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BAE Systems – Strong H1 Performance – Improving Defence Outlook By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

baesysMaintaining positive full-year guidance and having posted revenue, underlying profits, earnings per share ahead of equivalent performance a year earlier together with raising the first-half dividend payment by 2% BAE Systems looks very well placed to take advantage of what most agree is a far more positive attitude and approach emerging from NATO and other governments toward future defence spending.

With several European governments including the UK having already announced an intended rise in defence spending and general consensus that, given the increased nature of threats against us, concerns over Russian and Chinese intentions and so on, that spending on defence by NATO and other governments must now rise it seems to me that the outlook for defence companies looks to be stronger than it has been for many past years.

Despite caution on the part of the MOD and delays to certain military shipbuilding programmes the outlook for increased spending on defence by the UK government as outlined in SDSR 2015 and subsequently is in my personal view very unlikely to be negatively impacted by Brexit. Orders for defence equipment confirmed a couple of weeks ago and that in this case BAE Systems is not involved together with confirmation following the House of Commons vote last week that the Trident nuclear deterrent submarine replacement ‘Successor’ programme will now move forward to build, is a further strong signal of intention by the Government that there will be no weakening of UK resolve. BAE Systems is already through the large amount of development work currently being undertaken will continue to be the major beneficiary of ‘Successor’ build work.

Later this year Sir John Parker will report on recommendations to deliver a National Shipbuilding Strategy for the naval sector and following this, the Government is expected to formalise the intention to build eight Type 26 frigates plus five other vessels to replace the existing Type 23 frigates. Meanwhile BAE Systems continues to build three additional Offshore Patrol Vessels for the Royal Navy that had been awarded within a £348 million contract in August 2014 together with continuing to be engaged on the final fitting-out phase on the first of the two new Queen Elizabeth Class Aircraft Carriers, HMS Queen Elizabeth at the Carrier Alliance base at Rosyth in Scotland together with continuation of build of the second carrier, HMS Prince of Wales. Both carriers remain on budget and in the case of the second carrier, I believe at least six months ahead of schedule.

Building of the ‘Astute’ class submarines at Barrow in Furness continues and the follow on of ‘Successor’ class build a few years from now is eagerly awaited by staff at this very highly invested and efficient submarine facility.

In military aircraft platforms, electronic systems, cyber and intelligence BAE Systems continues to do very well. Internationally the company is also doing well and while there have been disappointments in the US maritime segment here again sentiment suggests that the bottom has now been reached. Large military aircraft programmes such as the F-35 Joint Strike Fighter are progressing very well as is BAE Systems large involvement in Typhoon build and support. Radar enhancement and additional weapons delivery systems on Typhoon together with the recent award of the 10 year Typhoon Total Availability Enterprise agreement worth an estimated £2.1 billion over the contract lifetime are very important wins for BAE Systems. Hawk build for the Sultanate of Oman along with 12 Typhoon aircraft under construction continues and apart from Typhoon build BAE Systems is also constructing 22 Hawk AJT aircraft for Saudi Arabia. Significant further export potential remains.

In his first half statement CEO Ian King remarked that “In the first half of 2016, BAE Systems performed well. Despite economic and political uncertainties, governments in our major markets continue to prioritise national security, with strong demand for our capabilities. In the US, we are seeing encouraging signs of a return to growth in defence budgets and improved prospects for our core franchises. In the UK, the result of the EU referendum will lead to a period of uncertainty, but we do not anticipate any material near-term trading impact on our business. Our business benefits from a large order backlog, with established positions on long-term programmes in the US, UK, Saudi Arabia and Australia. We are well placed to maximise opportunities, deal with the challenges and continue to generate attractive shareholder returns.”

