BAE Systems plc (BA) Earnings Call Transcript & Summary

Yes. I think ESG has been -- it's so interesting to see how that's gone exponential. Since I joined the business in the end of 2019. In those first few investor meetings I had, it came up in hardly any of the conversations. And then by 2021, it was in every single investor meeting we had and certainly funds flow in exponential, too, in ESG. And what I found interesting is the U.S. investors were far more pragmatic with ESG. It was like ESG is important to us as an investor tell us a company what you're doing about it. And you could have a good conversation, and they were satisfied that we have -- we do have a lot of really good things that we're doing on ESG from our net zero by 2030 commitment, to the great things we do in electrification of buses and now narrow-body aircraft. To the things we do for social impact, the apprenticeship programs, the graduate training programs, all the real rich investment we do in the communities that we operate in, that's a real social impact. And then on governance, everything falls apart, if you don't have strong governance and we have world-class governance. So I think when you get to have that conversation about the great things we're doing in ESG, it's exciting because we do have a lot to offer. What is frustrating is when you get to sort of the European position, you have these exclusions in place. And what's -- since the Ukraine conflict has transpired, the European conversation has become much more pragmatic, similar to the way the U.S. looks at things. So that -- it's been more constructive, I would say. And the interesting thing to me is that it's sort of like this Maslow's hierarchy of needs. You really can't have self-actualization or exist as a society unless you can protect it. And it's very clear now that the defense industry plays a very strong role in being able to protect a free society. And so the conversation is getting to a better place, I'd say.

All right. That's good to hear. I wanted to touch on the topic of execution risk as well. We've seen a number of topics that are -- have become top of mind now. for all industrial companies like semiconductor, labor, titanium and energy. So which have you found as most challenging from BAE perspective? And how do you mitigate the risks there?

Yes. So we certainly are not immune to all these supply chain pressures and labor tightness, and it has affected our top line growth. Although we did post close to 3% top line growth, half year to half year. And so we -- and we did post margin expansion. So even in this inflationary environment, we're able to push margins. And I think that's a testament to the strength of our commercial models. So 30% of our business is in cost plus. So this inflationary pressures ultimately get passed to the customer. And then the rest of our business is very much supported by strong escalation clauses and also very good back-to-back ranges with our suppliers. And because we're very long-term oriented on our contracts, we can provide a very strong long-term demand signal to our suppliers. So they can order the materials they need far in advance. So we've been well insulated, I'd say, from -- but not immune, but well insulated from all these sort of supply chain and inflation issues, I think the real struggle is probably the labor shortage. So and I think every company and every industry is grappling with some issue or some degree of that. And we're certainly seeing that in our business. But I think that's a short-term issue. I mean the programs will build out. That backlog doesn't go away. So what happens is it just pushes revenue to the right a little bit.

All right. You've mentioned it that H1 margin was solid. It was 10.5%. Could you help us understand maybe if you still have some low-hanging fruits that you could pick in terms of boosting profitability? And on the flip side, any project where you have slightly higher execution risks that we need to be aware of?

Yes. So the second half of the year, it's just a feature of our business. We tend to be second half weighted, and this will be no different. So we should see some mid-teen type H2 versus H1 growth on the top line, and we should see margins grow faster than that. So a lot of that is coming from the commercial side of the business, Electronic Systems commercial portfolio. And so we will -- and that typically carries a higher margin. So that will be a feature of our H2 revenue stream and just the build-out of some of the programs that we're on across the portfolio is more H2 weighted. So we do see an H2 pickup. And we -- as I said, we should be able to grow margins from here. I think Charles, the CEO did quite a lot to I think raise the bar on operational excellence. When he came in, he did a lot to change the culture to have a very open culture where you can share issues without sort of fear of retribution. And it's really important that you don't have this sort of hero culture where you try to solve everything down at your business unit level. And then before you know it, the problem gets bigger and bigger. What Charles is really good at doing was bringing this open culture where if I have a problem, I don't need to be the hero, I need to ask for help. And so being unafraid to do that has been an important part of that. So what it means is you can bring all the resources in the organization to help fix a problem. And if you do that in early stage, you can avoid a major train wreck. And these are very complex programs that we operate in. There will be things that go wrong. But if you have an open culture where people get the help they need, you can really mitigate a lot of these -- the issues that will emerge. That's one. I think the second part is you have to have a commercial model that matches the risk. And so I think the company in the past has learned some lessons on taking fixed price risk on immature design and development work. We do not do that and we won't do that. And so that's been a big part of that. We have commercial models that match the risk. And that's -- I think it's been a helpful part, too, in mitigating some of these issues of the past. So we really are focused on performance and operational excellence is the key of all of that. And with the culture and the business models, it's very helpful to deliver that.

