BAE Systems plc

Summary

BAE Systems plc provides defense, aerospace, and security solutions worldwide. The company operates through five segments: Electronic Systems, Cyber & Intelligence, Platforms & Services (US), Air, and Maritime. The Electronic Systems segment offers electronic warfare systems, navigation systems, electro-optical sensors, military and commercial digital engine and flight controls, precision guidance and seeker solutions, military communication systems and data links, persistent surveillance systems, space electronics, and electric drive propulsion systems. The Cyber & Intelligence segment provides solutions to modernize, maintain, and test cyber-harden aircraft, radars, missile systems, and mission applications that detect and deter threats to national security; systems engineering, integration, and sustainment services for critical weapons systems, C5ISR, and cyber security; and solutions and services to intelligence and federal/civilian agencies. It also offers data intelligence solutions to defend against national-scale threats, protect their networks, and data against attacks; security and intelligence solutions to the United Kingdom government and allied international governments; anti-fraud and regulatory compliance solutions; and enterprise-level data and digital services. The Platforms & Services (US) segment manufactures combat vehicles, weapons, and munitions, as well as provides ship repair services and the management of government-owned munitions facilities. The Air segment develops, manufactures, upgrades, and supports combat and jet trainer aircraft. The Maritime segment designs, manufactures, and supports surface ships, submarines, torpedoes, radars, and command and combat systems; and supplies naval gun systems. It also supplies naval weapon systems, missile launchers, and precision munitions. The company was founded in 1970 and is based in Farnborough, the United Kingdom.

Operations

Corporate Strategy

BAE Systems has a corporate strategy that builds on their vision and mission. It is comprised of six key long-term areas of focus that will help BAE achieve their vision and mission. It is centred on maintaining and growing their core franchises and securing growth opportunities through advancing their three strategic priorities.

1. Sustain and grow their defence and security businesses

• Deliver on commitments effectively and efficiently
• Develop offerings to meet the future defence and security needs

2. Continue to grow their business in adjacent markets

• Take capabilities into adjacent attractive markets
• Develop dual-use opportunities delivering civil solutions to leverage back to meet challenges for defence customers

3. Develop and expand their international business

• Mature international activities, broadening offerings to established customers
• Develop relations with additional customers

4. Inspire and develop a diverse workforce to drive success

• Ensure diversified thinking and harness the full potential of people
• Create an environment and proposition in which people will thrive

5. Enhance financial performance and deliver sustainable growth in shareholder value

• Seek opportunities to drive efficiency, standardisation and synergies
• Identify opportunities for higher-margin offerings

6. Advance and integrate their sustainability agenda

• Emphasise the vital role played in protecting countries and civilians and supporting communities
• Progress the delivery of their decarbonisation strategy

Priorities

Serving as a bridge between the long-term strategy and short term objectives, are the strategic priorities. These priorities have been successfully demonstrated by BAE Systems.

• Drive operational excellence
  • BAE Systems has been part of the F-35 programme since its inception, bringing our expertise into the development, advanced manufacture, electronic warfare systems and sustainment of the world’s largest defence programme. Led by the US, with participation from the UK, Italy, Netherlands, Australia, Canada, Denmark and Norway, this collaborative programme delivers a stealthy, multi-role combat aircraft capable of operating from land and sea to nations across the globe. As a key partner, BAE collaborates with the programme’s prime contractor, Lockheed Martin, to deliver around 15% of each aircraft (excluding propulsion), playing a major role in the development, production and sustainment of each jet.
• Continuously improve competitiveness and efficiency
  • To improve production efficiency and increase capacity, BAE has embarked on the process of constructing a new, modern ship lift/ land-level ship repair complex at our Jacksonville, Florida shipyard. Once it is fully operational, the complex will feature a ship lift that can easily move vessels in excess of 25,000 tons, and the new land-level repair complex will enable the team to work on three or more ships simultaneously parked ashore with access to their hulls. The $200m (£166m) investment will bring a 300% increase to the shipyard’s current dry-docking capacity and expand the shipyard’s customer diversity by bringing in more commercial work.
• Advance and further leverage our technology
  • BAE Systems is working with partners to design and deliver a new flying combat air demonstrator, which will play a critical role in the delivery of the UK’s Future Combat Air System. The flagship project is part of a suite of novel technologies being developed by Team Tempest, which will see BAE Systems engineers lead the design, test, evaluation and build process and bring together new digital engineering technologies. The first flight of the demonstrator is set to take place within the next five years.

