Take cover from BAE Systems

Political events over the past year have raised the heat on BAE. The murder of journalist Jamal Khashoggi in October 2018 prompted Germany to prohibit arms sales to Saudi Arabia, with a ban that was extended for another six months in March 2019. BAE leads a pan-European consortium to provide and maintain 72 Typhoon aircraft for Saudi Arabia, of which Germany is a member. At its full-year results in February, it warned that the German ban could affect its ability to support its Saudi activities and “may have a consequential impact” on its financial performance. A recent UK government ban on new arms licences for weapons that might be used in the Yemen conflict, meanwhile, could affect future BAE sales to the kingdom and its partners. In March 2018, BAE signed a memorandum of intent to provide 48 further Typhoons to Saudi Arabia, which would require a new export licence. The Labour party has signalled that it would scrap arms sales to Saudi Arabia should it enter government. None of BAE’s competitors have a substantial exposure to the kingdom anymore. It’s a lucrative market for the company – for now.

Beyond Saudi Arabia, BAE’s Qatari Typhoon contract, along with BAE’s capital expenditure committed towards its US expansion, is eating into its cash flow. Free cash flow (FCF) fell from £1.3bn to £615m in the full year to 2018, and BAE has warned that FCF will “not be linear over the three‑year period”. Operating business cash flow, which is operating cash flow less capital expenditure, was down 43 per cent year on year to £993m. A £307m working capital outflow was larger than house broker Berenberg expected. Delivery delays within its Paladin armoured vehicle programme and ongoing issues with its UK offshore patrol vessel operation contributed here. BAE is now targeting cumulative FCF of £3bn-£3.3bn by 2021, which is around £300m-£600m below pre-results consensus. It will need substantial improvement in cash generation in later years to meet this goal.

Growth in the US businesses, which accounted for 42 per cent of last year's sales, did help to limit the impact on revenues, which fell marginally at the full year, from foreseen reduction in Typhoon production. Here, BAE is ramping up its production of F-35 fighter jets, with levels forecast to be at full rate in 2020, and working capital and capital expenditure predicted to rise in support of US growth. BAE is well established in the US, with over 70 years’ presence and 11 per cent of its £6.7bn 2018 air sector revenues generated here. But the group may be nervous about the planned $120bn (£94bn) merger between US aerospace giants Raytheon and the aerospace arm of United Technologies. Onlookers, including President Trump, have raised concerns over the deal’s impact on competition. 

Any thoughts that BAE may have on a tie-up of its own in response, though, would be likely to run into trouble, particularly if it involved an overseas competitor. In his 2017 book, The Economics of Arms, professor Keith Hartley suggests that international mergers could create political and monopoly problems, with nation states fearful of “a loss of independence and national security” and regulators mindful of “the reduced bargaining power of national defence ministries”. It’s unlikely that a merger with another UK aerospace and defence business, meanwhile, would provide the necessary scale.