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BAE Systems – Best Foot Forward By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

 

baesys30 Jul 15. Sales and operating profits ahead albeit that underlying EBITA and EPS are a touch down summarise top and bottom line financial highlights of BAE Systems half-year results announcement this morning. Suffice to say that while plusses and minuses abound in equal proportion as evidenced by the rare sight of currency translation benefits set against a small increase in net debt these are a solid set of numbers. I suspect that in relation to timing and this being a large defence prime the various plusses and minuses should be regarded as not being particularly untypical for a huge international business such as this. The bottom line take though is that despite considerable turmoil in defence markets around the world BAE Systems really does appear to be riding out and managing this difficult storm very well.

With guidance left intact and with consensus forecasts met there were few if any real surprises in H1 results. Markets took a similar view marking the shares up by half a percent in early morning trade today. There are ample positive highlights to note during the first six months of the year and I will detail some of those that the company has reminded us of today further down. One piece of excellent news is that the order backlog now stands at a very healthy £37.3bn. This provides excellent sales visibility going forward. Without doubt the past five years have been ones of considerable upheaval and change for BAE Systems just as they have for most defence equipment suppliers and those engaged in services, systems integration and through life product support. Nation after nation have been doing all that they could to cut back on defence expenditure and often this has meant that legacy defence programmes have been cancelled much earlier than planned and that purchase of new equipment has been pushed back. To adapt and change to meet what governments have been forced to do in the name of affordability has come at a high cost to defence equipment suppliers.

Now, all of a sudden and as it was probably always going to do, the prevailing attitude toward defence spending by governments is showing signs of reversal. The penny at last seems to have dropped and if countries such as the UK really are now getting the message that the level of threats against the country really are increasing and if they recognise that the geo-political world really is becoming far less stable then we can I believe be pretty sure that others will be getting the same message too.

BAE Systems has in my view done exceptionally well to move through the upheavals caused by defence cuts without being harmed. The period since SDSR 2010 in the UK in since the process of budget sequestration in the US began two years ago has certainly been tough on the defence industries of both countries. The impact on BAE Systems has not been insubstantial and yet, as it has always done before, the company has quickly adapted to the change demanded by its customer through making itself ever more efficient and competitive. Typhoon is a good example of this and BASE Systems and its partners have worked very hard to bring production costs down. True, Typhoon has lost out on the initial fast jet competitions in both India and Qatar it seems and this is clearly a disappointment. But that does not mean that either country has turned its back on what they know well is truly brilliant aircraft capability.

To that end I remain extremely confident of Typhoon export success in the months and years ahead and I know full well that the company continues to work very hard as it engages with a number of new and existing potential Typhoon customers. On their side is that those that already use Typhoon are absolutely delighted with the capability that they have acquired. Another important aspect that supports my positive view is that the UK Government has over the past year sanctioned various levels of expansion of Typhoon capability enhancement. Of particular note here is Captor E-Scan together with additional weapons capability and integration.

Clearly announced Typhoon enhancements are to be considered as excellent news for the domestic Royal Air Force customer but they are equally important for the export customer as well. Indeed, they are exactly what the export customer has been demanding. All that I can say for now is watch this space.

So to the operational and strategic highlights of the H1 results announcement: A £859m demonstration phase contract was agreed for the UK Royal Navy’s Type 26 frigate programme and we may reasonably expect this to soon lead to confirmation of the initial order by the Government for Type 26 ships. As mentioned above, the company has reminded investors that good momentum is now being achieved in the progressive expansion of Typhoon aircraft’s capability, including the integration of the Captor E-Scan radar and the integration of additional weapons.

On the F-35 Joint Strike Fighter Lightning II programme production of rear fuselage assemblies from the BAE Systems Samlesbury plant the UK and also deliveries of the electronic warfare suite that come from BAE Systems US is now being ramped up. Also, having earlier this year been awarded a contract to supply remote electronic units for the Boeing 777X aircraft there is a useful reminder that this now means that BAE Systems will be providing the complete suite of flight control electronics for the aircraft’s fly-by-wire system.