Market

Total Addressable Market:

Here, the total addressable market (TAM) is the global defence market which is valued at $2.24 trillion based on worldwide military expenditure figures for 2022.

Serviceable Available Market:

Here, the serviceable available market (SAM) is the defence market in select geographical regions (shown in map) accessible to the company which is valued at $1.37 trillion based on the respective 2022 military expenditure figures.

Serviceable Obtainable Market:

Here, the serviceable obtainable market (SOM) is the defence market in select geographical regions (shown in map) accessible to the company which is valued at $1.28 trillion according to the 2022 BAE Systems Annual Report.

Region Accessible:

USA

UK

Map showing Global Presence of BAE Systems.

Kingdom of Saudi Arabia

Australia

India

France

Germany

South Korea

Japan

Italy

Largest Region:

USA

Market Drivers:

-         Invasion of Ukraine and tensions in East Asia drive increased spending.

-         Increased spending by Japan in response to perceived growing threats from China, North Korea and Russia.

-         Aids and grants to Ukraine

Market Trends:

-         Unmanned combat vehicles

-         Autonomous fighter jets

-         Edge computing

-         3D printed technology

-         Use of AI in defence equipment

Competition

Competitive Advantages:

• World class defence capabilities across multiple domains - air, land, sea and undersea
• Strong customer relationships - largest defence supplier in the UK and Australia, and among top ten in the US
• Diversified Business Portfolio - wide range of mission critical electronic systems including electronic warfare systems, flight and engine controls, night vision systems, surveillance and reconnaissance sensors, and power and energy management system.

Competitors:

Company Name	HQ	Founding Year	No. of Employees	Revenue (FY 2022)	Market Cap.
BAE Systems	Farnborough, United Kingdom	1999	93000	$26.3B	$29.6B
Lockheed Martin Corporation	Bethesda, Maryland, United States	1995	116000	$66.0B	$113.3B
Northrop Grumman Corp	Falls Church, Virginia, United States	1994	95000	$36.6B	$65.3B
General Dynamics	Reston, Virginia, United States	1952	106500	$39.4B	$61.3B
The Boeing Company	Arlington, Virginia, United States	1916	156000	$66.6B	$136.5B
RTX (Raytheon)	Arlington County, Virginia, United States	1922	182000	$67.1B	$125.4B

Financials

Most recent half

Income Statement (£m)	H1 2023	H1 2022	% change
Revenue	10997	9739	12.9%
Operating Income / EBIT	1233	1028	19.9%
Net Income	1005	647	55.3%

The first half of 2023 saw a 12.9% growth in the total revenue generated, resulting in subsequent growths in operating income and net income. This comes after a £1.8bn contract from the Czech Republic to produce 246 CV90 MkIV infantry fighting vehicles. The Air sector also saw continuation with the Qatar Typhoon and Hawk programmes.

Historical data - 5 years

Income Statement - (£m)	FY-22	FY-21	FY-20	FY-19	FY-18
Revenue	21258	19521	19277	18305	16821
Gross Profit	14063	12468	12413	11803	10898
Gross Margin	66%	64%	64%	64%	65%
EBITDA	2846	2545	2384	2259	1874
Operating Income / EBIT	2384	2389	1930	1899	1605
Net Income	1674	1912	1371	1532	1033

Balance sheet - (£m)	FY-22	FY-21	FY-20	FY-19	FY-18
Total assets	31462	27135	27530	25630	24746
Total liabilities	20062	19467	22609	20119	19128
Net assets	11400	7668	4921	5511	5618

Details

Financial forecast / projection - 5 years

Income Statement - (£m)	FY-23	FY-24	FY-25	FY-26	FY-27
Revenue	24688	26076	27735	28967	29832
Gross Profit	15980	16878	17952	18749	19309
Gross Margin	65%	65%	65%	65%	65%
EBITDA
Operating Income / EBIT	2424	2534	2668	2758	2810
Net Income

Details

Valuation

Intrinsic Valuation (DCF)

Expected Return on Investment

The Stockhub users estimate that the expected return of an investment in BAE Systems plc over the next five years is 31%. This value was arrived at through the use of an intrinsic valuation in the form of a discounted cash flow model.

