BAE-Systems

BAE-Systems

Morningstar Equity Analyst Report | Report as of 25 Jun 2020 08:04, UTC | Page 1 of 14
Morningstar Pillars Economic Moat Valuation Uncertainty Financial Health Source: Morningstar Equity Research
Analyst Wide QQQQ Medium —
Quantitative Wide Undervalued Medium Moderate
Quantitative Valuation
BAESY
p GBR
Undervalued
Fairly Valued
Overvalued
Current Price/Quant Fair Value 0.93 Price/Earnings 10.5 Forward P/E 10.9 Price/Cash Flow 9.7 Price/Free Cash Flow 13.7 Trailing Dividend Yield% 2.01 Source: Morningstar
5-Yr Avg 0.98 21.4 — 18.7 48.4 4.06
Sector Country 0.87 16.9 11.9 11.8 19.2 3.21
0.80 16.8 13.9 11.2 18.4 2.30
Bulls Say OBAE Systems is well positioned to capitalize on growth in global defense spending. OThe company has an incumbent position on the F-35 Lightning II fighter jet, the world’s largest programme, which will support production and support revenue for decades. OA privileged position on the Tempest next generation Eurofighter programme supports revenue and offers growth beyond the Typhoon programme.
Bears Say OLower U.K. defense spending as a result of weak economic growth in light of a no-deal Brexit could negatively impact the group’s revenue growth in the short term. OLoss of income from Saudi Arabian support may put the dividend at risk and affect investor perception of BAE as an income play. OA persistent valuation overhang on global defense names due to increased ESG pressure placed on investment mandates.
Important Disclosure: The conduct of Morningstar’s analysts is governed by Code of Ethics/Code of Conduct Policy, Personal Security Trading Policy (or an equivalent of), and Investment Research Policy. For information regarding conflicts of interest, please visit http://global.morningstar.com/equitydisclosures Upbeat Trading Update From BAE Systems; Strong Order Intake and Ample Liquidity; Attractive Upside Business Strategy and Outlook Joachim Kotze, Eq. Analyst, 09 December 2019 BAE Systems enjoys incumbent positions on a diverse set of major global defense programmes. Defense spending in the U.S., a key market for BAE, declined for nearly a decade since the end of the Iraq war in 2011. The outlook for defense spending is positive with rising budgets in the U.S. and commitments from NATO partners to meet their minimum spending requirements. BAE Systems is well aligned with U.S. Department of Defense growth programmes.
Wide-moat BAE Systems released a rather upbeat trading statement for the first half of 2020, where they see strong underlying demand and order intake in line with original precoronavirus expectations. Sales for the first half are flat compared with the 2019 comparable period, with profit down 15% due to lower volumes of high-margin products and COVID-19-induced production stoppages. Management reiterated that the group maintains a solid liquidity position and that cash flows for the first half are broadly in line with expectations. Further clarity will be provided on the payment of the final dividend with the release of first-half results on 30 July and we see no reason to suspend the payment in light of the group’s defensive cash generation. Shares are down 28% since pre-COVID-19 level and we believe there is ample upside to our fair value estimate of GBX 570 (ADR: $30). This is a good entry point for long-term investors looking for a stake in a wide-moat, defensive business.
BAE’s 15% programme share on the F-35 Lightning II fighter, currently in ramp-up and expected to achieve full-rate production in 2020, will support revenue for the next 15-20 years on production alone. U.S. combat vehicle production and revenue is set to double over the next five years with subsequent margin improvements as they resolve ramp-up issues. The U.S. Navy is looking to increase the size of its fleet, which bodes well for the U.S. ship repair business as ship retirements are delayed and mothballed ships re-enter service.
The Qatar contract for the delivery of 24 Typhoon fighter jets, valued at GBP 5 billion, will support the programme’s production revenue into the early 2020s with support revenue to grow modestly and stabilize well into the 2030s. Maritime revenue will be boosted by the Astute and Dreadnought submarine projects to the Royal Navy and Type 26 frigates deliveries to the Australian Navy.
BAE Systems is a stable, mature business with a high level of recurring revenue from support services and an incumbency on long-term programmes offering high visibility and stability of revenue and cash flows. The company pays a stable and secure dividend, currently yielding 4% gross, and should grow in line with our earnings growth outlook of low to midsingle digits over our five-year forecast horizon. We are positive on the fundamental outlook for BAE Systems driven by a portfolio that is well aligned to growth in global defense spending.
