BAE Systems forced to take second look atto Plan A After hatching the most ambitious deal of the year but ultimately failing to secure enough political support to make it happen, BAE Systems, Europe's biggest defence contractor, heads into 2013 having gone back to Plan A. The company's biggest investors disliked the idea of BAE tying up with EADS, the pan-European aerospace and defence company, and appear happy that the tense month-long negotiations of late summer are over. Meanwhile BAE's share price has regained much of the loss it suffered during the wrangling. But defence industry executives say the lost opportunity of getting back into civil aerospace is a big blow to BAE's long-term future. BAE is now back to trying to grow business in areas such as cyber, and in expanding defence markets such as the Middle East, India, and Australia, while cutting costs and keeping up dividend payments. "They are heading towards a cliff," said one senior executive from a defence company that does not directly compete with BAE, noting that its big platforms, especially the Typhoon fighter jet, are struggling to find new markets. The problem for BAE is that it is shrinking together with its major markets, the US and UK. Though it will throw off plenty of cash for a while, enabling it to offer healthy dividends, it is struggling to grow its order book, indicating an uncertain future. In terms of mergers and acquisitions, there are no other obvious candidates willing to take on BAE's £5bn pension hole and the politics surrounding a cross-border deal, bankers say. Alternatively, while splitting up the company would leave it with a decent US business, the stump would be weighed down by the pensions hole, legacy commitments and an uncertain growth story. Growth is not coming easily because BAE's business is becoming increasingly dependent on unpredictable markets, especially in the Middle East. This year the company expects little growth and no improvement in earnings per share unless it signs an expanded contract for jet fighter training with Saudi Arabia. On Wednesday BAE hinted it was having trouble securing that contract signature by year end. It said that if an agreement was not reached before then, it would "reduce the group's underlying earnings per share by approximately 3 pence per share." BAE on Friday announced a £2.5bn contract covering 12 Typhoons and 8 Hawk training jets for Oman. Though the deal was widely expected, it is an important achievement especially in light of BAE's continued trouble in getting its deal with Saudi Arabia signed. Investors and analysts are not complaining yet because BAE is cutting costs by laying off staff and closing manufacturing sites, while proposing a 6 per cent dividend yield. "Although the top line backdrop for defence remains tough, at least BAE holders are being paid to wait until either export orders emerge or until defence budgets bottom out," says Benjamin Fidler, analyst at Deutsche Bank. But not everyone agrees that the US will bounce back quickly and regarding BAE's most important growth market, Guy Anderson of IHS Jane's Defence notes: "Competition is intense with Britain's competitors in North America and elsewhere in Europe also looking to export growth with a keen eye on the Middle East." BAE also hampers itself with its convoluted international structure, one the deal with EADS would have helped to improve. EADS, together with Italy's Finmeccanica, is the other major partner in the Eurofighter consortium that builds Typhoon. In fact, the discussions between Ian King, BAE's chief executive and Tom Enders, his counterpart at EADS, came out of their meetings over what to do with Typhoon. Though those discussions are likely to continue even though the deal to tie together BAE and EADS failed, any consolidation within Typhoon is likely to be slower and more difficult. But for BAE and its peers, Typhoon is yesterday's technology - even if executives will vehemently deny it. The aircraft of the future will not have to have a pilot in its cockpit. So-called UAVs, especially the kind that drop bombs and shoot missiles, are expensive to develop and Europe, given its fiscal challenges, is a shrinking market. That means not all the companies competing in the field will find a buyer to justify their investment. Most executives and analysts believe there will be room for one, at most two fighter jet UAVs and not a lot more for the tactical kind that helps armies scope out their enemies. European makers, including BAE, Dassault and EADS, will face competition from Israel and particularly the US, which is developing several types of unmanned aircraft. With the tie-up of EADS and BAE - both of whom have expensive UAV development programmes - having failed, international partnerships, such as the one that caused so much trouble at Typhoon, will be the order of the day again.