Analyse recent annual reports in conjunction with the market conditions and prepare a financial report to provide input to the Sr. Executives of BAE systems for the purpose of preparation of a Financial Strategy for the Company.
Assess the financial position of BAE systems by analysing the recent annual statements against the strategies adopted by BAE in the recent past. The paper would also attempt to document operational impact based on currently implemented strategies and show potential effects, if the current strategy continues, based on forecasted data results by a financial model.
Parties Involves BAE Systems Board of Directors and the Business Consultant
Methods and Processes
The methodology would involve the analysis of the current financial state of the organization against the strategies being followed. The impact of the various short and long term strategies on the financial state of the organization would be studied. The process of secondary source research would be used. The recent annual reports of BAE would be obtained from BAE site, relevant magazines and academic journals would be referred for the strategies being followed by BAE and finally, the analysis would be related together to come up with the current state followed by the suggestions for improvement. Appropriate financial models would be used to justify the recommendations.
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The output of the analysis about BAE would a set of strategies recommended for BAE, together with the financial forecast for the organization. This analysis is expected to provide, much needed inputs to the Sr. Management of the BAE for the development of financial strategy of the organization.
The final report shall be submitted to BAE Systems Board of Directors by July 23, 2010.
Still negotiable based on the approval and implementation of the proposed strategy.
2. Executive summary
The aim for this report is to study the strategies implemented by BAE Systems during the last accounting year.
BAE Systems with its 120,000 employees worldwide delivers a full range of products and services for air, land and naval forces, as well as advanced electronics, security, Information technology solutions and customer support services (BAE Systems, 2010). With the analysis of the company's annual report for 2009, this study will analyse by comparing its strategies to a newly proposed one by showing financial projections using valuation models. The annual statements of last 5, including the latest, will be studied to suggest the projections for the year 2010. The projections would be subject to the strategies being followed, as suggested in this analysis.
3. Proposition of a new strategy for BAE Systems
The Aerospace and Global Defence industry can be considered an extremely cyclical. As seen on annual reports of the companies belonging to this industry year to year revenue figures can fluctuate dramatically (Brylawski, 1995). And currently this industry have also its share of intense competition, challenges on meeting government regulations and securing large defence contracts. Currently, BAE systems is the largest aerospace and global defence contractors in the world (West, 2010). Operating as a group in seven home markets with a wide portfolio of products and capabilities serving defence customers across the air, land and sea domains (BAE Systems 2010:5).
But based on its Annual report on the previous fiscal year, it posted a net loss of £67 million (see Appendix 2: Group Income Statement), despite the annual revenue of £22.4Â billion and the underlying operating income of £982Â million. The loss was mainly due to regulation penalties incurred during that fiscal year. The impairment losses, financing adjustments and regulatory penalties affected the profit figures for the organization.
This report is to provide a strategy that would ensure profitability on years to come given the volatility of the industry of BAE systems and the effects of inflation (which rose from 2.9% to 3.5% in 2009). Strategy taking into account methods to raise revenue, cost reduction and effective corporate governance would be recommended.
3.1 General competitive position of BAE Systems
The current strategy of the BAE group is based on its vision, which is to be the premier global defence, security and aerospace company; and the mission of the organization is to strive for retaining the position to deliver sustainable growth in shareholder value through a commitment to Total Performance (BAE Systems 2010:14). The current focus of strategy is positioned to optimise progress of the business in the current environment, the Group Strategic Framework continues to develop to recognise against the strategic objectives, and to highlight the Group's focus on delivery and performance (BAE Systems 2010:14). This strategy has worked effectively during all the acquisitions and disposals transacted from the year 200 to 2009. For the group/department of BAE systems the Electronics, Intelligence & Support, the acquisition on the year 2000 of two former Lockheed Martin businesses, Control Systems and Aerospace Electronics Systems, have made BAE and the group the world leader in digital engine controls, flight controls and electronic warfare solutions.
Always on Time
Marked to Standard
For the Land & Armaments group, another key strategy of acquisition that has established a global land systems business was implemented on years 2004, 2005 and 2007, when the company acquired Alvis, United Defense and Armor Holdings respectively.
For the Programmes & Support Division, another key acquisition that has provided access to government security business was done in 2008, when the company have finally acquired Detica and together with the acquisition of VT Group's shipbuilding business has further strengthened the Group's global maritime business (BAE Systems 2010:16). And lastly for the international sector BAE as a group has become Australia's largest defence contractor primarily due to the acquisition of Tenix Defence in 2008 (Smith & Frost 2008).
