[A-List] UK arms industry: fiscal crisis at BAE

[Michael Keaney]

Bombshell over defence contracts leaves BAE friendless
Defence giant's profit warning has damaged directors' credibility and
reawakened memories of its near-collapse in 1991
By Michael Harrison, Business Editor
The Independent, 13 December 2002

BAE Systems may have changed its name, but it has not lost any of its
capacity to shock. This week's bombshell that the world's second-largest
arms manufacturer is facing substantial cost overruns on two of its biggest
Ministry of Defence contracts sent BAE shares into a fresh tailspin
yesterday. They have now fallen by 40 per cent since Wednesday's profits
warning. At one stage yesterday they dipped briefly below 100p - the kind of
level last seen just over a decade ago when the company was still called
British Aerospace and it was teetering on the brink of bankruptcy.

The cause of the crisis back then in the autumn of 1991 was a piece of
financial engineering that went disastrously wrong. The chairman at the
time, Professor Sir Roland Smith, had embarked on an audacious plan to buy
Austin Rover and Royal Ordnance and then rationalise the two businesses,
selling off chunks of BAE's vast landbank to pay for the resulting
redundancy bill. When the recession arrived and property prices duly
crashed, BAE's strategy was left high and dry. Sir Roland was ousted and
only an emergency £432m rights issue saved the company from being swallowed
up by Arnold Weinstock's GEC.

Today BAE is staring down the barrel of a gun once more, although this time
the crisis is of a different nature. It is not financial engineering but
aeronautical engineering that threatens to be the company's undoing. The
problem can be summed up in one word: Nimrod. The plane has been around
since the 1960s. GEC-Marconi almost came unstuck in 1986 trying to develop
an airborne early warning version of the Nimrod. Sixteen years later BAE,
which now owns GEC-Marconi, has run into trouble with the £3bn development
of a maritime reconnaissance version.

The contract involves stripping the existing fleet of Nimrods down to their
fuselages and then rebuilding them with new wings, tailfins, cockpits,
engines and mission systems. As an executive from a rival defence company
admits: "It's a huge and horribly complex job. When the Nimrod was built
originally, it was put together with little men using rubber hammers and
rivets who could bend things to fit. Today, they are using computers and
lasers. It is a question of having to take a 1950s design and apply 21st
century technology."

The City thought BAE had got all of the bad news out of the way two years
ago when it announced it was taking a £525m charge, £300m of which related
to delays and cost overruns on the Nimrod programme. This week's profit
warning demonstrates that is emphatically not the case.

Together with cost overruns on the Astute nuclear-powered submarine
programme, analysts fear BAE could be looking at a balance sheet hit of
anywhere between £800m and £1bn.

Unsurprisingly, the company is now virtually friendless - in Whitehall and
the City. The Ministry of Defence reacted with unusual speed and vigour to
Wednesday's warning, making it clear that BAE would have to accept
responsibility for the cost overruns and pay the penalty for its "failure to
perform". In the City the reaction was scarcely less scathing. Even BAE's
own joint house broker, ABN Amro, switched its recommendation on the shares
to "sell".

What alarmed the City was not just the cost overruns themselves but the
damage that has been done to the credibility of BAE's management. The profit
warning followed several days of increasingly fevered speculation in the
market that a just such a statement was imminent and equally emphatic
assurances from within BAE that all was well.

The City's anger at being misled made the subsequent punishment all the
harsher. In a withering note headlined: "The leopard has not changed its
spots", Goldman Sachs said it was cutting its forecasts for BAE "severely"
and estimated the Nimrod and Astute fiascos would cost the company £800m.
Sash Tusa, the bank's defence and aerospace analyst, added: "Our lack of
confidence in either the guidance of BAE's management or in its ability to
manage programmes leads us to impose an additional 20 per cent discount on
the value of the company in its current form."

Credit Suisse First Boston was equally critical. Its defence analyst, Harald
Hendrikse, said: "In our view, with the shares down 200p since August, the
charge is not the problem, management credibility is. How can we be sure
there is no further bad news on other contracts?"

The man with whom the buck stops at BAE is Mike Turner, its chief executive.
He was parachuted into the top job when the previous occupant John Weston
was unceremoniously dumped last March. This is Mr Turner's second profits
warning in three months. In September, he caught the markets offguard by
announcing a £120m write-down on two other military programmes. He then
further unnerved investors by appearing to renege on BAE's long-standing
pledge that profits would start to rise in 2003. In a curious formulation,
he said: "We are more confident than ever that we are going to get profit
growth but we can't say in what year."

It was not the message the City wanted to hear and it accelerated the slide
in the share price. As a former BAE executive says: "The company still
operates on a need to know basis and unfortunately it applies that attitude
not just to secret weapons programmes but also to its relationship with the
City."

Pessimists such as Goldman Sach's Sash Tusa now believe BAE will have to
slash its second-half dividend by a half. Worse, the profit warning has
reawakened fears about BAE's Achilles heel - cash flow - given its reliance
on very big and lumpy procurement contracts that can very easily fall behind
schedule, as Nimrod now has.

Goldman Sachs reckons BAE will suffer a cash outflow of £1.5bn over the next
two years, taking its borrowings up to an eye-watering £3.6bn and stretching
its balance sheet considerably. "BAE in our view needs to take radical
action to staunch this bleeding," it adds.

BAE was supposed to have overcome its vulnerability to shocks like this by
widening its geographic spread and concentrating its mix of businesses.
Throughout the 1990s, investors were treated to a string of mind-bogglingly
large write-offs on its regional aircraft activities until BAE finally
exited the business altogether.

Save for its 20 per cent stake in Airbus, which accounts for some £3bn of
sales a year, it is now even more defence orientated. But it is the
Pentagon, not the MoD that is now BAE's biggest single defence customer. It
will become even bigger as the £100bn F-35 joint strike fighter goes into
production. By contrast, UK defence programmes - such as Nimrod and
Eurofighter - now account for just 18 per cent of turnover.

But, as BAE has repeatedly demonstrated over the years, just when investors
think it is safe to get back into the water, along comes another nasty
surprise. BAE says it will "never again" take on a "lousy" fixed-price
contract such as Nimrod or Astute. "We have learned our lesson," a spokesman
said. History has had a tendency of disproving that.