Assuming that a suitable return level of five years is 10% per year (based of the S&P 500 returns) and BAE Systems achieves its return level of 31%, then the company can be considered as undervalued.

Assumptions

Description	Value	Commentary
Valuation Model	Discounted Cash Flow Model	One form of intrinsic valuation is the discounted cash flow model where future cash flows are discounted to the present value. Research has suggested that to estimate the expected return of an investment over a long-term investment horizon, a discounted cash flow model provides an accurate projection.
Financial Projections	Stockhub, CapitalIQ, Yahoo Finance	To improve the reliability of financial projections, a mixture of sources was used when projecting key financial metrics such as revenue.
Discount Rate	WACC	The weighted average cost of capital was used as the discount rate as it expresses the return that both bondholders and shareholders demand to provide the company with capital. The cost of equity and cost of debt have been calculated in the tables provided below using values taken from the company's financial statements, beta for the stock, and expected market returns.

Free cashflow calculation

Current Share Price: £9.68
£ million	Historical								Projected
	2015	2016	2017	2018	2019	2020	2021	2022	2023	2024	2025	2026	2027
Income Statement
Revenue	16787	17790	17224	16821	18305	19277	19521	21258	24688	26076	27735	28967	29832
% growth		6%	-3%	-2%	9%	5%	1%	9%	16%	6%	6%	4%	3%
Cost Of Goods Sold	7101	7212	6085	5923	6502	6864	7053	7195	8708	9198	9783	10218	10523
% of revenue	42%	41%	35%	35%	36%	36%	36%	34%	35%	35%	35%	35%	35%
Gross Profit	9686	10578	11139	10898	11803	12413	12468	14063	15980	16878	17952	18749	19309
gross margin	58%	59%	65%	65%	64%	64%	64%	66%	65%	65%	65%	65%	65%
Selling General & Admin Exp.	5200	5838	6229	6203	6457	6681	6640	7431	8509	8988	9559	9984	10282
% of revenue	31%	33%	36%	37%	35%	35%	34%	35%	34%	34%	34%	34%	34%
Depreciation & Amort.	351	333	263	269	511	543	513	549	553	584	621	648	668
% of revenue	2%	2%	2%	2%	3%	3%	3%	3%	2%	2%	2%	2%	2%
Amort. Of Goodwill and Intangibles	0	0	82	78	101	128	188	215	272	313	361	406	447
% of revenue	0%	0%	0%	0%	1%	1%	1%	1%	1%	1%	1%	1%	2%
Other Operating Expense	2872	2929	3032	2821	3087	3348	3283	3786	4222	4459	4743	4954	5101
% of revenue	17%	16%	18%	17%	17%	17%	17%	18%	17%	17%	17%	17%	17%
Total Operating Expenses	8072	8767	9261	9024	9544	10029	9923	11217	12731	13447	14302	14938	15384
Operating Income/ EBIT	1263	1478	1533	1527	1647	1713	1844	2082	2424	2534	2668	2758	2810
EBITDA	1614	1811	1878	1874	2259	2384	2545	2846	3248	3431	3649	3811	3925
Tax Expense	147	213	216	191	94	225	198	315	295	308	325	336	342
Effective tax rate	12%	14%	14%	13%	6%	13%	11%	15%	12%	12%	12%	12%	12%
EBIAT	1116	1265	1317	1336	1553	1488	1646	1767	2129	2226	2343	2422	2468
Cashflow
D&A	351	333	263	269	511	543	513	549	553	584	621	648	668
% of revenue	2%	2%	2%	2%	3%	3%	3%	3%	2%	2%	2%	2%	2%
Amort. Of Goodwill and Intangibles	0	0	82	78	101	128	188	215	272	313	361	406	447
% of revenue	0%	0%	0%	0%	1%	1%	1%	1%	1%	1%	1%	1%	2%
Capital Expenditure	-359	-408	-389	-358	-360	-385	-516	-599	-741	-782	-832	-869	-895
% of revenue	2%	2%	2%	2%	2%	2%	3%	3%	3%	3%	3%	3%	3%
Change in NWC	717	108	640	192	422	-196	-95	132	521	550	585	611	630
% of revenue	4%	1%	4%	1%	2%	-1%	0%	1%	2%	2%	2%	2%	2%
Unlevered FCF	391	1082	633	1133	1383	1970	1926	1800	1692	1790	1907	1996	2059

Notes on projections

Revenue projections were adapted from Capital IQ's estimates, and cross-checked with Yahoo Finance.