Analyst Note Joachim Kotze, Eq. Analyst, 25 June 2020
Productivity at the air and maritime sites in the U.K. and U.S. were most affected by the implementation of distancing and safety measures, exacerbated by supply chain disruptions. Productivity levels have normalized since the start of the outbreak, with 90% of employees back at work. The group’s commercial businesses, which represent only 10% of sales, were most affected by the pandemic as demand has shrunk and could take a while to recover. Key programs such as the Astute submarine for the Royal Navy, Typhoon fighter jets for Qatar and U.S. combat vehicles remain on track, and are meeting performance hurdles. The payment of GBP 1 billion to the U.K. pension scheme has been concluded and the $275 million acquisition of Collin’s radio business was completed in May. The group expects the proposed acquisition of Collin’s GPS business for $1.9 billion to close early in second-half 2020.
Economic Moat Joachim Kotze, Eq. Analyst, 07 April 2020 We assign a wide moat rating to BAE Systems Plc based on the presence of high switching costs and intangible assets in the form of engineering and technical know-how and long-standing relationships with global defense departments.
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Close Competitors
Currency (Mil)
Market Cap
TTM Sales
Operating Margin
TTM/PE
Lockheed Martin Corp LMT
Boeing Co BA
Northrop Grumman Corp NOC
General Dynamics Corp GD
USD
USD
USD
USD
100,906
99,711
50,329
42,011
61,127
70,550
34,272
38,838
13.53
-8.91
11.58
11.78
16.31
0.00
22.68
12.36
industry
The global defense is concentrated and characterized by close cooperation between contractors and governments. Suppliers must command the requisite technical know-how and capabilities to develop and produce, often in partnerships with each other, large defense programmes stretching decades. Governments and global defense departments are often the only buyer and, due to the highly confidential and sensitive nature of national security, requires a strict screening and approval process.
BAE Systems has 81,900 employees, of which, roughly two thirds (54,000) are engineers. In 2019, the company invested GBP 1.7 billion in research and development, or R&D, of which, GBP 237 million was self-funded, the balance is financed by customers. BAE Systems enjoys established positions on a diverse set of long-term programmes. The position it forged as a trusted supplier through strong relationships with governments allow it, and other large incumbents, to identify emerging trends and opportunities in the defense market. This insight affords the firm the ability to fund early stage research into next-generation further developed with customer funding. Decades of investment in advanced manufacturing capabilities and a track record of managing complex projects and supply chains cement its, and other incumbents’, positions as preferred partners. The technical requirements and complexity to satisfy defense contracts create a high barrier to entry, making it difficult for new entrants to enter the space.
technologies
that
is
The industry has been largely unchanged for the past 10 years following large-scale consolidation in the U.S. during the 1990s, post the Cold War. We note that the merger between Raytheon and United Technologies will have a minimal impact on BAE Systems’ competitive positioning in the U.S. as there is limited capability overlap.
low chance of switching providers. Governments commit billions of dollars to the development and production of programmes lasting multiple decades. As an example, the first round of funding has been earmarked by the U.K. government for the development of the Tempest fighter jet, successor to the Typhoon, expected to enter into service in 2035. Governments and defense departments are reluctant to switch providers mid-programme as it is costly, disruptive, politically unpopular, or there is a complete lack of an alternative provider.
In the U.K., BAE Systems has the sole capability of supplying fighter jets to the RAF and nuclear submarines and frigates to the Royal Navy. And in the U.S., where BAE Systems has a 60% share of the non-nuclear Naval repair market, the strategically located shipyards afford it a geographical advantage as there is usually only one shipyard supporting an entire region. In both instances switching costs are high as no alternative provider exists.
Revenue generated from aftermarket support, maintenance, and training constitute 43% of group sales and despite aftermarket margins being only moderately higher than that of new equipment margins, their recurring nature smooths the lumpy new equipment revenue profile. Service contracts vary in length depending on customer and programme but are typically 10 years with a break clause after five years. The degree and extent of competition that exists in the aftermarket varies vastly across regions and domain. For instance, in U.S. and U.K. Naval repair and maintenance there is little to no competition, whereas a higher level of competition exists within the combat vehicles aftermarket.
In the development phase of a programme cost-plus contracts are common, where governments bear most of the risk and generate margins of 8% to 10%. Defense contractors carry the risk in the production phase and enter into fixed price contracts with margins ranging between 10% and 14%. The spread of risk from government to contractor puts a cap on the margins that may be earned by the industry but limits cyclicality at the same time. This, in conjunction with aftermarket sales, translates into stable and predictable return on capital throughout a programme’s lifecycle.