According to the firms most current Annual report total sales revenue is at £22.4Â billion (see Table 1) an increase of 21% from 2008 numbers, operating income at £982Â million (see Appendix 2: Group Income Statement), total assets listed at £25.4Â billion and total equity at £4.7Â billion (2009).
Table 1 show the percentage of Sales generated by each group under the BAE Systems in 2009 Source extracted from the Annual Report 2009.
Using the Porter's five forces analysis, we can derive a strategy outlining the major forces in Aerospace & Global Defence Industry.
Bargaining Power of Suppliers
BAE Systems has a wide range of suppliers for both large and small companies, thus if decided to switch; costs is not an issue, as long it can find a better supplier that can match technological capability to customer requirements. Currently BAE systems apply SBAC 21st Century Supply Chain Programme - SC21 tools and techniques for operational performance management and the tiered approach to supplier management (BAE Systems 2010). There are some areas of production for BAE like the creation of fighter aircrafts in which its supplier's are usually concentrated and has strong labor unions, but again due to diversity of the overall business operations of BAE the assessment of this supplier power can be considered at medium risk.
Threat of Substitutes
BAE systems is aware of its competitors' ability to provide other substitute weaponry to its customers, but not every competitor can offer in-house equipment and production quality that BAE can actually deliver. The threat of substitute can be considered medium, because there is still the existence of low priced but relatively competitive arms and weapons companies in the aerospace industry.
Bargaining Power of Buyers
The power of buyers describes the effect that the firm's customers have on the profitability of BAE overall. Even though based in the UK, BAE's main buyers are in the US.BAE's US subsidiary alone has accounted for 58.5% of total group sales (West 2010). The US Government in defence is by large have a lot of economic power and because of this the buyer's power can be considered high due to the challenge of capturing a high proportion of the value created is reduced. BAE's large buyers have significant leverage to negotiate lower prices because of the threat of losing a buyer that accounts for more than a half of total sales revenue, BAE is not in a strong position.
Threat of New Entrants
The threat of new entrants for BAE can be considered low, due to the Aerospace and defence large capital requirements, customer's brand loyalty, government regulations, economies of scale unique products and BAE's wide range access to inputs for continuous production. If a new firm decides to enter the market, in order to just compete with the wide range of products and services being currently available for BAE, the former needs to undertake a massive an expensive campaign for marketing just to introduce their products, and the challenge is also the effectively of this marketing campaign since BAE systems have already established a strong brand identity in arms industry.
BAE has also the advantage of an advanced production system with key access to inputs, which a new firm may be overwhelmed to know that in order to be at par with the existing firms it has to have an outstanding production system with access to key inputs as well.
Rivalry among Existing Competitors
Among the other forces of this critical framework, the rivalry among BAE's competitors is quite high. Major competitors globally by BAE are EADS from France, Raytheon from the US, Lockheed Martin and Boeing also from the US, and from the UK Rolls-Royce. Majority of these companies have posted significant high sales revenue for the fiscal year period of 2009, and they also continue to consolidate to remain competitive. Becoming the market leader has been the main goal of all players in the Aerospace and Global defence industry, and with government budget cuts (Wachman 2010), especially in the US, competition on securing large contracts have never been intense. Overall cost of production is significantly high in this field, firms may tend to overproduce and reduce prices to sell more.
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3.2 Strategy recommendation
BAE needs to be aware of its Book value and its total earnings, especially on depreciating assets. The strategy recommended, is to continue to acquire financially stable companies to add key improvements to the group, this is just one way to reflect a high closing book value, and dispose or sell, non performing divisions of the group.
The BAE group should create a plan to maximize shareholder's value by buying back their market shares by allocating an appropriate portion of their capital. And due to lack of future contracts, they may opt to cut a portion of their work force just to drive down costs and focus the need to drive efficiencies across the business and the continued development of four global initiatives Land, Security, Readiness & Sustainment and Unmanned Aircraft Systems.
