BAE will be left behind without a safer pilot It is natural to regards any merger proposed by BAE Systems, the UK's biggest defence company, with suspicion. Had it a better record of predicting its industry's future and doing deals at the right price, it would be in less of a pickle. So BAE's latest brainwave - to be taken over by EADS, the Franco-German owner of Airbus, at a tricky time in the defence industry - sounds awfully typical. The company that sold a 20 per cent stake in Airbus when the latter had problems with the A380 aircraft, and ploughed the money into US defence before being hit by Pentagon cuts, is once again dealmaking in haste. Many British members of parliament would like BAE to carry on flying the flag - or to combine forces with Rolls-Royce, the UK aerospace company - rather than choose a European solution. Some investors would prefer it to plough on in defence, paying a big dividend to reward their loyalty. But the EADS merger, in which it would hold a 40 per cent share and oversee the defence side from London, is the best option BAE is likely to be offered. It would take a company with better strategic and dealmaking skills to navigate through the next decade alone. Like the UK and French governments themselves, it is time for BAE to recognise its limitations. Governments, not investors, will ultimately decide the fate of the EADS-BAE deal. In the defence industry, the customer - in the form of air forces, armies and defence ministries - is king. Sovereigns pay the bills, block unwelcome takeovers and insist on their weapons being built by their citizens. The biggest customer - and the most powerful sovereign - is the US. Its defence budget of $740bn dwarfs that of the UK, France and Germany combined. It held 46 per cent of planned spending in 2011, according to the International Institute for Strategic Studies, while the three European countries held 10 per cent. While the US has defence sovereignty, Europe pretends to have it. A European company has to break into the US to stand alongside Boeing and Lockheed Martin. EADS tried and failed last year when it lost the $35bn contract to build US Air Force refuelling tankers to Boeing after an outcry in Congress. BAE's superior access to the US market is its best asset - it is trusted by the Pentagon and 43 per cent of its revenues come from the US. But it paid a stiff price for the status, not only abandoning its Airbus stake but overpaying in 2007 for Armor Holdings, which made armoured vehicles needed in Iraq. With the US, the UK and European countries implementing defence cuts after Iraq and Afghanistan, BAE is nastily exposed. "The reason BAE is looking at EADS is that the deals that it made in the 2000s took it into a strategic dead end: overexposure to defence in general, and US defence in particular," says Sash Tusa, an analyst at Echelon. The UK government could block the deal and insist on BAE finding a British solution, akin to the outcome in 1999 when British Aerospace merged with Marconi rather than DaimlerChrysler Aerospace. The latter merger would have created the European defence company that governments wanted. Instead, they made do with EADS. Such an intervention would be popular with MPs, but short-sighted. Rolls-Royce and BAE are different enterprises - one is in advanced manufacturing and one in defence systems. The fact that they are both British and have headquarters on St James's Park does not turn them into natural partners. If anything, a merger with a US defence company such as Northrop Grumman or Lockheed Martin would be even tougher to sell to MPs. The EADS-BAE deal can be structured to leave BAE intact as a listed British company, holding 40 per cent of the cash flows of the joint operating company, similar to the structure of Royal Dutch Shell. Any US takeover would have to be carried out simply, forming a single company run from the US. "People doing my job have worked for 25 years to structure a two-headed Anglo-US company and no one has managed," says a banker gloomily. With the Pentagon in charge, BAE would be put in its place. Meanwhile, France is the more likely government obstacle to a deal. EADS has operated under a compact among the French state and other shareholders that has, for example, allocated board seats according to nationality. One of the attractions of a BAE deal for Tom Enders, the EADS chief executive, is that it lets him escape from these chains. It would be as wrong-headed for France to interfere as for the UK to exercise its veto. The Pentagon could easily block a deal by imposing a stricter separation of BAE's US operations from its parent to offset increased French influence. This is made likelier by the history of Franco-American suspicion and rivalry in procurement In theory, BAE does not need to merge at all. It could also carry on as an independent, making smaller deals in European and US defence, a strategy known internally as the "string of pearls." Pearls, however, are expensive. BAE's balance sheet is too weak to pay in cash, while its low-rated shares are not much of an acquisition currency. From where BAE stands, thanks to its own decisions, an EADS deal is the best of a limited set of choices. It would bring a degree of managerial freedom, a healthier balance sheet, a calmer and more far-sighted strategic brain at the top in the form of Mr Enders, and some time to fashion a response to defence cuts. No defence merger is easy given the interference of governments and the pressures on the industry. BAE has made its life harder by driving into a cul-de-sac. A deal that gets it out and saves face is, under the circumstances, not bad.