Competition among incumbents in initial bidding rounds for new programmes is intense. Winning a contract secures an incumbent position on a programme with a
BAE Systems has incumbent positions on a diverse set of key programmes, covering all domains and extending beyond 2030 and up to 2040. In air, the group has a 15%
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programme share for the F-35 lighting II fighter jet and is a key partner on the Eurofighter Typhoon production and support programme. On land the group is modernizing and upgrading the U.S. combat vehicle fleet with the Paladin M109, armored-multi-purpose-vehicle (AMPV) and (ACV) programmes. BAE amphibious-combat-vehicle Systems is the sole provider for Dreadnought and Astute submarines and Type 26 frigates to the Royal Navy and the Australian Navy. The firm also holds key positions in U.S. ship repair. Revenue from key programmes cover 60% of group revenue.
We assign a narrow moat rating to Electronic Systems. In Electronic Systems, BAE Systems is a tier 2 supplier to the prime contractors in the U.S. and faces a higher level of competition from peers such as Raytheon, Northrop Grumman, and L3 Technologies. The segment is product dominated and lacks recurring aftermarket revenue. However, being the sole-source provider of electronic warfare equipment on the F-35 programme and performing a growing amount of classified work for the U.S. government along with a diverse set of complex products, such as avionics and radar systems, supplied to defense and civil markets, we believe the segment warrants a narrow moat based on intangible assets in the form of technical know-how.
BAE Systems fulfills a U.K. government-to-government contract to supply and support Typhoon fighter jets to Saudi Arabia. Recent geopolitical developments surrounding the assassination of journalist Jamal Khashoggi at the Saudi consulate in Istanbul and Saudi Arabia’s involvement in the war in Yemen have led to pressure from the U.K.’s allies to suspend support. Germany’s bans on arms exports to Saudi Arabia means that new deliveries of Typhoon fighters will not be fulfilled. U.K. support for Saudi Arabia’s Typhoon fleet continues, but further pressure could put this revenue at risk. Saudi Arabia contributes 12% to group operating profit with minimal long-term fixed costs or assets. The suspension of support will merely lead to a loss of income that we believe is a valuation rather than a fundamental risk and will not fundamentally affect BAE Systems’ ability to generate economic profits.
The impact of a no-deal Brexit on BAE Systems’ ability to generate economic profit is minimal. BAE only derives 8% of revenue from exports to Europe, and the partnership on the Eurofighter Typhoon between Germany, France, and
the U.K. falls outside the scope of EU trade regulation. Some disruption on the sourcing of raw materials may be expected but should be mitigated over time.
The group’s strong incumbent position on a range of key defense programmes limits the impact of programme concentration risk on profit sustainability over the long term. The group boasts strong technical capabilities, strategic assets, and long-standing partnerships with key governments, increasing the probability of participation in future programmes. The stable industry structure, long-term programmes, and predictable returns above the cost of capital results in a wide moat rating for BAE Systems.
Fair Value & Profit Drivers Joachim Kotze, Eq. Analyst, 07 April 2020 Our fair value estimate for BAE Systems of $30 per share remains unchanged as we update our model and account for the acquisition of Collins’ GPS and Raytheon’s radio businesses, which adds marginally to our fair value estimate, but is offset by short-term COVID-19 headwinds. Due to production and supply chain disruptions and the resulting effect on profits and cash flows as a result of COVID-19, we expect free cash flow (preacquisitions of GBP 1.8 billion) to decline by GBP 300 million to GBP 800 million in 2020, from GBP 1.1 billion in 2019. Low production rates and the inability to effectively deliver finished goods will negatively affect working capital and advance payments.
the contribution of
Longer term, our adjusted EBIT is forecast to grow 6% per year to GBP 2.3 billion in 2024. This is driven by revenue growth as a result of low-single-digit increases in global defense spending and the above-mentioned acquisitions. From a programme perspective, the biggest contributors to growth are the ramp-up of the F-35 fighter jet, U.S. combat vehicle deliveries, U.S. ship repair, and U.K. and Australian maritime activity. This is offset by declining revenue from Tornado fighter jet and Hawk trainer jet production and support. We expect operating margins to normalize at 10%, this is in line with the current level and the long-term average. Industry margins tend to be stable with growth driven predominantly by changes in defense spending and corporate action.
