* South African state weapons firm Denel in crisis
* Saudi Arabia makes $1 bln bid for partnerships, equity
* Murder of Saudi journalist Khashoggi complicates deal
By Alexander Winning and Joe Bavier
JOHANNESBURG, Nov 20 (Reuters) - Loss-making South African arms maker Denel has a problem as it fights to survive. Its potential saviour is Saudi Arabia, now drawing fierce criticism following the killing of journalist Jamal Khashoggi.
But after being mismanaged for years and tainted by a far-reaching influence-peddling scandal, state-owned Denel now needs the kind of help that the deep-pocketed Saudis can provide.
Reuters analysed five years of South African arms export data, spoke to former and current Denel employees and obtained internal Denel presentations on plans to rescue the company.
What emerged is that Saudi Arabia and its allies account for almost half of South Africa's recent arms exports and a significant portion of future orders.
So rejecting Riyadh's $1 billion offer could severely hamper efforts to save Denel, which relies on foreign sales for more than 60 percent of its revenue.
Saudi Arabia is seeking a broad partnership with Denel that would include acquisition of the company's minority stake in a joint venture with Germany's Rheinmetall.
The Saudis - on a drive to build a domestic arms industry as traditional suppliers worry about its human rights record - are keen to close the deal by the end of next month. A source with knowledge of its offer said the kingdom could take its business elsewhere if that does not happen.
Some Denel employees are also keen on a tie-up, seeing it as the only way to rescue the firm, which is struggling to pay salaries. But some South African officials are concerned about doing business with Saudi Arabia.
"Denel depends on the deal. The entire industry depends on the deal," said Helmoed Heitman, a defence analyst. "I think it's 50/50. The pragmatists want to go in, but the Khashoggi thing is bad PR."
With President Cyril Ramaphosa and the ruling African National Congress facing an election next year, the deal promises to become a political issue.
South Africa's main opposition party, the Democratic Alliance, says the Saudi offer should be rejected.
"Putting our state defence firm at the disposal of a murderous despot would make the whole nation complicit in the human rights atrocities of the regime of Saudi Crown Prince Mohammed bin Salman," said DA lawmaker Stevens Mokgalapa.
"That there are negotiations to consider this at all is an indictment of the approach of the Ramaphosa government to international human rights violations."
Saudi Arabia denies that the crown prince ordered Khashoggi's killing.
Denel owes its existence to South Africa's own dark past.
Its direct forebear, Armscor, was forced to produce nearly all of its own defence and security hardware in response to sanctions on the apartheid government.
It's that expertise that is now so attractive to Saudi Arabia as it seeks to build its own industry, Andreas Schwer, head of the Saudi state defence company, SAMI, told Reuters.
"South Africa is very integrated in their capabilities because they had to become quite independent," he said last month. "We believe South Africa can offer us more than just products. They can help us on this journey."
Denel - formed in 1992 - only started to turn a regular profit from 2011 after being restructured several times. But its financial position remained weak as it used profits from some divisions to subsidise others.
In 2016 senior management became embroiled in a corruption scandal involving friends of former president Jacob Zuma, the Gupta brothers. In response, banks pulled lending. The company recorded a 1.7 billion rand ($122 million) loss - its first in eight years - in the financial year that ended in March.
Denel's new management is working on a turnaround plan to secure new funding and exit some loss-making business units, like satellite development and its Pretoria Metal Pressings foundry, a presentation seen by Reuters showed.
It also wants to cut its salary bill by 20 percent and achieve cost savings of between 157 million and 608 million rand in each of the next five years, the presentation showed.
But it missed out on additional state funds in last month's budget, and labour unions reject wage cuts. A cash crunch has become so dire that the company cannot provide toilet paper to some employees, and production lines sometimes stand idle as payments to suppliers fall behind.
Members of the National Union of Metalworkers of South Africa, which represents a quarter of Denel's 4,000-strong workforce, marched to the public enterprises ministry this month to demand a 7 billion rand ($500 million) bailout.
Insiders say even that would be little more than a stopgap.
"The machine has stopped," a former Denel executive told Reuters. "I can't see how Denel can pull itself up by its bootstraps without an equity partner."
Ramaphosa appeared open to bringing in a partner to bolster Denel when he acknowledged the Saudi bid earlier this month.
Foreign Minister Lindiwe Sisulu said any deliberations over a potential deal would be based on South Africa's values.
"Our common religion is human rights. We have suffered too long to ever veer away from that religious belief," she told journalists last month.
But Khashoggi's death has created a dilemma.
Asked about the killing, Ramaphosa told reporters: "We are hoping that they will deal with the matter speedily so that the truth will come out."
The United States has announced sanctions against those believed to have been directly involved. Germany is halting arms exports to Saudi Arabia until it explains the killing.
It's the kind of backlash that Riyadh - under fire since 2015 over its war against in Yemen - has long feared and it explains why the government is building its own arms industry. It's also why it has turned to South Africa.
"South Africa's export policy was always stable and robust ... and we need very reliable partners on the political side, on the export policy side. Partners who do not change their minds," SAMI CEO Schwer said before Khashoggi's murder.
In 2013, South African sales to coalition allies Saudi Arabia and the United Arab Emirates made up around 9 percent of total arms exports, a Reuters analysis of data shows.
Since the Yemen war began, South Africa has sold the two countries military hardware - armoured vehicles, sniper rifles, bombs, mortars and surveillance equipment - worth 4.6 billion rand, or 44 percent of total arms exports.
But what might have appeared a natural arrangement to save Denel now appears fraught.
Despite apparent government enthusiasm to do business with Saudi Arabia and Denel's pressing need for financial rescue, not everyone is open to the kingdom's overtures.
Responding to Reuters publication of details of the Saudi bid, Denel chairperson Monhla Hlahla rejected out of hand a sell-off of Denel's stake in Rheinmetall Denel Munition.
"The board of Denel is selling neither Denel, or RDM. I want to be clear about that," she told a local television network.
News of the Saudi overtures has also provoked an outcry on South African social media, but a senior ANC source said the government would not be rushed into a decision.
"It's a strategic asset, so I would be wary about dealing with any foreign country, be that the Saudis or anyone else," the source said.
But despite Ramaphosa's assertion that Saudi Arabia was only one of several suitors, no others have come forward publicly.
"A billion dollars over two or three years would turn around Denel," said Heitman, the defence analyst. "The longer we wait, the less Denel is worth. People will leave and that's where the value lies."
Reporting by Alexander Winning and Joe Bavier Editing by Giles Elgood