* GKN says its Driveline unit could combine with U.S.-based Dana
* Says to consider auto unit deal alongside demerger plan
* Says had "a number of approaches in respect of its businesses" (Adds Melrose comment, extra analyst comment, updates share price)
By Sarah Young
LONDON, March 2 (Reuters) - British engineering company GKN is holding talks with Dana Incorporated over its auto business, opening up a new front in its battle to fight off a hostile 7 billion pound ($9.6 billion) bid from Melrose Industries.
GKN said on Friday that any combination of GKN Driveline with Ohio-based Dana would be effected mainly in equity but gave no details on control.
Seeking to fight off turnaround specialist Melrose's cash and shares approach which it argues undervalues it, GKN already had a plan to separate its main aerospace and automotive businesses by the middle of next year.
News of the potential tie-up between GKN Driveline, whose customers include Fiat Chrysler and VW Group amongst others, and Dana, failed to excite the market however, with GKN shares trading down 1.7 percent at 427.6 pence at 1205 GMT.
Melrose, whose business model is to buy engineering companies, improve their margins and resell them, reiterated on Friday that it believed its management would provide better value for GKN investors.
"We have said all along that this is a decision about which management team can deliver value and long term growth. Today's news appears to show that GKN doesn't trust itself to do so," a spokeswoman for Melrose said.
For its part, GKN said the potential deal with Dana could provide greater value to shareholders than its demerger plan and it would therefore explore it as an option alongside it.
The similar sizes of Dana and GKN Driveline -- Dana's annual revenues of $7.2 billion roughly equate to Driveline's 5.3 billion pounds ($7.29 billion) -- plus the fact that any deal would be done mainly in equity rather than cash, also led some analysts to question the combination.
"Is it the only game in town?" Jefferies analyst Sandy Morris said.
"My snap reaction is I'm not utterly convinced that this is the best option over and above persisting with the demerger...and then seeing what strategic options come along."
Other potential tie-ups could also emerge after GKN said the talks with Dana came about after it "received a number of approaches for its businesses", which as well as Driveline include the aerospace unit, a supplier to Airbus and Boeing, and GKN powder metallurgy, which also supplies car manufacturers.
Under Melrose's offer, GKN shareholders would receive 1.49 new Melrose shares and 81 pence in cash for each GKN share, meaning GKN shareholders would own about 57 percent of the enlarged firm. The deal values GKN shares at around 406.5 pence based on current valuations.
The entry of Dana, a maker of axles and driveshafts, into the GKN fray could prompt scrutiny from British lawmakers as some politicians have already expressed worries about GKN ending up in foreign hands.
Britain's defence secretary has said he has "serious concerns" about a change of ownership at GKN, which also makes components for the Eurofighter Typhoon combat jet, and lawmakers are due to quiz both GKN and Melrose executives about GKN's future on Tuesday.
GKN cautioned that the discussions with Dana may not lead to any transaction and its board advised shareholders not to take any action in relation to the Melrose offer.
Dana said in a separate statement on Friday that it was in talks regarding "a potential transaction involving part of GKN's business."
Melrose shareholders are due to vote at a March 8 meeting on the potential acquisition and the turnaround specialist's plan to issue shares to help to finance the GKN bid.
GKN also on Friday issued a second statement to say it was in talks with its trustees over what a possible demerger of its business would mean for its pension schemes. It had previously warned that Melrose's bid could hit its pension.
It said it would make a 160 million pound contribution to the scheme upon demerger. ($1 = 0.7265 pounds)
Reporting by Sarah Young Editing by Kate Holton and Keith Weir