BAE Systems’ (BAESY) CEO Ian Graham King on Q2 2014 Results – Earnings Call Transcript

This activity, along with the commitment to build three offshore petrol vessels and the restructuring agreement, will provide long-term clarity for complex warship manufacturer in the U.K.

The Queen Elizabeth Class aircraft carrier program is progressing well, and the first vessel is structurally complete. The carrier was named in the formal ceremony by Her Majesty, the Queen earlier this month, and has subsequently been floated out of the dry dock in which the ship was assembled, allowing assembly of the second ship to get underway.

In the submarines business, Artful, the third of the seven Astute Class submarines was launched in May. Alongside build of Astute Class boats, engineering work continues to accelerate on the successor program.

In Saudi Arabia, the Group continues to make good progress with the provision of capabilities that now support 38 Typhoon aircraft in service. In addition to delivering a high-end defense capability, we are committed to the continued development of Saudi Arabia’s industrial base, in line with the Kingdom’s stated national agenda.

In June, we have managed the reorganization of our portfolio of interest in a number of industrial companies in Saudi Arabia and an enhancement of an existing relationship with Riyadh Wings. This reorganization is expected to enhance the growth prospects of these businesses in Saudi Arabia and support skills and technology development in Kingdom with increasing local employment.

In Australia where BAE Systems is the largest defense contractor, there was a government commitment to increase defense spending. We continue to perform well on the Canberra class landing helicopter dock program with the first of the two ships completed and expected to be delivered to the customer in the second half of the year. We are discussing with the Australian government options needed to sustain industrial capabilities across the shipbuilding sector. It is important we resolve this key issue.

Other international markets offer a range of opportunities. We now have initial funding for the large Korean F-16 upgrade program and see other military aircraft upgrade prospects. Our MBDA joint venture recently won a key contract for ASRAAM, a precision air-to-air guided weapon with the new government in India. Other prospects in India for M777 Howitzers and the next batch of Hawks continued to be pursued in this new political environment.

We are seeing significant renewed interest in MBDA for ground-based air defense systems from international markets, and we have vibrant campaigns to address international opportunities for Typhoon aircraft and combat vehicles.

In the area of Cyber Security & Intelligence, our U.S.-based business continues to be impacted by delays in procurement awards and increases in the number of award protests. Much of the reduction has come from the Afghanistan withdrawal and the impact on our lower margin IT support activity. The strategy to develop our U.S. government mission support activities remains robust and we continue to address substantial bid prospects.

As you may have seen, we have just completed a small bolt-on technology acquisition with Signal Innovations Group, a provider of imaging technologies and analytics to the U.S. intelligence community. Although small in scale, this acquisition provides us with additional technology that has the potential to be exploited for commercial applications.

Through the Applied Intelligence business we continue to successfully develop our strategy for commercial cyber with good growth in the first half and contract wins across international markets. We achieved further strong order intake, growing the order backlog 25% in the first half. This success builds on our 60% growth in the order backlog last year. We continue to invest in the business as we build our cyber skills base. For the second year running, over 40% of BAE Systems graduate intake in the U.K. will join the Applied Intelligence business.

In addition to the drive into cyber, we invest heavily in the skills and technologies we need to sustain and grow our wider business for the future. We focus company-funded investment in the areas of both defense and commercial aircraft electronics, unmanned technologies, and as I mentioned, to build our commercial cyber business.

We should remember that in defense work we work with our customers to develop the skills and technologies to meet their requirements. Customer-funded R&D is an important component of our overall investment. Today, the overall percentage of both our own and customer-funded R&D is approximately 6% of Group sales.

Group’s capital allocation policy remains unchanged. We continue to supplement dividends with returns to shareholders through the share repurchase program announced last year.

I will now hand over to Pete to take you through the detailed financials. Pete?

Peter J. Lynas – Group Finance Director and Executive Director

Thanks Ian, and good morning. As Ian mentioned, our results have been impacted by the stronger pound, both in absolute terms against 2013 and against the assumptions made in our guidance. And I’ll make that impact clear as I give the usual trading review and then move into the 2014 full-year guidance. For reference, the U.S. dollar is average 167 so far this year compared to 154 last.

