The problem was the small size, especially relative to the Hurricane, which also meant it was lower powered than the Merlin, a bad option for the already slower Hurricane. I'd keep it's power up rather than toss a weaker engine at it.
Now if the Brits could design an aircraft around the 12Y engine, which had been around since 1932, that was light weight and perhaps wooden like the Mosquito it could have been a fine interceptor. The company doesn't seem to have been building any military aircraft as of 1936-40 before the Mossie. They tried in 1929 with the DH.77, which is an example of what could be done with a light aircraft and a lower powered engine.
Hmm - yes, lower power vs. Merlin might be a problem, especially on the big aircraft the Hurricane was. Small size will not, though.
I very much agree that De Havilland designing a fighter might be a win-win situation, in fact I've strated a thread about D-H being more involved in ww2 some time ago:
link . Including a what-if fighter.
You need to be careful about dumping designs like the Blenheim and Battle too quickly. The fact is when they were introduced they were the state of the art like the TBD Devastator, Vought Vindicator, and Ms. 406 but were they were at the start of the wave of new all metal monoplanes and were thus quickly overtaken. The problem is if you time this wrong you end up with the same situation the French had in May and June 1940 when they were in the process of swapping out older designs for newer ones at the worst possible time.
The imperative of impending war means you may have to suck it up with the older designs and the best approach at least in the short term is figuring how to improve those through airframe modifications and use them in the most effective way possible in terms of munitions and tactics.
I will recommend against being sattisfied with old designs if and when industry can make better aircraft.
The 1st reason being that aircraft don't fly by themselves, and for 2nd reason that aircraft are manufactured to do a task. Sending out slow aircraft armed with bombs into the hundreds of Flak will just make many crewmen die, with tasks uncompleted. The Battle have had almost twice the wing area the Spitfire had, much thicker wing, with same engine, carrying twice the fuel and 3 times the crew -> no airframe modification will make it go 300 mph with Merlin III. Henley might be a much better bet, being smaller. Possibly also the Blenheim, with a little nip'n'tuck, but let's not over-do it - Bristol can do better job with ALT Beaufort.
Please note that I did not recommend that UK cancels all of it's designs - Hurricane, Spitfire, Wellington, Hampden, trainers certainly have a role in any ALT RAF. Whitley probaly too, unless A-W makes a 4-engined bomber? A slightly modified Defiant might also serve well, ditto for a cleaned-up Blenheim.
A Vindicator-like aircraft might be a good addition, actually - a small, light aircraft that can dive bomb, with decent bomb-load.