BAE systems need to be more competitive. The help of external agencies can be sought to identify the business processes, which are not working in the favour of BAE systems. In addition to the external agencies, the critical analysis of internal systems and processes can be conducted for crystallising the strategies, which would enable BAE to come out of current financial position. The encouragement to innovation and improving internal communication within the organization to apprise all regarding the current financial position and how it can be improved would result in the new ideas coming up from employees of the organization. Few steps towards finding the appropriate solution to resolve the current financial situation are given as follows -
Support the initiatives to improve the profitability: An effective ideas management program can result in organization becoming more competitive. A big organization like BAE systems tend to get complacent. This was observed in the case, where BAE systems was heavily dependent on the MOD contracts for the development of its focus business area. The result was the loss as observed in the balance sheet. This kind of debacles can be avoided by harnessing the ideas skills of the large employee base BAE has. The organization can invite for suggestions from the employees on the areas of new initiatives and cultural differences, which can potentially result in the savings in terms of time and cost. The ideas scheme can be a rewards program. As it is simple to manage and operate, the chances of cost increase do not exist.
Cost reductions in operations: Any organization can grow its profits by focusing on the ways to increase its revenues (Top line growth) or decrease its costs (decreasing bottom-line). While a sharp focus on the improving business is definitely helpful, it is very important to keep a good check on the increasing costs. It is observed in this case that, BAE had been growing revenues but also increasing the costs with greater rates. The organization would need to focus on the efficiency and rationalization programs to increase the effectiveness of its investments. As per the comments made in the latest annual report of BAE systems, the company does not expect its land and Armament business to do well in the year 2010. The organization's strategy in such scenario should be to focus on reducing the costs.
Need to be prudent in capital investments - One of the major losses happening the year 2009 were the impairment losses amounting to £973. This loss was due to impairment charges in the Armor Holdings investments as the contract for the production of the follow-on vehicles was cancelled by the Department of Defense contract in United States. Though, these impairment losses were expected, as BAE systems had already warned investors that such a contract cancellation can result in impairment losses, still, a prudent approach would have helped. In another case, the company failed to explain to the Department of Justice in US & Serious Fraud office of the UK, the supply of equipments to Tanzania. Instead of fighting the case, the company pleaded guilty paid $400 million fine to the department of Justice, for making regulatory filings containing false statements. These all factors led to the undercutting of BAE systems earnings. This is clearly highlighted from the fact that the earnings of the BAE systems in 2009 before the impairment and amortization of intangible assets, tax and finance costs saw a growth of 17%, a sum of £2.22 bn as compared to £1.9 bn. This shows the potential of the organization in terms of increasing the revenues. On the similar lines, the Earning before interest, Tax & amortisation (EDITA), grew 15% since 2008, still the company was pushed into red. The revenue growth figures have made shareholders confident over the future performance of the BAE systems. The analysts have come up with a 5% growth expectation with the return on the sales improving everywhere, including US, where the Management is not as keen for sales. The sales figure for 2009 were a bit higher than the expectations. The consensus of the analysts was £20.8 bn, while actual sales was £22.4 bn.
3.3 Financial forecast
To be able to compare and contrast the current and the proposed strategy, financial projection will be employed, to outline key differences and possible improvements for the Board of Directors for BAE System, and base their decision on its results.
3.3.1 Financial forecast based on current strategy
Using the residual Income and Dividend Valuation Models, we can forecast the 5 year financial projections based on the current strategy, all of the necessary inputs are available in the Balance Sheet of BAE systems (see Appendix 3) except for the Ke (Cost of Equity) in which we will compute as follows.
Ke = 17.6p (projected dividends next year with 10% value projection) + 0.10
330.30 GBX (source: current FT Market data)
Ke (Cost of Equity) = is valued at .15 or 15%.
Now we can compute for BAE Systems residual income using data we already have. On Table 3 we can see each individual outputs in millions of £. Our key inputs for computation are listed on Table 2 as:
Div pay out
No. of shares
Earnings per share projected for next year, given the average earnings growth of 10% (Financial Times 2010). Total number of shares posted at 34 million, Net Assets is at 25 million and total equity is listed at 4655 million.
For Table 2 opening book value starts at 7289 million at the start of the fiscal year, then closed at 4727 million at the end. With a net loss incurred for the fiscal year ended 2009, The Net present value or NPV turns starts negative at year 2 following the current strategy and continues to be until reaching the 5th year of the projection. Which means given those figures and compounded with the annual inflation rate, the next 5 years would be very difficult in terms of overall profitability of BAE.
We will also use the Capital Asset Pricing Model (CAPM) to gauge our cost of equity.
