Insight: Defence Market

Where now for BAe System?

BAe System with its high exposure to defence and little exposure to the fast growing commercial markets needs new tactics. Investors needs convincing that the company has a viable medium to long term plan for sustainable stable growth. They are concern about the company’s long-term earnings outlook and the significant decline of its cash position.

One question that looms large is where does the company go from here. It was the previous board that sold BAe’s stake in Airbus to focus on winning a large share of the giant US defence market. This strategy was credible when Boeing dominated the commercial market and when US defence spending was ramping up as the country fought two wars. But times have changed. Now the huge US defence budget is being cut over the next decade.

Analysts believe that there are no easy choices and that the company has three basic options: to be takeover / to merge, to break itself up or to continue as a standalone business. A takeover by a US company would possibly lead to a migration of jobs, expertise and technology across the Atlantic, which may lead to the UK government blocking this option with its “golden share”. A break-up option would likely find potential buyers for its US defence interest subject to Pentagon’s approval, but this would leave the company with a much-diminished UK operation that would not have the critical mass to compete on the global stage. The status quo of independence is not a viable option.

However, the view here, and of our contacts, is that the company should develop a plan that will consist of a combination of two or more of these options. Developing a right plan for a defence company is never easy. The industry is a political one. At the same time, the company needs to protect the value generated from the special relationship with the US, UK and Australian governments. Therefore one could possible see a plan that includes a step, which allows the company to put its military vehicle assets into a venture with Ford Military and GKN.

Defence Market Perspective

It is clear that the defence industry is experiencing annual incremental decline of about 2.5%. Executives are expected to do more than they did in previous downturn. As result, we urge defence companies to establish a Cost and Cash Sensitive Restructuring plan that will create a defence business for the future growth.

It will be no surprise to readers that defence spending is in a tailspin within developed economies. The Iraq and Afghanistan wars are over and military spending is scheduled for prolonged reductions. Therefore, even though some of this reduction may be offset by defence spending in several areas of the globe, especially in the Middle East, India, China, Russia, South Korea, Brazil, and Japan, management is being required to react.

In previous downturns, management actions included merger with competitors, entry into adjacent markets, entry into entirely different markets, and investing to create the next generation technologies. This downturn will likely require the same king of actions, plus more. It will include more emphasis on international sales and development of new products and technologies to address the new threat environment.

Yet we sense that much of the industry is responding with incremental actions. Transforming an organisation into a value crating business for the future requires more than pulling a few operational levers. It means executing a Economic Profit Building(EPB) plan that focus on life-cycle cost reduction, business model transformation, smart product introduction and new market opportunities. Defence programs have become extraordinarily expensive and affordability is a slogan repeated by budget-constrained governments.