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BAE Systems' fight with the British government might look like a disaster. But it isn't. Not only does the defence contractor need to have the row; it might pay dividends in future. That certainly seems to be the verdict of the stock market. BAE's shares have actually risen by a quarter this year. They are also up by 5% over the past month.
The row concerns a £2.9 billion ($5.3 billion) order for two aircraft carriers. At first glance, BAE's demands look extravagant. The group isn't just trying to sweeten the terms of the order; it is trying to get the government to rewrite its whole policy on defence procurement. That means the state underwriting more of the risk on all big weapons development projects, and BAE getting a bigger share of such work without the tiresome chore of competing for it.
If it doesn't get its way, BAE hasn't just threatened to pull out of the carrier contract; it has threatened to withdraw from the whole warship-building business. That would look cheeky at the best of times. It looks unbelievably brass-necked from a company that incurred nearly £1 billion of cost overruns on two big projects over just a year or two.
So why is BAE pushing its luck? The reason is simple. It has no choice if it wants to lift itself out of a rut.
The group's UK defence programmes business is a ghastly drag on the group. It accounted for a fifth of group turnover last year but it only contributed 5% of the profit. In 2002, thanks to cost overruns on two huge defence contracts – to build Astute submarines and Nimrod maritime patrol aircraft – it generated a thumping loss.
BAE must take a chunk of the blame for this. It didn't handle the contracts well. Over the years, the company has notched up an unenviable record of poor project management.
But it has been operating with one hand tied behind its back. That's because the UK government forces it to tender for development projects on a fixed-price basis. Thus, for the opportunity to make an often slender margin, BAE has to shoulder the risk of potentially huge overruns.
Take the carrier contract. That is worth no more than 5p on the share price, or £152 million, if all goes well, according to Merrill Lynch. Against that, the company worries it might be on the hook for a share of more than £1 billion of cost overruns if the carriers prove more expensive to build than expected.
Not only has this held back the group's results; it has also prevented BAE expanding in the US. Poor results in the UK meant that it failed in a bid to acquire a prime Pentagon contractor a few years ago. When it attempted to merge with a US group last year, potential partners took one look at the UK programmes business and blenched.
This matters because the US is now BAE's biggest customer. Its defence department gives it more business than the British government. What's more, the US business earns four times the margin the UK business does. It is also growing far faster.
Threatening to shrink the UK business isn't actually a high-risk strategy. In fact, it would reduce BAE's risk. Warship building isn't a very profitable activity. And you don't need to do it to sell high-tech weapons to ships, which is where BAE makes its margin.
True, the shipyards might not be saleable, and could take years to close. But not taking on new loss-making contracts would at least protect the company against losses in future.
Nor is it clear that BAE is really running a huge risk by having a row with the UK government. True, the company does not want to alienate Whitehall completely. But it is pushing at a half-open door. Concerned to preserve a major defence contracting capability in the UK, the defence ministry has already conceded the principle of moving from a fixed-price to a more cost-plus focused system.
BAE's business has actually started to turn around – something that the shouting match has hitherto obscured. Thanks to a high oil price, its large Saudi contracts are becoming more profitable and fresh orders are on the horizon. The company has won a large export order for its Hawk trainer aircraft that should be profitable. The Eurofighter Typhoon production schedule is finally ramping up.
This improvement presents BAE Systems with an opportunity to clean up its UK defence book. What is encouraging is that the company seems determined to grasp it.
BAE trades at a discount of about 25% to its European peers on a price/earnings basis. If it succeeds in taking some of the risk out of the UK business, not only should that discount start to shrink, but US expansion would become a possibility again. Gaining that option would do no harm to the share price.
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