel.

Source: National Audit Office.