Key business highlights during the first half of the year included BAE Systems Eurofighter Typhoon partner Leonardo-Finmeccanica signing contracts to supply 28 Typhoon aircraft to Kuwait and which is expected to result in airframe manufacture, capability upgrade and Electronically Scanned (E-Scan) radar integration work valued at approximately £1bn for BAE Systems,, a ten-year partnership arrangement with the UK Ministry of Defence, expected to be worth £2.1bn, to support the UK Typhoon fleet, three contracts with a total value of approximately £300m to support the UK Ministry of Defence’s fleet of Hawk fast jet trainer aircraft until 2020, an £118m contract to build engineering and training facilities in the UK for F-35 Lightning II aircraft, confirmation from the UK and French governments for a new €2bn (£1.7bn) project to build an unmanned combat air system demonstrator, a further £472m contract extension by the MOD for the Type 26 frigate demonstration phase, a $245m (£183m) contract to provide three gun systems and a trainer for the Royal Navy’s Type 26 frigate and a $149m (£111m) contract for the production of new Assault Amphibious Vehicles for the Japanese Ministry of Defence, a $182m (£136m) contract to refurbish 262 Swedish Army CV90 combat vehicles. In addition, the MBDA joint venture partnership in which BAE Systems has a 37.5% interest, won various new orders of which the share to BAE Systems was £462m during the first half of 2016.

Although down by a small amount on the last year end figure the group order book of £36.3 billion at half year period end remains very high. Importantly, cash flow remains satisfactory and in line with company expectations while net debt as defined by the group and that stands at £2 billion is little changed on the figure for a year earlier.  Given erratic movements in US and UK bond yields the pension fund deficit has risen during the year to £6.1 billion. On this matter BAE Systems confirmed that with the next UK triennial review due to take place in April 2017 the group will be looking at various options for the future.

Rather than attempt to re-write the very detailed and interesting trading activity section of the BAE interim results statement I have attached the link to this here Half-yearly Report 2016.pdf

 

On top of full year earnings guidance that is anticipated by the company to be 5% to 10% higher than the 36.6p underlying earnings per share that it reported for FY15 BAE Systems management has given the following divisional guidance as well:

 

Electronic Systems: Low single-digit sales growth is expected in 2016 with margins around the middle of an increased 13% to 15% range.

 

Cyber & Intelligence comprising the US Intelligence & Security sector and UK-headquartered Applied Intelligence business: Low single-digit sales growth is expected in 2016 with stable sales in Intelligence & Security and good double-digit growth in Applied Intelligence. Margins are expected to improve to within a 7% to 9% range principally as anticipated second half sales growth in Applied Intelligence outpaces the continued high investment in product development and marketing costs.

 

Platforms & Services (US): Sales are expected to be some 10% lower, including a reduction in naval ship repair activity as the pivot of the fleet to the West Coast continues. Margins are expected to increase, to a range of 7% to 8%, including charges taken in commercial shipbuilding in the first half.

 

Platforms & Services (UK): Sales are expected to be slightly lower in line with planned lower Typhoon deliveries. Increased submarine programme activity is expected to offset reducing aircraft carrier sales. Margins are expected to be at the lower end of a 10% to 12% range.

 

Platforms & Services (International): Sales are expected to grow around 5% in 2016 with increased Typhoon aircraft support. Margins are expected to be at the lower end of a 10% to 12% range.

 

HQ costs are expected to be similar to those in 2015. Underlying finance costs are expected to increase by £35m in 2016. The effective tax rate remains dependent on the geographical mix of profits, but is expected to increase slightly by around 2%.

 

With a good set of half-year numbers under its belt BAE Systems looks set fair for a future that to me looks even more interesting than the past and that has innovation right at its heart. If the government is serious about encouraging innovation and in recognising the hugely important role that defence plays in the prosperity agenda then its prime example is BAE Systems. A great company, one that is truly international in every respect and that is looking forward to achieving more growth.

 

CHW (London – 28th July 2016)

Howard Wheeldon FRAeS

hwheeldon@wheeldonstrategic.com

Tel: 07710-779785

 

 

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