The COGS margin was projected by taking the average of COGS margins from 2017 onwards, as there seems to have been a stabilisation after this year.

The Selling General & Admin Expenses, Depreciation and Amortisation, Other Operating Expenses and the Tax Expenses were projected by applying average of each respective margin over the historical period and applying it to each forecast year.

Amortisation of Goodwill and Intangibles was projected as growing from 1.1% to 1.5% to model the steady increase in its margin seen in the historical period.

• Note: Upon cross-check with BAE System's Annual Report, Capital IQ presents the true depreciation expense as "Depreciation and Amortisation", and the true Amortisation Expense as "Amortisation of Goodwill and Intangibles".

Capital Expenditure was taken as having a steady 3% margin, seen from the recent step up in its value (2021, 2022)

Change in NWC was projected by taking the average of the non-negative margins from the historical data, and applying this average as the margin for each forecast year.

Calculation of the discount rate (WACC)

WACC		Notes
Weights
Total Debt	6610
Market Cap	29363
Total	35973
Wd	18%	Weight of debt calculated as the total debt as a proportion of total capital.
We	82%	Weight of equity calculated as the market cap as a proportion of total capital
Debt
Total Debt	6610	Cost of debt was calculated by taking interest expenses from the income statement and dividing this by the total debt making note of the fact that debt is a tax deductable item.
Interest Expense	-233
Rate	3.5%
Effective Tax Rate	12%
Rd(1-t)	3.1%
Equity
Risk Free Rate	4.05%	Capital asset pricing model was used to calculate the cost of equity. Risk free rate of the US Treasury 10 Year was used.
Beta	0.57	Beta for the stock was found from Yahoo Finance
Market Rate	10%	Current market rate was calculated as the average returns of the S&P 500 over the past 50 years.
Re	7.4%
Discount Rate	6.6%	This is the value used for the WACC
Perpetuity Growth Rate	2.0%	A perpetuity growth rate of 2% was used as this is sufficiently low to ensure that the company is not projected to increase in size far faster than the global economy in the very long term.

Cashflow projection

£ millions		2023	2024	2025	2026	2027	Terminal Value (Perpetuity Growth)	Notes
		1692	1790	1907	1996	2059	45229	The terminal value of the company was calculated using the Gordon Growth Model.

DCF

Present Value of FCF	7769
Terminal Value	45229
Net Present Value of TV	32791
Enterprise Value	40559
Net Debt	1866
Equity Value	38693
Shares Out	3050
Equity Value per Share	£12.69
Current share price	£9.68
Difference	31%

Sensitivity Analysis

A sensitivity analysis was also conducted to reflect how changes in the discount rate and perpetuity growth rate would affect the intrinsic value of the company.

£12.69		Perpetuity Growth
		1.0%	1.5%	2.0%	2.5%	3.0%
WACC	5.5%	£13.61	£15.12	£17.07	£19.66	£23.30
	6.0%	£12.17	£13.36	£14.84	£16.75	£19.30
	6.5%	£10.99	£11.95	£13.11	£14.57	£16.44
	6.6%	£10.69	£11.59	£12.69	£14.04	£15.77
	7.0%	£10.01	£10.79	£11.73	£12.87	£14.30
	7.5%	£9.18	£9.83	£10.60	£11.51	£12.64
	8.0%	£8.47	£9.02	£9.65	£10.40	£11.31

Relative Valuation

Expected Return on Investment

The Stockhub users estimate that the expected return of an investment in BAE Systems plc over the next five years is 15%. This value was arrived at through the use of a relative valuation method in the form of a comparable company analysis.

Assuming that BAE Systems achieves its return level of 15%, then the company can be considered as undervalued.

