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What Next for BAE Systems?

LONDON -- Well, that was a lot of fuss and bother about nothing.

The other month, BAE Systems' (LSE: BA.L  ) proposed merger with EADS was all over the front pages of Western Europe's newspapers after the negotiations were leaked. Then it became clear last week that a deal could not be done, not least because the German government simply didn't like it.

So it's back to business as usual for BAE, you might think. That would be logical: Few were screaming for change before the EADS deal became public. But that doesn't seem to be the market's reaction. The problem with opening a can of worms is that once you've opened it, it's hard to put the worms back.

The legacy of the failed merger has, ironically, become BAE's most immediate strategic challenge. What has changed in BAE's world is:

1. The merger has highlighted BAE's strategic dependence on the shrinking U.S. and U.K. defense markets. That was well-known prior to the merger talks, and most analysts were content to see BAE ride out the cycle, curtailing its cost base while developing new markets. Perhaps the real significance is that the merger talks suggest that BAE's own management does not have confidence in a "go it alone" strategy.

2. The handling of the EADS deal has not won any plaudits for chairman Dick Olver and CEO Ian King, who were hardly the City's favorite duo before this episode. Fund manager Invesco Perpetual, which controls 13% of BAE and is the firm's largest shareholder, was not shy about hauling the company's management over the coals and criticizing the planned merger.

3. The company's strategy looks incoherent. One of BAE's justifications for the merger was to get into the booming aerospace sector and buy back into the Airbus program that it sold its interest in just six years ago. That doesn't demonstrate the long-term perspective you would expect in such an industry. It is in stark contrast to Britain's biggest defense and aerospace play, Rolls-Royce.

4. The breakdown of talks has, supposedly, "put the company in play." What does that really mean? It suggests that the company's management lacks complete faith in BAE's future and might be open to offers. U.S. defense contractors such as Northrop Grumman have been suggested, but they are similarly under pressure from reduced defense spending, and a U.S. bid for BAE would raise big political questions on both sides of the Atlantic.

What are the options now for BAE?

Invesco Perpetual's lead fund manager, Neil Woodford, has called on the company to increase its focus on shareholder value by returning cash through share buybacks. And there is hope that BAE may be able to secure contracts in Saudi Arabia that would provide the cash flow to fund such expenditure. But cash is also needed to reduce the company's pension deficit, which is about half the current 10 billion pound market cap. And a change of leadership might be needed to instill confidence, too. This outcome should be moderately positive for the share price, and good news for income investors.

Becoming the target of an opportunistic bid is not something the company can engineer. If that did happen, shareholders would receive a decent bid premium, but it would hardly be ideal to sell the company at such a low point in the cycle. Nor does it look as if shareholders would support adventurous or sizable acquisitions. That option seems to be closed off.

A breakup of the group is another option. The company might either sell its U.S. operations or concentrate on the U.S. by shedding its U.K. businesses piecemeal. But now is not the best time to obtain good value for defense assets. Disposals might be a dangerous course of action, and not one that is guaranteed to give good value to shareholders.

So the boring option of doing what the company does best -- and rewarding shareholders over the long term -- looks like the most favorable strategy. Perhaps not surprising, then, that this is what is advocated by key BAE shareholder Neil Woodford, one of the U.K.'s best and most renowned fund managers.

And there is much to learn from Woodford. You can find out more about his investing style -- and where he is putting investors' money right now -- within this special report from the Motley Fool: "8 Shares Held By Britain's Super Investor." It's free, and you can get it delivered to your inbox by clicking here.

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Tony owns shares in BAE Systems. The Motley Fool owns shares of Northrop Grumman. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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