So the headline numbers and compared to the first half of 2013, sales have reduced by some £900 million to £7.6 billion. Around £400 million of that reduction was due to exchange translation. The volume reductions in Land & Armaments were as expected, and there was a significant second half bias in sales due to the contracted delivery schedules for Typhoon aircraft this year.

Underlying EBITDA decreased by 7% or 4% of constant currency to £802 million, giving a return on sales of 10.5%. Underlying finance cost in the first half was slightly down at £89 million. Underlying earnings per share were marginally lower than in 2013 at 17.7p, benefiting from the Group’s share repurchase program and lower tax rate. And there is a bridge charge showing the movement in EPS appended to the presentation posted on the web.

There was an operating cash inflow in the first half of £287 million, benefiting from the sale and lease back of our two residential compounds in Saudi Arabia. Net debt to June 30 was just under £1.2 billion. Order backlog is reduced to £39.7 billion and £0.4 billion of that is due to exchange translation. And finally, the interim dividend has been increased to 8.2p per share, up 2% on the 2013 interim.

In addition to the effect of exchange translation, there were a number of other impacts, items impacting the balance sheet in the first half. Tangible fixed assets reduced as the second of our Saudi residential compound sale and leas back transactions completed in April. As anticipated, advances continue to be consumed on the Omani Typhoon and Hawk program, the European Typhoon contract, and the Saudi training program.

The first of the two payments into the Salam VOP settlement has been received. Cost incurred are being charged against a number of provisions created in previous years. The IAS 19 accounting pension deficit is increased over the six months to £3.6 billion, and I’ll cover that on the next slide. And finally, net debt close to £1.2 billion.

This slide shows the pension scheme assets, liabilities and deficit as accounted for under IAS 19. The value of the scheme assets has increased by £0.6 billion over the period to £22.1 billion. Liabilities increased by £0.9 billion to £26.9 billion.

Real discount rates have reduced by further 20 basis points in the U.K. and by 60 basis points in the U.S., mainly driven by bond yields. So overall, a net £200 million increase in the Group’s pretax accounting pension deficit.

As you know, the pension accounting is not the important issue; it’s the funding position that’s more relevant. And 2014 is a significant year for triennial funding valuations with all nine of the Group’s U.K. schemes falling due.

Discussions between the company and the trustees of those schemes are currently ongoing as to the underpinning assumptions behind the calculation of the liabilities. And we expect those discussions and any subsequent revisions to deficit recovery plans to be completed by the year-end.

Moving on to cash. This slide sets out the movement from our net debt position of £699 million at the beginning of the year. There was an operating business cash inflow of £287 million. Interest and tax payments were £141 million. 2013’s final dividend paid in June was £383 million.

Under the three-year share repurchase program of upto £1 billion; we bought back 56.6 million shares in the first half at a cost of £235 million. And since commencement of the program, we have bought back 108.2 million shares at an average price including cost of £4.14. Exchange translation to all other movements totaled £11 million.

We did repay $500 million of long-term borrowings in the period, so we closed at June 30 with gross debt of £2.6 billion, cash of £1.4 billion and net debt of £1.2 billion. The cash flow performance of the five sectors is shown here, and I’ll return to this when I get to the results of each of the sectors. But just to note, the total cash outflow for pension deficit funding in the period was £163 million, the cash outflow at head office contains £148 million of that.

Moving now to the sectors, I’ll cover the year-to-date performance here and then return to the full-year outlook a little later. And so, to the first of those sectors, Electronic Systems and the figures shown here are in U.S. dollars.

The sector delivered sales of $1.85 billion, almost identical to last year and in line with guidance. Sales in the commercial area of the business now stand at 22%, and growth there is helping to offset the expected pressures on the defense side.

The return on sales achieved the 12.9%, which is consistent with the first half of ’13. Cash conversion of EBITDA in the first half was ahead of last year’s, and we do expect an improved conversion level over the full year.

Despite the U.S. budget pressures, order backlog stands at $6.2 billion, sustained since the start of the year on further F-35 LRIP awards. And this backlog does not include the currently protested award for enhanced night vision goggles.

