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BAE Systems – Well Positioned For Future Growth By Howard Wheeldon, FRAeS, Wheeldon Strategic Advisory Ltd.

ian kingWith BAE Systems FY 2015 preliminary results coming broadly in line with expectations and previous outlook I suspect that I could hardly better the words from CEO Ian King in my own analysis of results today at the top of the statement when he says:

“We have delivered another year of solid performance. BAE Systems has a large order backlog generated by a well-balanced portfolio of businesses serving the needs of customers in many of the world’s larger accessible markets. The Group is well placed to continue to generate attractive returns for shareholders as defence budgets recover and our commercial adjacencies of cyber and commercial electronics continue to grow.”

 

There is ample clarity throughout the FY15 results and more than enough guidance to provide a view that the outlook for the company is good and that management is confident. It always pays to be patient in matters related to defence equipment and procurement as timing is never easy to predict Even so, an important point that I almost always try to make when looking at BAE Systems performance and future expectations is that approximately 40% of group activities relate to support and upgrade work on existing and previous programmes plus a large variety of other support related business activities. Another hugely important factor that I would always point to when talking about BAE Systems is its diverseness and wide spread of business activities based internationally. Very few if any other large defence prime can match BAE Systems when it comes geographical spread.

 

Even so, while the underlying EBITDA figure was just a touch down at £1.68 billion last year, following the impact of previously announced planned slowing of Typhoon production and the Australian shipyard impairment and rationalisation costs, underlying earnings per share, assisted by previously signalled release of overseas tax provisions, rose by 2.2p to £40.2p. FY15 sales increased by £1.3bn to £17.9bn and with confirmation of a £36.8bn forward order book, although this is down on 2014, in my view underpins a satisfactory level of confidence from the BAE Systems board in future prospects across the whole business arena. Acquisitions have been few in 2015 although investment in new business activities such as Reaction Engines shows a determination by the company to ensure that it is well placed within the UK government innovation agenda. The balance sheet remains strong with net debt standing at £1.4bn on shareholder funds up by £1bn. The final dividend is once again raised making a total payment for the year of 20.9p and that marks the 12th consecutive year of dividend increase.

 

Importantly guidance for 2016 is equally positive with the company pointing to underlying earnings being 5% to 10% higher than the [tax provisions release] adjusted figure of 36.6p for 2015. Of note are comments that international Platforms and Services are likely to see sales being higher in 2016 and margins also being improved. Fewer UK deliveries of Typhoon will adversely impact on domestic platforms and services activities although the company anticipates that reducing sales in relation to the two Queen Elizabeth class carriers are likely to be offset by increased submarine programme activity.

 

In Electronic Systems the company has pointed to low single digit sales growth with increased margins. The same is true for the growing Cyber and Intelligence based business activities based in the US and the UK although sales for platforms and services activities in the US are anticipated to be lower. Even so, the company anticipated the recent signing by President Obama of the Bipartisan Budget Act of 2015 which lifted the defence budget caps for 2016 and 2017 by $33bn and $23bn respectively to enhance the funding environment for the groups US business activities through 2017.

 

Important new business wins in key US based technology areas in 2015 have included the Eagle Passive Active Warning Survivability System (EPAWSS) electronic warfare upgrade for US Air Force F-15 aircraft and electronics upgrades to US Special Operations Command C-130J aircraft. BAE Systems was also selected by Boeing to develop and manufacture the next-generation digital electronic warfare system for the US Air Force’s Eagle Passive Active Warning Survivability System programme. The programme upgrade of up to 400 US Air Force F-15 aircraft could be worth in excess of $1.0bn (£0.7bn) over the programme life. The company also received further contracts in support of the US combat vehicle industrial base. These including $104m (£71m) for the engineering and manufacturing development phase as part of the competition for the Amphibious Combat Vehicle 1.1 programme.

