11 September 2014

BAE Systems plc – Teal Group Analysis

Author: Philip Finnegan, Drawn From: Defense & Aerospace Companies Briefing

BAE Systems plc – Teal Group Analysis

Strategy: BAE Systems plc (BAE), the United Kingdom's largest defense and aerospace contractor and the world's third largest defense contractor, is working to manage pressures on its business from budgetary cut-backs in the United States and the United Kingdom. BAE is now focusing on migrating capabilities across home markets and broadening its international business. It is also working to mollify shareholders with a stock buyback and a management shift intended to satisfy frustrations with the failed merger with EADS (now Airbus).

Strengths: BAE Systems' strategy of expansion into the United States proved to be an astute move. Despite its recent decline, the US defense budget is the world's largest, presenting the company with a number of opportunities. Moreover, the US electronic warfare business, much of it purchased from Lockheed Martin Corp., is an extremely desirable property with strong technological leadership in its field.

BAE Systems also has used this strategy of building up its position as a domestic manufacturer in other countries, including Australia and Saudi Arabia. Saudi Arabia in particular has proved to be an extremely valuable customer, representing one-fifth of the company's total sales.

BAE Systems remains committed to improving its profitability rather than gaining market share. With this focus, it has been willing to get out of the unprofitable regional aircraft market and sell off stakes in unprofitable joint ventures. In addition to the potential for growth in defense sales to key markets such as Saudi Arabia and the United States, BAE Systems sees the potential for growth in the homeland security market, integrated services and unmanned aerial vehicles.

Weaknesses: BAE has built up a very strong position as the world's leading ground systems company through its acquisitions of United Defense and Armored Holdings in the United States. With the wind-down of operations in Iraq and Afghanistan, US purchases of equipment have plummeted.

The US Army's serious budgetary crunch means that major programs are being postponed or cancelled
As a result, BAE is being forced to close facilities and lay off personnel in its US ground systems businesses.

More broadly across the corporation, BAE Systems also is unable to achieve the synergies that one might expect of a company of its size. US technology transfer restrictions hamper its ability to share technologies and even information within the company between its US and UK business units.

BAE Systems' position on the network centric systems of the future is relatively weak in its UK operations, particularly compared to the strength of its US operations.

Like other European defense companies, BAE Systems is handicapped by low British spending on research and development and funds wasted on duplicative national programs in Europe.

Opportunities: BAE Systems has aggressively worked to build up its cyber security, intelligence and security business both in the United Kingdom and the United States. Despite disappointments, it remains committed to increasing the business. Commercial cyber security is seen a particularly promising portion of the market.

Electronic Systems is also seen as a potential growth area.

International sales outside the United States also offer opportunities. Saudi Arabia in particular offers promise following formal agreement on pricing for the Typhoons and a series of large value support contracts.

Management is focusing increasingly on improving its profit and cash generation.

Threats: Further cuts in the US defense budget, particularly in the Army, would hurt badly. There could be a direct impact in new prime contracts and a secondary impact by driving other prime contractors to keep more business in-house. That could hurt the Electronics business.

For BAE, the lack of new work to keep ground facilities open is a very serious threat. If programs such as the Joint Light Tactical Combat Vehicle are further postponed, the company's position will further worsen with inadequate work to keep key facilities like York, Pennsylvania open.

The armored systems business faces increasing competition both in the United States and in the United Kingdom. It also faces a steeply declining worldwide market.

Affordability of UK programs also is a serious problem for the company. The UK Ministry of Defence has cut its procurement plans and programs.

Instability in Saudi Arabia would represent a serious threat to the company's very profitable Al Yamamah arms for oil program since the Kingdom represents 20% of the company's sales. It has represented a significantly greater share of profits in recent years.

About the Author

Philip Finnegan

Philip Finnegan

Phil is Director of Corporate Analysis at Teal Group. He has provided strategic and market analysis for clients in commercial aerospace and defense, including major U.S. and European prime contractors, since joining Teal fifteen years ago.

He also writes and edits Teal's Defense and Aerospace Companies Briefing, which analyzes the performance, outlook and strategies of 50 aerospace and defense companies in the United States, Europe, Asia and South America. He is a co-author of the annual World Unmanned Aerial Vehicle Systems with responsibility for UAV companies.

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