The Cyber & Intelligence sector comprises the U.S. intelligence and security business together with BAE Systems’ applied intelligence. The numbers again are here in dollars. In aggregate, sales reduced by 13% to $0.9 billion. The U.S. business saw a further 22% decrease, driven largely by reduced budgets of the sector’s two largest customers along with further reductions in analysis support on Counter-IED activity in Afghanistan. Growth in the Applied Intelligence business was 7%

Despite the top line performance, margins have improved to 8.9%. Cash flow performance includes the capital cost of the replacement ERP system and stand up of a Malaysian operating center in the Applied Intelligence business.

Order backlog increased to $1.4 billion, and despite the first half, top line pressures, backlog in the U.S. business grew by 8% on imagery analysis and cyber support awards. In the Applied Intelligence business backlog grew by 25% and now stands above $0.5 billion for the first time.

The U.S. Platforms & Services sector aggregates the Land & Armaments and the Support Solutions businesses. As Ian mentioned, in a further cost reduction move the Support Solutions business is being disaggregated across the other three U.S. businesses. For 2014, we will continue to provide transparency of the two businesses within the sector and we will advice of changes to be made to reporting structures for ’15.

So I’ll move straight on to the performance of the first of those two businesses, Land & Armaments. Sales in the first half reduced by 14% to $1.26 billion. As per our guidance back in February, broadly reset activity has almost halved, the major mine protective vehicle production contract has completed and deliveries of the US M777 Howitzer contracts have largely traded out.

Despite the expected top line reductions, the business has outperformed at the margin level, delivering a return on sales of 10.9% through strong program execution and cost reduction. Cash flow was significantly improved compared to last year with more than 100% profit conversion.

Order backlog is reduced in line with the sales traded. In the Support Solutions business sales of $1.51 billion in the first half were in line with the expectations with good volumes in naval ship prepare activity. However, the return on sales in the period was at just 2.5%.

In addition to the lower margins arising from last year’s issues on the Radford contract, a further $20 million of charge have had to be taken on commercial ship build programs.

Order backlog reduced to $4.8 billion on the sales trading outs under the five-year U.S. navy multi ship — multi-option ship prepare contracts and ordinance programs. The recomplete for the Hawaiian contract was successfully secured in the first half.

In the Platforms & Services in U.K. sector, sales were up $2.8 billion, 15% lower than in the first half of 2013. This year Typhoon aircraft deliveries have a significant second half bias. Under the Saudi Arabian Salam contract, there were four aircrafts delivered in the first half with eight scheduled for the second half. And on he European program, there were eight aircraft deliveries in the first half with 22 scheduled for the second half as we transition to deliveries of Tranche 3 standard.

The return on sales of 13.8% seen in the first half of 2014 has benefited from strong program execution and accelerated risk reduction on the European Typhoon production contract as the Tranche 2 aircraft deliveries moved towards completion.

As expected, the $0.2 billion of cash outflow in the period reflects the consumption of customer advances on the Omani Typhoon and Hawk program, the European Typhoon contract and the Saudi training aircraft program. Order backlog reduced to £20.4 billion, primarily on the trading of Typhoon aircrafts, Indian Hawks and carrier.

Stripping out the exchange translational impacts of sterling against the euro and Australian dollar, sales in the international businesses for the first six months of £1.576 billion are unchanged from 2013. EBITDA was at £157 million, giving a consistent return on sales of 10%. There was an operating cash inflow of £541 million, which includes a net £349 million from the sale and lease back less initial rentals of the two Saudi residential compounds.

Whilst order backlog has reduced from last year and high following the awards in 2013 of the five year support contracts and weapons package, orders totaling £1.3 billion are being finalized with the Saudi customer.

For reference, there is a chart providing a summary of the trading performance of all five sectors appended to the presentation posted on the web, and that summary also contains the numbers of headquarters which include a one-off net benefit of £13 million, and that arises from the reassessment of a long-term liability that’s a further charge taken on settlement of U.S. contract pricing dispute.

This chart sets out our guidance for each of the sectors through to the end of the year; and so, firstly electronic systems where guidance is unchanged. We continue to expect 2014 sales in dollar terms to be similar to those in ’13. More than 20% of the business is now in commercial markets where we are seeing continued good levels of growth helping to offset reductions on the defense side.