Comparable company analysis

Market Data										Financials				Valuation Ratios
Company	Ticker	Share Price	Currency	Shares Out /millions	Equity Value /millions	Net Debt /millions	Enterprise Value /millions	EPS		Revenue /millions	EBITDA /millions	Net Income /millions		EV/Revenue	EV/EBITDA	P/E
BAE Systems plc	LSE: BA	9.62	GBP	3050	29341	3406	32747	0.50		22516	2776	1941		1.45	11.80	19.24
Rolls-Royce Holdings plc	LSE: RR	2.56	GBP	8362	21408	3732	25140	0.25		19665	2180	1514		1.28	11.53	10.24
Safran SA	ENXTPA: SAF	155.98	EUR	420	65527	-81	65447	8.00		24065	4477	3166		2.72	14.62	19.50
Thales S.A.	ENXTPA: HO	140.78	EUR	209	29353	915	30267	6.08		19607	2499	1203		1.54	12.11	23.15
Leonardo S.p.a.	BIT: LDO	13.95	EUR	575	8025	4110	12135	1.62		16347	1536	857		0.74	7.90	8.61
Airbus SE	ENXTPA: AIR	137.79	EUR	789	108744	-4661	104083	5.33		67010	7702	3872		1.55	13.51	25.85
Northrop Grumman Corporation	NYSE: NOC	430.17	USD	151	65085	13726	78811	30.23		37881	7243	4649		2.08	10.88	14.23
Hensoldt AG	XTRA: 5UH	31.63	EUR	105	3321	632	3953	0.80		1904	251	77		2.08	15.74	39.54
Dassault Aviation societe anonyme	ENXTPA: AM	185.32	EUR	79	14640	-8190	6451	10.61		6850	733	806		0.94	8.80	17.47
Rheinmetall AG	XTRA: RHM	271.23	EUR	43	11771	828	12599	11.71		7175	1004	474		1.76	12.55	23.16
L3Harris Technologies, Inc.	NYSE: LHX	181.48	USD	189	34318	9158	43476	4.19		17988	2760	802		2.42	15.75	43.31
Raytheon	NYSE: RTX	85.47	USD	1460	124786	31532	156318	3.74		70573	12088	5562		2.21	12.93	22.85

BAE Systems plc valuation	EV/Revenue	EV/EBITDA	P/E
Average Comparable Ratio	1.76	12.39	22.54
Revenue	22516	NA	NA
EBITDA	NA	2776	NA
EPS	NA	NA	0.5
Implied Enterprise Value	39553	34404	NA
Net Debt	3406	3406	NA
Implied Equity Value	36147	30998	NA
Shares Outstanding	3050	3050	NA
Implied Value Per Share	11.85	10.16	11.27
Average	£11.09
Current Share Price	£9.68
Difference	14.6%

Risks

BAE Systems believes that managing risks effectively is key to successfully delivering on their strategies and strategic priorities. They employ a thorough, multifaceted, top to bottom risk management framework, which aims to mitigate any risk to their strategy that is identified. The Board has the overall responsibility, advised by the Audit, ESG and Executive Committees. The basis of the framework is:

Identify, Analyse, Evaluate, Mitigate

All risks primarily affect their future revenue and financial health.

Government customers, defence spending and terms of trade risks

These risks affect strategies 1, 2, 3, 5

• 95% of sales in 2022 were in defence. Government expenditure on defence can vary based on policy, politics, budgetary constraints as well as national security threats, and some governments have already faced constraints. However, BAE has a geographically well-spread market, many countries within which have announced plans to defence spending in response to the currently elevated global threats. BAE also benefits from a large order backlog, as well as establishment with long-term projects.
• BAE systems faces threats to their ability to secure and maintain government contracts. Financial reviews can lead to budgetary reconsiderations and premature termination of contracts. However, BAE is established as being a major contributor to the industrial capabilities of the countries within its market.
• BAE also faces a risk with the fact that its cashflows depend on the timing and success in being awarded contracts as well as when they receive the corresponding cash. Not receiving cashflow on time can lead to an inability to focus on their own expenditure without requiring external funding - impacting credit rating. However, BAE manages their balance sheet conservatively, to ensure flexibility, as well as monitoring liquidity to ensure the retrieval of cash needed for operations.