The company has also been selected to provide information technology services to the US government in a single-award Indefinite Delivery, Indefinite Quantity contract. Other orders and contracts of note include the US Army’s Enhanced Night Vision Goggle III programme now proceeding, with framework contract value of up to $435m (£277m), a $110m (£70m) contract from the US Army to upgrade 36 M88A1 recovery vehicles. In total, we are told that some £1.3bn of international orders are being finalised at the half year stage.

Other highlights include acquisition of Eclipse Electronic Systems, Inc., a provider of highly-advanced Intelligence, Surveillance and Reconnaissance products and services which completed last month and importantly, a strategic assessment of manpower and services businesses within the US-managed Intelligence & Security sector which the company had previously announced. The statement includes reference to an options review process being undertaken to address an anticipated workload reduction in Australian shipbuilding business and some initial headcount reductions in the first half and also that the Land Systems business in South Africa has now been disposed. Finally, through BAE Systems’ 37.5% share of the MBDA guided weapons joint venture, there is reference to recent contracts signed in Egypt and Qatar and MBDA with a value anticipated in the region of €1.2bn (£0.9bn).

I do not propose to analyse BAE Systems first half performance in further detail and will leave equity analysts to do that. From my perspective and given the difficult circumstances that defence finds itself in these are a very good set of results demonstrating not only resilience but also confidence. The company is financially in excellent condition and continues to work hard to further improve performance. The strategy remains the same – to be the premier global defence, aerospace and security company and one that combines with a commitment to deliver sustainable growth in shareholder value through a commitment to total performance. This is a complex business and in the year ahead there will be further complex issues to face. Not least will be what impacts there might be on the company from SDSR 2010. It is no use second guessing this but with the UK Government having committed to spending 2% of GDP on defence and agreeing that there will be a 1% annual increase in the defence equipment budget BAE Systems can I believe look forward with greater confidence. Yet to come is Trident replacement in the form of Successor moving toward main gate. Yet to come is Type 26, a long programme of shipbuilding at Govan and Scotstoun that will take those operations through much of the next two decades. Meanwhile the Astute programme continues to make good progress in Barrow-in Furnace and there is another vessel yet to come. Progress of the two Queen Elizabeth class carriers continues apace with the first vessel, HMS Queen Elizabeth now being fitted out and a large section of the second vessel, HMS Prince of Wales, having been rolled out of Scotstoun this week ready for moving to Rosyth during August. Finally on ships, work progresses on the first of three OPV vessels for the Royal Navy.

In terms of aircraft, work on Typhoon continues and the company has said that sales which in any event were well up during the first half due to higher deliveries of the aircraft to Salam (Saudi Arabia) and of Tranche 3 equipment deliveries, are expected to continue increasing by close to 10%. Work continues on the £2.5bn order for Typhoon and Hawk aircraft for Oman and a huge amount of campaign sales work is currently being undertaken in a number of states in the Gulf Region just as they are in the Far East and Asia as well. As mentioned, work on the Lockheed Martin F-35 Joint Strike Fighter on which BAE Systems is a Tier One partner is now being ramped up and the programme appears to be going very well and meeting stated objectives. There is more than a decade of work ahead and maybe even two! BAE Systems is also engaged working with Northrop Grumman on what will be the next generation T-X trainer program and that if the partnership which includes L-3 was to win could be worth $11 billion or more over many years.

While the US remains an unknown quantity in terms of defence it is not all bad news. Some contract work has been won by the company but there is no denial that progress in terms of moving away from the fear of further sequestration impact is not in sight yet.

In summary BAE Systems is managing a difficult market situation well. Hopefully the worst of this is now behind us and, given the increased level of threats and geo-political tensions, with increasing realisation that spending on defence by western nations has gone down far too far down and with Middle East states and countries such as India increasing spending on defence the outlook for those companies that have worked hard to make themselves more efficient and competitive does look better. BAE systems is certainly one of them.

hwheeldon@wheeldonstrategic.com

Tel: 07710 779785

 

 

 

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