On margins, we expect to see performance of the high-end of our 12% to 14% guidance range. Next Cyber & Intelligence; and here we are revising sales guidance slightly downwards due to the continued pressures in the U.S. business.

In the Applied Intelligence business we continue to expect double-digit growth, and so for the sector in aggregate we now expect sales in ’14 to be some 5% below those in ’13. Despite the U.S. top line pressures, we expect margins towards the higher end of the improved 8% to 10% range.

Moving to Platforms & Services U.S., once overall guidance is as shown on the chart and aggregate is unchanged; this is best considered in two parts. In Land & Armaments, we reconfirmed previous guidance of the top line that is in the $2.25 billion to $2.4 billion. And our margin level we now expect fully delivery slightly ahead of the previous 9% guidance.

In the Support Solutions business we continue to expect 2014 sales to be only a littler lower than in ’13. However, due to the further charges taken in the first half in commercial shipbuilding we are reducing the margin guidance in the Support Solution sector for this year.

On Platforms & Services U.K., here guidance for both sales and margin remained unchanged. And as I’ve mentioned earlier, due to the timing of Typhoon aircraft deliveries on both European and Saudi contracts, there is a significant bias to the second half. And following the benefit in 2013 of the Salam price escalation catch up, margin in this sector is expected to return to within our usual 10% to 12% range.

And on the last of the sectors, Platforms & Services International, sales guidance is largely unchanged other than for the exchange translation impact from the Australian dollar the euro. That impact is projected at around £150 million year-over-year.

Last year’s trading that arose from the Salam price escalation and the high weapons volumes is expected to be largely match this year by increased level of support to the Typhoon aircraft that are now in service. Our margin guidance here is also unchanged. And to complete your 2014 models headquarters’ costs are expected to be significantly lowered in ’13 and that includes those first half one-offs.

Underlying finance costs are expected to be marginally higher. The effective tax rates guidance for the full year is reduced to around 20%, in line with the rate of the half year. And the final number is, of course, dependent upon the geographic mix of profits.

With last year’s non-recurring benefit from the Salam price escalation settlement and before the impacts of the stronger pound, we continue to expect the Group’s reported earnings per share to be some 5% to 10% lower than in 2013. Exchange translation assuming average rate of $1.70 is expected to impact earnings by around 1p compared to previous guidance.

This final chart highlights the cash utilization we expect in 2014. The first column shows the position of the half year and the second column provides the full year guidance. In respect of operating cash flow, we are not planning for any material capital expenditure above depreciation levels. We have completed the sale on lease back transactions of both of our residential compounds in Saudi Arabia, and those at the gross level have generated some £400 million of proceeds.

Within working capital we expect to incur cost of around £300 million against provisions created in previous years that are held in the balance sheet. The most volatile area remains the level of customer advances. And as expected, the major advances we received in 2012 on the Saudi Trainer Aircraft contract and the Omani contract are being consumed. And you’ll recall that under terms of that Omani contact no further cash will be received until deliveries commence in 2017. Advances are also being consumed on the European Typhoon contract.

The final operating cash flow items is the U.S. pension deficit funding, which will again be around £400 million, and that includes the accelerated funding arising from the share repurchase program.

The non-operating cash flow items are far more predictable. Outflows for interest and tax are expected to total around £300 million. Dividend payments in the full year of the share buyback program should deliver a further £1 billion of cash returns to shareholders.

And so, overall, and as per previous guidance, 2014 is expected to be year of better operating business cash flow, but with an increase to net debt post those shareholder returns.

In summary, then in the first half we have seen some mix performance in the U.S. sectors, but that’s been largely mitigated by good delivery in the U.K. business and the lower tax rate. For the full year, other than for exchange translation we are reiterating the earnings per share guidance that we gave in February. Ian?

Ian Graham King – Chief Executive Officer, Executive Director and Member of Non-Executive Directors Fees Committee

Thanks Pete. So, in summary, a good start to the year. The Group is performing well, and with some anticipated second half bias remains on track to deliver our plan for the full year in line with expectations. In addition, we continue to develop new businesses opportunities laying the foundation for the future growth.

So what we’ll now do is we’ll take questions. I, as usual, have my colleagues here from the EC to answer the really difficult questions, but who’s got the first question? Christian? Christian, you are there?

Question-and-Answer Session

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