BAE Systems

Moat: 3/5

Understandability: 3/5

Balance Sheet Health: 4/5

A multinational defense, security, and aerospace company, BAE Systems is a major supplier to governments and military agencies worldwide, primarily focusing on the design and manufacturing of defense equipment and systems.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Explanation

BAE Systems operates in the defense, security, and aerospace sectors, with a primary focus on designing, manufacturing, and supporting defense equipment and systems. Here’s a more detailed breakdown:

  • Revenues Distribution: BAE Systems’ revenue is primarily derived from contracts with government agencies, mainly in the US, UK, and other countries in Europe and the Middle East. Sales are diversified across several segments:
  • Electronic Systems: This includes the design, development, manufacture, and support of electronic warfare systems, communication systems, and cyber solutions.
  • Cyber & Intelligence: This segment focuses on providing cybersecurity solutions, intelligence services, and information warfare capabilities. * Platforms & Services: This segment includes the design, development, manufacture, and support of naval ships, submarines, aircraft, and land vehicles. * Air & Maritime: This encompasses the company’s activities in the defense aerospace and maritime sectors, including production of aircraft systems, naval ships, and support services. * Other: This includes various other smaller business units.

BAE Systems’ business model has some level of geographic diversification with operations around the globe, but its contracts are heavily concentrated in government defence programs.

  • Industry Trends:
  • Increased Defense Spending: Geopolitical tensions and conflicts globally, including the war in Ukraine, have led to rising global defense budgets.
  • Technological Advancement: The need for constant innovation drives the market, with a greater focus on cutting-edge technology such as artificial intelligence, electronic warfare, and cybersecurity. * Cybersecurity: As cyberattacks become more frequent and sophisticated, demand is growing for robust cybersecurity solutions, driving revenue growth for companies like BAE Systems. * Multi-domain Operations: Modern warfare is increasingly moving beyond land, sea, and air to include space and cyber domains. This is creating a demand for capabilities across multiple domains.
  • Margins and Competitive Landscape:
  • Margins: Defense companies typically achieve better margins through innovation and technical know-how in key areas. BAE Systems’ revenue mix has moved over the last couple of years towards higher margin areas like electronic warfare.
  • Competitive Landscape: The defense industry is characterized by a limited number of major players and high barriers to entry, due to technical requirements, stringent regulations, and strong customer relationships. The competition primarily happens on a contract basis and requires significant expertise and government connection, making it difficult for new players to enter and compete. The top competitors include Lockheed Martin, Raytheon, Northrop Grumman, Thales, Leonardo, and Airbus.
    • What Makes BAE Systems Different: The company is notable for its strong relationships with the UK and U.S. governments, and possesses technical know-how in different areas of defense such as cyber and electronic warfare. BAE has also a decent exposure to international markets, which allows for stability. BAE also has a reputation for being a well-run company, with a good risk profile.

Financials

  • Revenues: Total revenue for 2023 was £25.3 billion, up significantly (13.6% YoY) compared to 2022. The company’s growth is driven by high demand for its diverse product range and defense modernization plans from its customers. The current global instability is creating growth opportunities for BAE in general.

  • Profitability: The company showed a strong 2023 performance, with underlying EBIT increasing by 15.4% to £2.46 billion. BAE Systems has been moving towards improving margins with focus on higher margin projects, and the results clearly indicate the strategy has been paying off. * The company’s balance sheet shows the level of debt to be pretty consistent from year to year, which is favorable. * Cash flow: The company is generating consistent positive free cash flow, which is always a good sign, and improving the company’s balance sheet over time.

  • Order Book: The order backlog reached record level of £69.8 billion at the end of 2023, up substantially from previous years, confirming strong demand and future revenues for the company. Strong order backlog gives a great level of future visibility. * Debt: BAE’s net debt-to-EBITDA ratio sits at 1.0, indicating the company’s debt is manageable and there’s still scope for further expansion through debt financing if required. * Cash & Equivalents: The cash balance on the balance sheet is relatively high with just over 3 billion in cash and cash equivalents at the end of 2023, giving the company substantial flexibility and room for acquisitions or growth investment. * The company is also planning a buyback program, to reduce the number of outstanding shares which will support the stock price.

