Industrials

Chris Bryant is a Bloomberg Gadfly columnist covering industrial companies. He previously worked for the Financial Times.

In theory these should be the best of times for BAE Systems Plc, Britain's biggest defense contractor. U.S. President Donald Trump wants to lift military spending -- BAE is a supplier on the F-35 fighter jet program -- and his saber-rattling has probably got other countries thinking about doing similar.

While Brexit has put a bit of a downer on the U.K.'s economic prospects, four-fifths of BAE sales are made overseas, including far-flung markets such as Saudi Arabia and the U.S. Indeed, with Britain poised to depart the EU, its government doubtless hopes more companies will emulate BAE's export success.

Sadly, theory and practice are rarely the same thing. BAE painfully underscored this on Tuesday, when it said would cut almost 2,000 jobs or more than 2 percent of its workforce.

While a lull in export orders for the Eurofighter Typhoon jet is the main reason given for the reduction, the company’s troubles may run deeper. Top-line growth is unimpressive, operating profit margins lag those of U.S. rivals and finances are stretched by a chunky pension deficit.

Dogfight
BAE's margins are less impressive than its U.S. peers
Source: Bloomberg

New chief executive Charles Woodburn, a former oil and gas industry executive, no doubt wishes he didn’t have to start off by getting rid of people. But running a tighter ship seems prudent given the state of the business.

BAE still expects underlying earnings per share to increase by as much as 10 percent in 2017. But with Typhoon production fading, revenue growth could be harder next year. Analysts reckon BAE sales and net income will be pretty flat.

Even though Qatar has signed a letter of intent to buy 24 Typhoons, it’s difficult to know if and when firm orders might materialize. Meanwhile, Saudi Arabia still hasn’t signed off on a follow-up order for Typhoons. It will hardly be delighted that BAE is doing business with local foes, the Qataris.

That’s troubling because BAE still has some hefty obligations. The pension deficit stood at almost 6 billion pounds ($7.9 billion) at the end of June. As a percentage of market capitalization, it's one of the biggest shortfalls among U.K. blue chip companies as my colleague Chris Hughes has noted.

BAE’s obligation to cut the deficit is being reassessed as part of a triennial review. JPMorgan analysts think the yearly pension top-up payments could double to about 400 million pounds from 2018, a burden for a company that had about 660 million pounds in free cash flow last year, according to Bloomberg data. BAE has roughly 1.7 billion pounds of net debt too.

Then there’s the dividend. As with oil companies, BAE is popular with income investors. The stock yields 3.5 percent. But maintaining the payout puts another burden on the company’s finances. Dividends consumed about 670 million pounds of cash last year.

Finally, BAE needs to invest more in research and development. While R&D expenses totaled 1.4 billion pounds last year, almost 8 percent of sales, only about 200 million pounds of that was funded by the company. Woodburn has flagged innovation as a priority.

BAE trades on just 14 times estimated earnings, while its peers typically fetch more than 20 times. Given the cloudy future for its fighter jets and the military precision needed to balance all these cash demands, that seems warranted.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Bryant in Berlin at cbryant32@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net