Free cash flow should be less volatile going forward and more closely matched to accounting profits as the industry
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(CEO) of the group in July 2017 and joined the group in 2016 as chief operating officer (COO). Prior to his time at BAE Systems, Woodburn held several senior management positions in the oil and gas industry.
Woodburn shifted the group strategy from a regional to a product focus. He changed the reporting structure, appointed new management, and committed a higher level of self-funded research and development spending as part of his implementation plan. We believe the changes are positive and should improve the competitive positioning of the group as the focus on development of next generation technologies intensifies.
The board is well diversified in terms of experience, independence, and gender. Of the 11 board members, four are female. Relevant industry experience is well balanced with board members who have experience from non-related industries which broadens the debate. Remuneration is fair and aligned with industry peers. The group made great effort in reducing the ratio of CEO remuneration to the average employee remuneration to 33 from 60. Base pay is reasonable, with short- and long-term incentives adequately aligned with shareholder interests. Total shareholder return and earnings-per-share growth measured over a three-year rolling period is the basis of measuring long-term performance. Communication to stakeholders is regular and candid, notwithstanding the secret and opaque nature of the industry. We believe BAE Systems warrants a standard stewardship rating.
moves away from large advance payments. Our assumptions are discounted at a weighted average cost of capital of 8.2%.
Risk & Uncertainty Joachim Kotze, Eq. Analyst, 07 April 2020 BAE Systems has a medium risk and uncertainty profile. Stable and recurring aftermarket support, service and training revenue, representing 43% of group sales, smooths the lumpy project and programme revenue stemming from changes in annual defense budgets. The bulk of programme development risk is borne by governments and defense departments, resulting in stable operating margins and returns for the contractors.
The biggest risk in our view stems from the negative impact of investor sentiment on the valuation of which there are three clearly identifiable sources: 1) a dividend cut, resulting from loss of Saudi Arabian income or a sharp drop in defense spending, and the precedence that pension funding takes over shareholder returns. Investors view BAE Systems as a secure income play and a change in dividend policy could have negative valuation implications for the stock; 2) fluctuations in interest rates could have an outsize impact on the value of the group’s pension liabilities, which, at GBP 3 billion, represents 17% of current market value; and 3) increased Environmental, Social, and Governance, or ESG, pressure placed on large global investment mandates. In time, a large pool of capital is likely to eschew companies that have products or services deemed socially undesirable.
A longer-term, unquantifiable risk is the uncertainty surrounding NATO’s future. The U.S./European treaty is increasingly coming under fire from voices within governments party to the treaty. A dissolution of NATO will lead to disruptions in global defense spending patterns, the impact of which is unquantifiable. The Special Security Agreement governing BAE Systems Inc, BAE Systems’ U.S. subsidiary, protects the group from a breakdown in U.S.-U.K. relations. The subsidiary includes U.S. board members and security officials with complete U.S. government oversight and is for all intents and purposes viewed as a U.S. institution.
Stewardship Joachim Kotze, Eq. Analyst, 07 April 2020 We assign a Standard stewardship rating to BAE Systems. Charles Woodburn was appointed chief executive officer
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Analyst Notes Archive
BAE Systems to Buy Collins GPS for $1.9 Billion in a Well-Guided Deal Joachim Kotze, Eq. Analyst, 21 January 2020 Wide-moat BAE Systems announced it is proposing to buy Collins Aerospace’s GPS business for a consideration of $1.925 billion, funded with debt. The asset is for sale as part of the regulatory process in the Raytheon/United Technologies merger. The price for the GPS business equates to 15 times expected fiscal 2020 EBITDA, or 12 times if the present value of the $365 million tax benefit is taken into account. This compares with BAE’s current EV/EBITDA multiple of 11 times. It is the largest deal for the group in a decade and equates to approximately 8% of BAE’s current market cap. The deal will immediately be earnings and cash flow accretive. We believe the acquisition is positive for BAE as it fits with the group’s strategic priorities and strengthens its competitive position.
The GPS business will integrate into the electronic systems segment and complement the existing portfolio. The GPS business has a large installed base on more than 280 military platforms and is expected to grow revenues in excess of 10% per year over the next four years while maintaining margins. The deal will make BAE the largest supplier of military GPS receivers, with twice the market share of its nearest competitor, and reinforce the group’s position as a strategic supplier to the U.S. Department of Defense.