BAE’s impressive order book, growing revenues, rising profitability and high free cash flow generation clearly underlines the fact that the company is doing very well, and has a solid foundation for growth in the future.

Moat

BAE Systems has a narrow moat, which sits at a 3 out of 5. The reasons for this rating are as follows:

  • Intangible assets: BAE Systems benefits from very stringent government regulations in the defense sector, leading to high barriers to entry. These include unique capabilities for large defense contracts, various intellectual property (IP) and design advantages, and close relationships with governments. While these act as a form of moat for BAE, they don’t act as barriers against other big players.
  • Switching Costs: BAE Systems’ customers can have switching costs related to their existing supply contracts and integration capabilities, as well as long established relationships. However, customers can often take their business to a new provider if pricing is overly egregious.
  • Cost Advantages While BAE might have some cost advantages in various production facilities, it is not a consistent feature across its business, which has a broad product base and varying capabilities.
  • Network Effects: BAE’s business has little to no network effects, hence it isn’t a source of competitive advantage.

While BAE Systems has advantages, these do not fully prevent new competition, especially considering the high barriers to success, are similar to most large defense companies. Therefore, BAE gets a narrow moat rating instead of wide.

Risks to the Moat and Business Resilience

  • Geopolitical Risks: Shifts in global and domestic political situations can lead to changes in defense spending, creating both opportunities and risks, and the reliance on large government contracts leaves the company open to changes in policy. In recent years, tensions with China and the Russian war on Ukraine have benefited the company, but future events may not produce similar results.
  • Technological Disruption: Rapid technological advancements could render existing products and services obsolete, leaving room for new disruptors to take their market share. BAE has tried to diversify its product range in new technology domains, but it can still be a source of risk for the company. * Project Execution Risks: The complexity of large projects increases the potential for cost overruns, delays, and customer dissatisfaction. * Dependence on Government Budgets: The primary revenue driver for BAE Systems is government budgets, which have been proven to be volatile in the past and may also be subjected to policy changes. This reliance makes the company sensitive to changes in government spending decisions.
  • Supply chain Issues: Like many companies around the world, BAE is dependent on third-party suppliers for its manufacturing process. Recent supply chain disruptions have highlighted the dependence on global manufacturing partners and that reliance could affect BAE if geopolitical or economic disruptions occur.
    • Reputation: The defense industry is a highly sensitive field, and the company is subjected to scrutiny when selling arms to countries with human rights concerns. Bad press or bad reputation could severely impact the business and their image.

Although BAE Systems has a reasonably strong position in the market, the business and the moat could be damaged by events, which are beyond company control.

Understandability

The understandability rating for BAE Systems is a 3 out of 5. This rating reflects the following:

  • Complexity of Operations: BAE Systems operates in a complex industry with specialized technologies and government regulations. Although the broad concept of making defense products is easy to understand, the specific technical details of their technology is not an easy task, not to mention understanding the regulatory and contractual details.
  • Revenue Streams: Although they have different sectors, revenue for BAE Systems comes from a small number of main customer contracts.
  • Financial Analysis: The company is a large well established company. The company’s financial statements, while available, are more complex than a standard retail business and understanding their nuances requires specialized expertise.

Balance Sheet Health

The balance sheet health for BAE Systems gets a rating of 4 out of 5. The reasons for this rating are:

  • Debt Management: The company’s debt is well-managed, and the net debt-to-EBITDA ratio sits at 1.0, which means the company is well within its target and there is no risk of an inability to pay back debts.
  • Cash Flow Generation: BAE Systems has a very good cash flow generation which supports the balance sheet’s long term stability and reduces risk from market downturns.
    • High Cash and Equivalents: BAE Systems has a good level of cash on their balance sheet that enables them to manage downturns and make large capital expenditure decisions.
  • Order Backlog: The record high backlog further increases the stability of the company, and assures revenue generation in future periods.
    • Potential Issues: The company is highly reliant on government contracts. These contracts may be subjected to political or financial turmoil, or could be canceled at any moment, meaning the company’s financials are somewhat exposed to macro factors, despite its solid financial situation.