All right. I just want to take the opportunity to open to the audience. So if you have any questions, please raise your hand and a mic will be passed on to you, until we have a candidate for that. I just want to talk about the buyback which is obviously a key element of your investment proposal. You've already done GBP 110 million in less than 2 weeks out of a GBP 1.5 billion program. So how front-loaded could that program be?

Well, we hope to get through as much as we can this year, the GBP 500 million tranche. And I expect there'll be -- it won't be completely evenly distributed across the next 3 years. But we've made good progress so far as you reflected. Yes, I think the buyback is important because it was enabled by us having a successful conclusion of the triennial pension review. And this company has had a history of pension deficits, and that's limited the company's use of cash. And I think we hit a real inflection point and we've been actively trying to get out from under this pension deficit shadow. And if you noticed in the half year results, we actually published a pension surplus. So that is a real historic marker. And with that visibility, we're able to set off this 3-year buyback program. And now we are allocating capital in ways that really are constructive and value accretive rather than having to put cash into a pension plan. So the pension is fully funded, and we are allocating capital in ways now that are really starting to accrete value.

All right. I wanted to talk also about the other use of cash, your potential for M&A. Are you finding the right assets at the right price? Does it make sense versus buying your own stock? Or how are you seeing the opportunities evolve in the past few months?

Yes. We certainly want to continue to participate in the sort of the bolt-on category of M&A. So we don't want to be doing transformational M&A, but we really want to add to the portfolio of companies that fit our strategy. And we've been and we'll continue to be very disciplined players in the M&A market. So there absolutely has to be a path to positive NPV in any deal that we pursue and we would continue to be very selective. But we do see opportunities. We're pursuing sort of a big opportunity set. We're wanting to expand our positions in space and hypersonics and autonomy and multi-domain networking. And we've made some really good additions in the last couple of years, the portfolio, the GPS business I mentioned, out of the Raytheon-UTC spin-off, the radios business that came out of that. The addition of In-Space, which is low earth orbit satellite maker out of the U.K. The recent addition of Bohemia Interactive. So synthetic training is going to be a growth area, and we're really pleased to have that in the business. And these are all acquisitions that are margin accretive. And so it's -- I think we've been really good in bringing value to the portfolio with M&A. And we're also divesting as well, things that are noncore. And so I think I talked about the 3Ps: so it's performance, which we've already kind of hit on; pension, which we've hit on derisking the pension; and then portfolio, making sure that we have a composition of companies that are positioned for above-market growth. So hitting on all those 3Ps for me is the way we changed the game in terms of that valuation discount that we've historically traded at. And we're making progress on all 3 of those. And there still is a discount, but I think that we're going in the right direction to change that.

All right. And my last question will be actually on free cash flow conversion. So how should we think of the conversion rates evolving over the next few years? Because, obviously, you're going to have sort of phasing of advances with the budget upswing, but also you probably will have to spend on CapEx to meet that higher demand. So how should we think of the conversion evolving in the next few years?

Yes. Well, that's another area that we've showed real steady improvement on. Historically, our cash conversion has been in sort of the 50% to 60% range, which isn't great competitively. And a lot of that is coming from the fact that we had to contribute meaningful amounts into this pension scheme. And so now with the pension and surplus, as I said earlier, we're able to invest that cash in interesting ways. And we've also done better with managing our cash cycle, been more analytical with looking at DPO and DSO and inventory days. That's helped our working capital. And going forward, we've communicated the 3-year target of GBP 4 billion -- in excess of GBP 4 billion from '22 to '24. And after we get through the GBP 1 billion this year, it means we're hitting GBP 1.5 billion a year thereafter. And I think that's pretty much all of our underlying earnings after tax. So we're converting almost all of our profit into cash, which is a really good turnaround from where we've been in the past. It just shows you the improvement in the business.

All right. Well, on that positive note, this will conclude this presentation and webcast. Thank you so much for tuning in.