BAE Systems

20 Feb. 2014. In brief, the company’s FY13 results summary reads as follows – revenue up 2%, underlying EBITDA up 3%, EPS up 9%, dividend raised 3% and in total, £850m returned to shareholders during the year. A good achievement all round within an industry that is being forced to adapt and change to meet new challenges. BAE Systems is well used to the needs of perpetual change and as the company moves through yet another period adapting to the changing global defence market it is important that it will do so from a position of financial and managerial strength.

Given the challenges with the current defence market internationally I take the view that the FY13 results were excellent, even if future prospects look even tougher than those immediately past. However there is scope for confidence; there are just as many growing international defence markets as there are contracting ones. My view is that medium and long term positives far outweigh the short term negatives.

As an international player with minimal net I believe that BAE Systems has an excellent opportunity to expand into emerging markets. No one denies that the next couple of years will be tough but with a well defined strategy BAE Systems is, in my view, in a very strong position to ride out mature market storms. The UK is a classic example and one where despite large scale cut backs in defence, BAE Systems now has increased clarity and understanding with its government customer to aid development during the next few years. While the US will clearly be weaker than in the more recent past, over the next few years international market opportunities in the Gulf States and further afield remain very strong – shareholders should remain optimistic.

Non-recurring benefit from settlement of the ‘Salam’ price escalation negotiations which appear within the FY13 results will inevitably have a negative impact on FY14 results. The company anticipate that the impact of this will likely reduce the FY14 earnings per share by somewhere between 5% and 10%. The company has also taken the opportunity to take a non-cash goodwill impairment charge of £865m to take account of lower defence spending in the US and increase in the weighted cost of capital.

Meanwhile in the UK a series of large, long-term defence programmes herald a positive outlook. During the past year the first Tranche 3 Typhoon aircraft was flown whilst deliveries to the European partner nations and export customers continued apace. Work on sizable export orders for Hawk fast jet trainers began and there was a significant agreement with HM Government which enabled a restructuring of the company’s shipyards to improve efficiency; hence the confirmation of an order for three Offshore Patrol Vessels for the Royal Navy before work beginson the proposed number of thirteen Type 26 frigates. In addition large scale work on the F-35 joint strike fighter continues at Samlesbury and this programme can be expected to continue for the next thirty years.

With over 600 BAE Systems staff already working on Type 26 frigate design and engineering proposals I suggest that the potential size and scale of this next big programme for the Royal Navy should not be underestimated. Large scale work on the Astute class submarine work continues apace at Barrow-in-Furness as does large scale design and engineering work on the ‘Successor’ programme of nuclear submarines, currently proposed as possible replacement for the four existing Vanguard class Trident submarines. BAE’s cyber security business, formally Detica and now titled as Applied Intelligence, will move through 2014 with a substantially increased order backlog.

With the ‘Salam’ price escalation discussions and agreement now behind them, Typhoon deliveries to Saudi Arabia continuing, orders for Hawk and most recently the award of further significant Tornado upgrading work the long standing and hugely successful relationship between the UK and Saudi Arabian governments is back where it needs to be. In export terms both Typhoon and Hawk continue to do well and orders for Typhoon have not so far been achieved in countries such as India or the UAE – potential remains. Indeed, it is worth noting that the non US/UK order intake to the international business area last year was £9.3bn. My own view on the potential for export sales of both Typhoon and Hawk remains extremely positive particularly to Middle and Far-East markets. BAE Systems together with its Typhoon partners continue to be engaged in discussions with several potential export-related customers. On Hawk, which remains the single most successful export programme for BAE Systems over the past thirty years, I take the view that with the aircraft significantly upgraded in T2 form considerable opportunities remain.

In the US where the effects of ‘sequestration’ are beyond the control of all those engaged in the defence market and which has determined an effort to shave $450bn (10%) off the defense budget over a ten year period BAE Systems has naturally been negatively impacted. Nevertheless, commercial electronics offers an area of growth and the recent BAE Systems contract win from South Korea to upgrade and modernise a 130 plus strong fleet of F-16 fighter jets was significant. Various other significant contract awards occurred this past year and while the outlook for US earnings remains limited  there is no reason to doubt that ongoing efforts to secure new work in other regions will provide positive results.

Howard Wheeldon FRAeS
Wheeldon Strategic Advisory Ltd,
M: +44 7710 779785


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