International market risks

These risks affect strategies 1,2,3,5

• The risks of operating in international markets include: social and political changes impacting the business environment, economic downturns, political instability and civil disturbances, the imposition of restraints on the movement of capital, the introduction of burdensome taxes or tariffs, change of export control, tax and other government policy and regulations in the UK, US and all other relevant jurisdictions, and the inability to obtain or maintain the necessary export licences. Similar to the risk on fluctuations in government expenditure, BAE has a geographically well-spread market, many countries within which have announced plans to defence spending in response to the currently elevated global threats. BAE also benefits from a large order backlog, as well as establishment with long-term projects.
• They are exposed to volatility arising from movements in currency exchange rates, particularly in respect of the US dollar, euro, Saudi riyal and Australian dollar. There has been volatility in currency exchange rates in 2022.
• Brexit can still affect BAE System's ability to participate in, and receive contracts for, European Union-funded projects. However, BAE has a major role in certain European programmes, such as the Eurofighter, and is also supporting the UK government in maintaining the UK's role in European security and defence.

Contract risk, execution and supply chain risks

These risks affect strategies 1,2,4,5

• There is a risk associated with the costs of fixed-price contracts exceeding the contract amount, and hence resulting in a local loss. The price is agreed based on a projection of the inflation rate, and hence is subject to fluctuation. It is important for BAE systems to maintain tight tolerances on quality, time and cost, in a reliable, predictable and repeatable manner. They have also limited fixed-price contracts regarding design and development, which tend to have more associated risk.
• Like any business associated with product manufacturing. BAE system relies on its supply chain, which has intrinsic risk. There are lead-time and availability issues, as well as pricing pressures from inflationary increases in labour, energy and key materials.

Cyber security risks

These risks affect strategies 1,3,4

• Cyber threats can cause business and operational disruption. BAE Systems faces risks potential cybersecurity threats in the form of:
  • Attacks impacting availability of its information technology and operational technology infrastructure and systems
  • Attempts to gain access to or delete proprietary and classified information, of BAE Systems as well as its customers, partners and suppliers.

These threats are mitigated through constant monitoring, as well as cyber security training for its personnel.

Competition in international markets

These risks affect strategies 1,3,5

• BAE systems need to be able to win contracts for new and high-quality programmes, while depending on UK and US government support. However, their multi-market and international presence, balanced business portfolio and their capable and reliable track record of delivery is a factor that combats this risk. BAE systems also invests in research and development, to ensure cutting-edge technology that puts them in line with, or ahead of, the competition.

Outbreak of contagious disease

These risks affect strategies 1,2,3,4,5

• Similar to that of COVID-19, new pandemics can cause sever disruption to its operations, as well as its market. However, having been through the coronavirus pandemic, it is expected that the experience in dealing with such an event can minimise the impact of future pandemics, experience including safe working practices and effectively implementing working from home.

Climate change and the environment

These risks affect strategies 1,2,3,4,5,6

• BAE systems could face rigorous environmental laws and regulations, regarding air emissions, waste handling, use and handling of hazardous materials, remediation of soil and groundwater, contamination and the prevention of pollution through greenhouse gas emission. This could affect operations, as well as an ability to sell. Harsh environmental conditions could directly affect operations, through natural disasters and accidents arising from the environment. Furthermore, the adjustment to a low-carbon economy could mean increased tariffs and compliance costs, as well as a potentially reduced demand base, driven by politics and morality. However, BAE systems are working towards the target of achieving net zero across operations by 2030.

Laws and regulations

These risks affect strategies 1,2,3,4,5,6

• Their operations are within a highly regulated environment across multiple jurisdictions, and is therefore subject to regulations related to import-export controls, money laundering, false accounting, anti-bribery and anti-boycott provisions. It is crucial that BAE systems maintains responsible business and financial practices. They may also be affected by export restrictions, affecting their ability to sell their products.

Acquisitions

These risks affect strategies 1,2,3,5

• BAE Systems believes in the virtue of investing in value-enhancing acquisitions, where such an acquisition brings them closer to their strategised goals. They must ensure successful migration and integration of acquired business, as well as perform post-acquisition monitoring of its expected benefits