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By Julian Nettlefold, Editor, BATTLESPACE

22 Oct 07. The words on everyone’s mouth at AUSA this year was, “When will the music stop and the defense budget get cut?” One observer told BATTLESPACE last year that he was selling out given that he thought the downturn would happen in 2008. Well judging by the orders announced in this issue to BAE in particular, there seems to be no end to the growth in defense earnings driven by demand from the conflicts in Iraq and Afghanistan, Homeland Security and exports.

Defining a number of pundits, BAE Systems is firing on all four cylinders and throwing off cash in prodigious amounts. However, in a differing strategy to that adopted by its U.S. counterparts as discussed below, BAE appears to be looking at purchasing lower margin businesses such as armoured vehicles, UDLP and armour products, Armor Holdings, notably cyclical businesses, profitable in the good times as we have seen, but marginal or loss making in bad times. Its U.S. counterparts appear to be looking at higher margin businesses which boost EPS and profitability, as Northrop has shown this time around. It may be that BAE is looking at low margin business to be in a position to provide profitable Through Life Support across the board as demonstrated in the deal with GD initiated by the DoD shown above and the recent Australian Land 121 order where profitability appears to be in future support not sales of FMTV vehicles. If BAE becomes a Support company in the future similar to VT and Babcock, its margins will drop as will then its rating and PE. (See: INDUSTRY TEAMINGS – BAE Systems and General Dynamics Land Systems have signed a memorandum of agreement to work collaboratively in support of the U. S. Army’s Heavy Brigade Combat Team modernization plan)

As we asked last week, where is BAE going post-Turner? We suggested a deal with Boeing or Lockheed but also an acquisition to grow the company even further. Alison Wood the BAE Future Business supremo was believed to be at odds with Mike Turner over growth philosophy, preferring to take a longer look with Mike Turner, given his age and retirement prospects, looking at short to medium, hence the smart move into armoured vehicles which will give that short to medium growth spurt. A source today suggested that a deal with EADS in the next few years would bolster that company when Eurofighter orders drop off. The FT reported, confirming our suggestions, that BAE Systems added 3.4 per cent to 507p on the back of strong results and raised forecasts from US defence contractors Northrop Grumman and General Dynamics. Traders also said BAE could be a merger target. On Tuesday, Lockheed Martin said it was looking for acquisitions.
The interesting points to watch is where the money is going, and looking at the results below, there is a lot of it about! The majors, Boeing, Lockheed, Northrop, Raytheon and GD have all made small bolt-on technology acquisitions in the past years, whilst Textron is diversifying heavily into C4I with its Overwatch and AAI acquisitions which also bolsters its UAV business. ITT is the one to watch with growth in its defense segment now making it the top performing segment with 40% of revenue. The win of the $1.2bn ATC business from Raytheon and Lockheed was a major win in an area where the company was little known, closely followed by the EDO bid which fills in gaps in sonar, IED and bomb technology which were not major players in the ITT portfolio. Harris has been looking more to the civil communications sector to grow its business.
Other targets to watch would be DRS which is also performing well and digesting its ESSI acquisition; DRS is expected to be back on the acquisition trail next year as ESSI was the equivalent of buying fourteen companies. ATK is another one to watch with rumours that some at BAE preferred that to Armor Holdings but, no doubt, the Land Systems segment would see th

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