BAE Systems Struggles Amid Political Risks

  • Jun 18, 2019 BST
  • Team Kalkine
BAE Systems Struggles Amid Political Risks

BAE Systems Plc (BA) is a Farnborough, United Kingdom-based defence, aerospace and security company with operations spread across the world. The group delivers a broad range of advanced defence technology that covers air, land, naval forces and cyber domain, keeps critical infrastructure and information security. The company’s business is differentiated in five operating segments: Platforms & Services (US), Maritime, Air, Cyber & Intelligence, and Electronic Systems. Charles Woodburn is the Chief Executive of the group.

BAE Systems is one of a handful of companies with genuine clout on both sides of the Atlantic, as underlined by the meeting between BAE Systems chairman Roger Carr and US president Donald Trump in London this month. It is the United Kingdom’s most prominent defence company and a key supplier to the Pentagon, which signifies the importance of the American market to the British defence group. Its American operations make amphibious assault vehicles for the marines, and its British factories build the rear fuselage for the US-led F-35 fighter jet programme. However, in recent times, its share price has been hit by domestic political uncertainties, and it has fallen by 25 per cent over the past 12 months. The company has fallen from its all-time peak of 668p reached in the spring of 2017, despite having orders worth more than GBP 48bn on its books and a secure a dividend yield of 4.6 per cent.

Mike Turner, former BAE chief executive who ran BAE from 2002 to 2008, said that the company would need to take more bold actions and to deliver growth in the long term, more drastic steps are required. Its exposure to the Saudi market is already one of the external factors weighing on its stock as business with the kingdom generated 36 per cent of BAE’s air sector sales of GBP 6.7 billion last year, and Turner reckons that the company needs to reduce its reliance on its deals in Saudi Arabia. He said that a day would eventually come when the Saudi business ends and to prepare for that day, the company should focus on the United States, both through acquisition and organically.

Following the killing of journalist Jamal Khashoggi last year, BAE had warned that its ability to support the jets in the kingdom could be at risk and its biggest export contract, the sale of 72 Eurofighter Typhoon jets to Saudi Arabia, has become a concern for investors. The market is worried that BAE Systems might be unable to supply some parts for the Saudis’ Eurofighter planes after a German ban on arms exports to Saudi Arabia. This could have an impact on the operational readiness of the 72-jets strong fleet as BAE is responsible for ensuring the maintenance and support of the kingdom’s Typhoon jets. This had also caused growing diplomatic tensions between Berlin and London, and the move by Berlin has hurt supply lines and caused consternation within the consortium.

The possibility of a Labour government led by Jeremy Corbyn has also made investors jittery, adding the tensions from the loss of Saudi business. Corbyn has said he can see no scenario where he would use nuclear deterrent, which could seriously disrupt the company that builds the UK’s nuclear submarines. Markets experts have said that the fair value might decrease by 180p if Saudi business and Dreadnought (nuclear submarines) are at risk. The chances of which significantly increases if the government is led by Mr Corbyn. However, analysts also feel that most of the potential downside has been already factored in by the market.

The company has made reducing its pension deficit, paying a solid dividend and delivering on its order book key priorities. But analysts have started questioning what else the company should do to improve its performance, prompted by lacklustre share price performance in recent months. Some market analysts feel that given the higher growth in civil markets, operating a more balanced portfolio between aerospace and defence would serve the company better. In 2012, an attempt to create a European aerospace and defence champion by merging BAE and what was then EADS, the parent of Airbus, failed as a result of personal opposition from the German chancellor, Angela Merkel. Another scenario some analysts talk about is demerging the company’s operations in the United States onto a standalone entity. The recent news of plan by United Technologies to merge with Raytheon to create a $120 billion all-American giant bodes well for a potential BAE-Airbus combination over the longer-term as the C-Raytheon combination signalled that investors were undecided about the relative outlooks for aerospace and defence.

The company has little funding to spare for significant acquisitions for the next two to three years despite generating cash, due to pension commitments, posing a significant immediate challenge to it. There was also the risk of not having the volume the company needed in the business, something that the company had addresses under the leadership of Charles Woodburn, who has focused on bringing in orders. Since taking the helm in July 2017, much of Mr Woodburn’s attention has been focused on the operational performance of the group. Mr Woodburn has tried to sharpen the group’s focus on new technologies by appointing a chief technology officer and has restructured the group, abolishing country-based business units in favour of three streamlined divisions: air, land and sea.

Despite the fact that the recent strong order wins there have been operational hiccups, notably possibility of a loss of GBP 47 million on its contract to build five offshore patrol vehicles for the Royal Navy and expectations of lower earnings from the construction of Britain’s two new aircraft carriers. However, the company said that its growth in the medium term is supported by an evolving pipeline of opportunities and its record defence order backlog, which is backed by a clear and consistent strategy which is aimed at delivering results and growth. Even if a second Saudi order is taking time to finalise, the executives at the company are hopeful of potential future orders for Typhoon from Germany and Spain. While its electronic systems division also promises growth, the volume is expected to be boosted from a ramp-up in production of the F-35 programme in which BAE holds a 15 per cent stake. Moreover, relationship with the government and the Ministry of Defence has improved significantly in recent time, and shipyards in the United Kingdom are busy building the Type 26 ships.

Despite the recent sluggish share price performance, the market is optimistic about the company, as many argue that it is going in the right direction with a healthy order book. Additionally, some analysts point out that is going in the right direction, and the consensus weighs a bit more on outperform zone.

Share Price Commentary

Daily Chart as at June-18-19, before the market closed (Source: Thomson Reuters)

 On 18 June 2019, at the time of writing (before the market closed, at 9:05 am GMT), BA shares were trading at GBX 486.84, down by 0.36 per cent against the previous day closing price. Stock's 52 weeks High and Low is GBX 680.60/GBX 439.40. The company’s stock beta was 1.12, reflecting more volatility as compared to the benchmark index. The outstanding market capitalisation was around £15.71 billion, with a dividend yield of 4.55 per cent.

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