 

In the UK BAE Systems received major contracts in relation to Royal Navy ships and submarines including an £859m Type 26 frigate demonstration contract and the full £1.3bn contract for the fifth Astute Class submarine. In SDSR 2015 the UK Government reaffirmed its commitment to shipbuilding continuity signalling an intention to eventually acquire eight Type 26 frigates and to begin a concept and design and build study based on an intention to eventually acquire a new class of lighter, flexible, general purpose frigates (Type 31) in addition to a further two new Offshore Patrol Vessels. Also within SDSR 2015 was further large scale commitment to Typhoon capability included complex weapons delivery and mission systems plus integration of Captor E-Scan radar. There was also commitment in relation to investment that will extend the service life of Typhoon until at least 2040.

 

Elsewhere and also related to UK based activities was a commitment in SDSR 2015 to the continued joint investment with France in the development of a future unmanned combat air capability together with an accelerated UK procurement plan to acquire the planned number of 48 F-35 Lightning II aircraft that will operate from RAF Marham and on the two Queen Elizabeth Class Royal Navy aircraft carriers currently under construction by the Aircraft Carrier Alliance of which BAE Systems is a major partners. SDSR 2015 also pointed to the total number of F-35 aircraft that the UK would take through the F-35 programme life being 138 aircraft. BAE Systems is a major component supplier and partner of Lockheed Martin within the F-35 Joint Strike Fighter programme supplying airframe assemblies and electronics equipment and of which, through the programme life, well over 3,000 aircraft are likely to be built.

 

In terms of international sales during the past year BAE Systems announced agreement with the Saudi customer for the provision of a further 22 Hawk Advanced Jet Trainer aircraft, associated ground equipment and training aids for the Royal Saudi Air Force, which will form an important part of enhancement to the Kingdom’s pilot training capacity. Work on other potential sales of Typhoon to Saudi Arabia and other counties in the region continue and the company has been in support of Finmeccanica in its bid to conclude a deal announced by Kuwait last year to supply 28 Typhoon aircraft to the Kuwait Air Force.

 

In India, BAE Systems has a long-standing relationship with Hindustan Aeronautics Limited (HAL). Delivery of a second batch of HAL-assembled Hawk aircraft continues and negotiations are underway to agree a third batch. The Group has also commenced discussions with HAL for further co-development of Indian Hawk aircraft to meet potential requirements for new capabilities. It is worth noting too that as a 37.5% shareholder in complex weapons manufacturer MBDA that this highly respected business continues to win significant orders including naval weapon systems and weapons awards in support of multiple combat aircraft types.

 

On Monday BAE Systems confirmed the important appointment of Charles Woodburn who will during the second quarter of 2016 join the BAE Systems Board and Executive Committee in the newly-created role of Chief Operating Officer. Mr. Woodburn will report to CEO Ian King. No other board changes were signalled.

 

BAE Systems shares traded up by around 1.6% in early morning trade Thursday publication of sound performance last year and a satisfactory outlook for 2016. Defence is never an easy business to be in but having come through a long period when Governments have been cutting back on defence spending my view is that we have now past the bottom of the trough and are on the way back up. BAE Systems has always placed strong emphasis on research and development investment and this in terms of meeting the innovation agenda requirements together with the very large level of existing support based business that the company have leave it well placed for many years ahead. That is not to suggest that there can be any degree of complacency or that it will, along with all other defence contractors, be expected to make itself even more efficient.

 

Large defence programmes are of course by their very nature complicated and with cash flow contraints on governments, be these caused by collapsing oil prices or budget deficits, makes timing of potential defence contracts enormously difficult to predict. Often frustration is the name of the game and there are other factors that can often act as a hostage to fortune. That is the nature of defence but it is also interesting to see how BAE Systems is at the same time as investing in all areas of its business gradually increasing the amount of business it does in commercial aerospace electronics based activities, cyber and intelligence and other areas   such as Reaction Engines.

 

One thing is for sure though, the world is an increasingly unstable place and one requires nations to ensure that they are well placed to cope with the increased level of threat. BAE is well placed to be a beneficiary of the changed government mind-set and thinking in relation to future defence capability requirements and enhancements.

 

CHW (London – 18th February 2016)

Howard Wheeldon FRAeS

hwheeldon@wheeldonstrategic.com

Tel: 07710-779785

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