To calculate for the CAPM, the formula is:
Assuming our stock beta is at .5 and the risk free interest rate is at 3.5% ( assumption on historical data). And the expected market return is at 10%. Our results based on this model would be as follows:
Equity Market Premium % is at 6.5%
Expected Return on Capital Asset % is at 6.75%.
3.3.2 Financial forecast based on recommended Strategy
Still, using the supposed EBITA on BAE systems annual report (2009) and following the strategy disregarding the penalties incurred, reduction of workforce due to lack of future contracts, BAE systems earnings could reach 2,190 £Million minus tax expenses. Table 5 shows the inputs on the recommended strategy and table 6 shows the computation of the same residual income and dividend valuation models.
Inputs: Table 4
Projected Earnings based on strategy
Div pay out
No. of shares
Outputs: Table 5 Residual Income and Dividend Valuation Model Projection based on Strategy suggestion. Source: Author's own computation
3.4 Firm value and share price strategy
BAE facing challenges on Intensive competition and budget defence cuts by their major customers should focus on increasing shareholders' equity by reduction of costs, adapting capabilities to the changing priorities of their customers and improve their Programme execution. Directors should monitor working capital expenditures to ensure that unnecessary further debt would be incurred that inevitably has an effect on book values. Higher book values (stockholders' equity) act as a positive in a buyer's assessment of purchase price, to some extent providing at least the illusion of a floor in value (Nation's Business 2006).
4. Recommendations dealing with corporate governance
Currently BAE Systems has faced problems facing its shareholders due to its criticism received on corporate governance and ethical conduct (Daily Mail 2010).As a recommendation, BAE should follow the financial reporting council (FRC) proposition on putting greater emphasis on the principles of UK's corporate governance code, and apply the annual shareholder re-election. This would have a significant impact a wider engagement for the company's shareholders. A necessary midyear review process should be conducted by an external facilitator to help in the evaluation process, metrics such as board effectiveness by dealing with issues in a timely manner should be considered.
Having a wide and complex set of operations, information dissemination in a timely manner is very important to ensure appropriate decisions. Key performance Indicators should be the guideline across all the managing directors and their performance will be evaluated by comparison of their actual results from targets.
5. Critical evaluation of the model used
Using financial models can provide actual figures for projection analysis that can create awareness for a company's board of directors (Palmgren 1999). The Residual Income Model can be used as a valuation of the firm, based on its total book value and residual income (Financial Education, 2010). During recent years it has been used as the primary valuation method due to its measurement of internal corporate performance and feasible estimation of the intrinsic value of common stock. The difference between a residual income and traditional financial statements are for the latter its purpose of preparation is to reflect earnings available to its owners, charges incurred for equity capital and dividends are not included, while the former adds the component of cost of equity capital for its calculation (Dodd 2001). Another limitation of the traditional income model is that it may not actually reflect the value of certain business activities. Such in our case with BAE system's numerous acquisitions, on its accounting model it seems that BAE have significantly improved profitability on its strategies, however this could not be all false, but using the residual income approach some of the acquisitions doesn't have the kind of effect, due again to the cost of equity capital (Bild, Guest,Cosh and Runsten 2002). The value of security using a combination of book value of the company (NAV) and a present value of the company on the basis of accounting profits is taken into consideration. Thus, the present value of the company is a direct sum of the net asset value and the present value of the residual income at the time of valuation. The residual income is also defined as the amount by which the expectation is of profits exceeding the required return on the equity. The importance of having the additional profit over the required return rate is that it is a measure of the wealth, the organization creates for its shareholders. This is where the company adds value to its assets, and a justification that the company is more valuable than the value of assets it possesses. The advantage of the RI or residual income model is that the profit and values are based on the accounting measures. In the similar vein, it can be said that as it only takes the accounting value under consideration, the true economic value of cash flows and assets remains hidden. Thus, a judicious use of RI model must be made, keeping in mind all the associated caveats (Ali, 2003).
BAE Systems being in an industry where intense competition exists should apply necessary strategies to ensure profitability in the coming years both for continuous operation and maximizing shareholders equity. Their current strategies for acquisition may have benefited them but the cost of violation of regulation procedures have definitely impacted over all operations. Using financial models like the residual income model, the board of directors can see, what would happen if they continue with their current policies on corporate strategy and governance, it has shown a negative impact on present firm's value, thus the recommendation for consideration of a new effective strategy to be implemented across the board.