City on watch for resumption of duel over warship maker

THE CITY is looking forward to a full-scale resumption of the bidding war for VSEL, Britain's only nuclear submarine manufacturer, within the next three weeks.

In that time, Michael Heseltine, President of the Board of Trade, is due to decide whether British Aeropsace and GEC can go ahead with their respective bids for VSEL. The belief in the City is that both bids will be allowed to proceed.

The Monopolies and Mergers Commission, which passed its recommendation to Mr Heseltine last week, has had a hard task. GEC's bid was referred to it on the grounds that the company already controls a substantial proportion of warship building through its Yarrow yard. BAe's bid was referred on thinner grounds - essentially that it should not be allowed to proceed while GEC was being held up.

The signs are that the Ministry of Defence is stepping back from its previous policy of encouraging competition in the defence industry whenever possible. If that is so, no serious reasons remain for blocking GEC. Most City analysts think that although some mild conditions may be imposed on GEC if it bought VSEL, they will not be so onerous as to undermine the logic of the bid.

The question is then, simply, who will blink first? Which side wants to buy the submarine maker more?

VSEL's share price is already well ahead of its position when the bids were referred to the Monopolies Commission. Then, both sides were offering £14 a share for the company. Last week, the share price was around £16.10, signalling the market's expectation of a two-way fight.

That price values VSEL at around £600m, a relatively easy bite for GEC with its £2.9bn cash pile to draw on. But BAe, the smaller and financially weaker contender, can also afford this price following a rights issue earlier this year. It can engineer substantial tax write-offs if it purchases VSEL and would like to get its hands on the £250m of cash within the company.

"At £16.50, BAe could still get some earnings enhancement out of VSEL," says Sandy Morris, engineering analyst at NatWest Markets. But some analysts believe the bidding could go as high as £18.00, which would delight VSEL shareholders but probably not the stock market. At that level, the buyer would be deemed to have overpaid. "BAe could pay £18 and still make the takeover work, but it would be too much," says Mr Morris.

VSEL is probably worth more to BAe than its rival. The purchase would strengthen BAe's balance sheet and broaden its business in a steadily shrinking defence industry. The company's management is also generally regarded as having enhanced its reputation since the bidding began last year. The danger is that it might squander this newly won goodwill by paying too much for VSEL.

GEC, too, genuinely wants to buy VSEL to protect its position in warship manufacturing. But it can also afford to play a longer game. At a press conference three months ago, Lord Weinstock, chairman of GEC, refused to rule out the possibility of an eventual bid for BAe, a plan which has been under consideration for a long time. The problem for GEC is that if BAe becomes a more successful company on the back of a VSEL purchase, it will become more difficult, if not impossible, to buy in the future.

In the end, much will depend on the wording of the recommendation by the MMC . If it still insists on the need for competition within the defence industry, GEC would probably have to abandon any thoughts of eventually buying BAe.

But if there seems to be no objection to such large-scale consolidation within the industry, Lord Weinstock may be content to let VSEL slip away and wait for the bigger prize in two to three years. Either way, VSEL is only one battle in a much larger war between the two defence giants.