Britain's BAE Systems, which earns nearly half its revenue selling arms to the Pentagon, could end up a takeover target after failing to seal its $45 billion deal with the Franco-German maker of Airbus civilian jets, EADS.

Politically, the deal's failure may hurt British Prime Minister David Cameron, who failed to persuade Germany's Angela Merkel to allow the merger and now faces uncertainty over the future of his country's most important engineering firm.

EADS shareholders mainly expressed relief at the collapse of the deal, fearing for their investment in a successful civilian planemaker as it ventured into a declining defence market. EADS shares (EAD.PA) rose 5.29 percent on Wednesday, while BAE shares (BAES.L) fell 1.38 percent.

The merger's failure is however a setback for EADS boss Tom Enders, who had hoped the merger would dilute the political control that Berlin and Paris exert over his firm.

Britain and France both backed the planned merger, but Germany never warmed to it, despite the companies saying they were prepared to pledge to keep jobs there, allow Berlin to hold a big stake and meet other conditions.

"We started asking ourselves, 'Does this deal really make sense?'" one senior German official said. "The market went down, investors were against it, the synergies were unclear, as was U.S. market access with the big state shareholdings."

BAE, a private company which enjoys privileged access to Pentagon contracts, would have needed Germany and France to limit their control of the combined firm to avoid alienating Washington which does not want foreign states exerting influence over its defence contractors.

"We had clear red lines that we were not willing to go beyond, relative to engagement and involvement of governments," BAE's CEO Ian King said. "If that was going to impinge on our ability to commercially run this new merged organization, and support and develop our existing business, then we wouldn't go to that point, and that is where we are today."

NEGOTIATIONS

Ultimately, German officials said, the parties were unable to resolve the shareholding issue to everyone's satisfaction. Paris wanted to retain the option of going up to 13.5 percent by buying a stake held by French firm Lagardere (LAGA.PA) at a later date. German officials insisted they be able to follow suit.

The British wanted a cap of 10 percent each, concerned that the Germans and French could approach a blocking minority if they went above that level.

Still, the companies believed they could have bridged the differences if Germany was more willing to negotiate.

"France and the UK agreed that Germany have the same stakeholding as France in the merged group. Separately, vast guarantees were given regarding safeguarding national security interests, sites, jobs. The topic of headquarters was being discussed very emotionally, but not an issue big enough to let the deal fail," a source close to the transaction said.

The merger would have created a group employing nearly a quarter of a million people that could better compete with U.S. rival Boeing (BA.N).

Asked whether BAE management felt under pressure as a result of the stormy investor reaction followed by the collapse of the plans, King said: "Certainly not. No more than usual".

Britain backed the deal and has largely supported BAE's case that French and German influence would have to be limited to make the deal work, especially given BAE's vast U.S. business.

"Our view is that for this company as a merged entity to have been successful, it would have needed to be able to operate as a commercial company free of undue control or influence by any single government and that's something that the company evidently has decided it is not able to achieve," British Defence Secretary Philip Hammond said.

The merger never won over either company's shareholders.

Barry Norris, founding partner at Argonaut Capital Partners, an EADS shareholder, said: "Today's decision to terminate the merger talks is a triumph for common sense and shareholder value. Having sunk almost 30 billion euros ($38.70 billion) into new Airbus plane projects, which are only now beginning to break even, it made no sense for EADS to now share this with BAE shareholders.

"Continuing merger negotiations would have resulted in a long battle with shareholders and sustained tension over weak corporate governance. That the problems in executing the deal proved too complex should be a source of celebration rather than regret," he said.

But without the deal, BAE remains exposed to severe cuts in U.S. defence spending as troops finish their withdrawal from Afghanistan. Among its many U.S. contracts, the British firm is the largest supplier of armored vehicles for the U.S. military.

Chairman Dick Olver said the firm would return to business as normal, despite what he acknowledged was a tough climate.

"We have an excellent Plan A, which is driving the company, admittedly in a difficult business environment, and the executives are doing an excellent job," he told reporters on a conference call alongside CEO King.

(Additional reporting by Sophie Sassard, Emmanuel Jarry, Arno Schuetze, Paul Taylor, Andrea Shalal-Esa, Tim Hepher, Mohammed Abbas, Kate Holton, Jason Neely, Philipp Halstrick, Paul Sandle and Sinead Cruise; Writing by Peter Graff; Editing by Louise Ireland)

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