We expect net debt to be 1.5 times pro forma fiscal 2020 EBITDA as a result of the deal. The group’s commitment to reduce the GBP 3.9 billion pension deficit will constrain its ability to make any further strategic acquisitions in the short to medium term. The GPS business will further entrench BAE’s long-term relations with the U.S. Defense Department and reinforce the group’s current wide moat rating. The deal is subject to the finalisation of the Raytheon/UTC merger. We have made no changes to our fair value estimate of GBX 570 per share and believe the shares are overvalued at the current price.
BAE Systems Reports FY 2019 Earnings and Accelerates Pension Deficit Funding; We Maintain Our FVE Joachim Kotze, Eq. Analyst, 20 February 2020
Wide-moat BAE Systems reported full-year results that were in line with Cap IQ consensus estimates. Revenue and EBITA increased by 7% and 5%, respectively, driven by solid performance from the electronic systems and U.S. platforms segments. Free cash flow increased sharply by 33% to GBP 1.3 billion. An acceleration in pension deficit funding was well received by the market, and shares are trading slightly higher. We maintain our fair value estimates of GBX 570 and $30 for the local and ADR shares, respectively. At current prices, the shares appear overvalued.
By segment, electronic systems contributed positively as a result of higher electronic warfare sales to the F-35 fighter jet program, driving EBITA growth of 13.4% to GBP 687 million. Improvement in combat vehicle delivery rates in the United States, from a challenging 2018, supported the 27% growth in the U.S. platforms business. Despite 11% sales growth, the air division’s margins were affected by the low-margin Qatar Typhoon contract, and EBITA for the segment grew only slightly by 3.3% to GBP 887 million. Maritime EBITA increased 28% as the Dreadnought submarine and Type 26 frigate programs continue to ramp up. The challenged cyber and intelligence segment was a drag on group profits, with EBITA down 18%.
Management said it expects mid-single-digit growth in adjusted earnings for 2020. Longer term, we believe growth is underpinned by solid positions on a diverse range of defense programs, such as the F-35, which is ramping up; combat vehicles in the U.S., which should benefit from higher margins as the group moves through initial low-rate production; and the continued ramp-up of the Dreadnought submarine program. We believe the successful acquisition of Rockwell’s GPS unit will complement BAE’s portfolio and entrench its position as a Tier 1 U.S. defense contractor. The GBP 1 billion payment to fund the pension deficit removes uncertainty and is the right capital allocation decision, in our view.
Upbeat Trading Update From BAE Systems; Strong Order Intake and Ample Liquidity; Attractive Upside Joachim Kotze, Eq. Analyst, 25 June 2020 Wide-moat BAE Systems released a rather upbeat trading statement for the first half of 2020, where they see strong underlying demand and order intake in line with original precoronavirus expectations. Sales for the first half are flat compared with the 2019 comparable period, with profit down 15% due to lower volumes of high-margin
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products and COVID-19-induced production stoppages. Management reiterated that the group maintains a solid liquidity position and that cash flows for the first half are broadly in line with expectations. Further clarity will be provided on the payment of the final dividend with the release of first-half results on 30 July and we see no reason to suspend the payment in light of the group’s defensive cash generation. Shares are down 28% since pre-COVID-19 level and we believe there is ample upside to our fair value estimate of GBX 570 (ADR: $30). This is a good entry point for long-term investors looking for a stake in a wide-moat, defensive business.
Productivity at the air and maritime sites in the U.K. and U.S. were most affected by the implementation of distancing and safety measures, exacerbated by supply chain disruptions. Productivity levels have normalized since the start of the outbreak, with 90% of employees back at work. The group’s commercial businesses, which represent only 10% of sales, were most affected by the pandemic as demand has shrunk and could take a while to recover. Key programs such as the Astute submarine for the Royal Navy, Typhoon fighter jets for Qatar and U.S. combat vehicles remain on track, and are meeting performance hurdles. The payment of GBP 1 billion to the U.K. pension scheme has been concluded and the $275 million acquisition of Collin’s radio business was completed in May. The group expects the proposed acquisition of Collin’s GPS business for $1.9 billion to close early in second-half 2020.
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The Research Analyst has not served as an officer, director or employee of the fund company within the last 12 months, nor has it or its associates engaged in market making activity for the fund company.
*The Conflicts of Interest disclosure above also applies to relatives and associates of Manager Research Analysts in India # The Conflicts of Interest disclosure above also applies to associates of Manager Research Analysts in India. The terms and conditions on which Morningstar Investment Adviser India Private Limited offers Investment Research to clients, varies from client to client, and are detailed in the respective client agreement.
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