BAE SYSTEMS PLC Raghav Pandey 070026065 Word Count: 5,483 ACC4053 | Financial Analysis CONTENTS 1. Introduction 2. Valuation of the Company 2. 1 An evaluation of BAE Systems’ current position and its future prospects 2. 2 Assessment of the value of BAE Systems based on the application of suitable cash flow based valuation techniques 2. 3 Assessment of the value of BAE Systems based on the application of suitable accounting based valuation techniques 3. Comparison of the valuation with the ‘market’ valuation 4. Appendices 4. 1 Appendix 1: PEST Analysis 4. 2 Appendix 2: SWOT Analysis 4. Appendix 3: Porter’s Five Forces Model 4. 4 Appendix 4: Key Financial Ratios 4. 5 Appendix 5: Weighted Average Cost of Capital 4. 6 Appendix 6: Shareholder Value Analysis 4. 7Appendix 7: Economic Profit 4. 8Appendix 8: Dividend Discount Model 4. 9Appendix 9: Price Earnings Ratio 4. 10Appendix 10: Asset Valuation Method 4. 11Appendix 11: Share Price Movement 5. References 1. Introduction $1,620bn. The world’s total defence and military expenditure in 2010. $687bn. United States’ military expenditure in the same year. Switzerland’s GDP in 2010 was $523bn, a country ranked 19th in the world.

The figures themselves place into context the scale of global defence spending and one set of companies which have benefitted the most from it are the defence suppliers. BAE Systems is one of them. BAE Systems today is a global defence, security and aerospace company. The group is based in the United Kingdom and is listed on the London Stock Exchange where it a constituent of the FTSE 100 index. The most recent financial year end of the company is 31 December 2010. The following report presents an analysis of BAE Systems and the industry it operates in including its competitors.

The paper evaluates the company in terms of its current position and future prospects using various strategic analytical models. The objective of the report also is to assess the value of the company through cash and accounting based techniques. In addition, the analysis provides a comparison of the measured value with the actual ‘market’ value of the company. The report has been divided into three sections. Section 2 presents the valuation of BAE which is then compared with the market value of the company in Section 3.

The research is accompanied by a number of appendices in the final section which consists of various analytical models and financial data. A list of references is also provided at the end of the report. 2. Valuation of BAE Systems The following section presents a valuation of BAE Systems derived from various models. The section is segregated into three parts. It starts with an evaluation of the current position and future prospects of the company. The second and third parts then build on the analysis through assessment of the value of BAE using both cash and accounting based valuation techniques. . 1 An evaluation of BAE Systems’ current position and its future prospects BAE Systems is currently the second largest defence company in the world. The company’s main competitors are Lockheed Martin, Boeing and Northrop Grumman. For the purpose of the analysis, BAE would be evaluated against Lockheed Martin (LM) and Northrop Grumman (NG) where required. Boeing may not be pertinent for such comparisons as its core business also includes manufacturing commercial airplanes, whereas both Lockheed Martin and Northrop, like BAE, are largely defence and security companies.

Chart 1: Top ten global defence companies (based on 2009 defence revenues in US$bn) (Source: Defense News, 2010) A number of analytical models, including, PEST Analysis, SWOT Analysis and Porter’s Five Forces Model were used to evaluate the company’s current position and future prospects. These models help in understanding the key features and characteristics of the company as well as the issues it is presently facing. One of the key strengths of BAE is its reputation and strong position in the defence industry.

BAE Systems was formed with a merger of British Aerospace and Marconi Electronic Systems in 1999 and has a heritage which dates back to the 19th century. Today, the group has become one of the largest defence contractors in the world with customers over 100 countries and combined sales of group exceeding ? 22bn in 2010, compared to ? 13bn in 2006. BAE Systems had a market capitalisation of ? 11. 3bn as on 31 December 2010 whereas its net assets on year-end had a value of ? 5. 4bn. The difference in the figures itself illustrates the company’s value and position in the market.

Chart 2: Defence Revenue of the three companies over five year period (US$bn) (Source: Defense News) Note: The ‘Defense News’ figures were used to avoid inaccuracies of exchange rates when converting BAE figures from ? to $ for each year. Defense News has not published the 2010 figures yet. As indicated in Chart 2, BAE has had consistent growth in revenue over the last five years which is in line with the growth in the industry itself. However, BAE had the highest relative growth among its competitors and surpassed both Northrop and Boeing to become the second largest defence contractor from number four in 2005.

Such steady growth has placed the company in a superior position in the industry. It has also given BAE the ability to continue to compete against its rivals and win contracts for national governments as well as develop advanced products. BAE’s growth over the years has been fuelled by defence spending of its two main buyers, US and UK. 73 percent of its revenues came from various organisations in the two countries (Chart 3) with US Department of Defense and UK Ministry of Defence as its principle customers.

Chart 3: BAE’s sales by key home markets (Annual Report, 2010) BAE Systems is now the largest supplier to UK Ministry of Defence and sixth largest to the US Department of Defense. Both America and UK, key members of NATO, have been involved in number of military operations over the last ten years including Afghanistan, Iraq and most recently Libya. These missions steered the demand for defence and military equipments in both countries and played a major role in the growth of BAE itself and other defence suppliers.

The growth in the industry, in turn, also helped BAE in establishing itself financially, another key strength of the company. Chart 4: Percentage Growth in Net Sales BAE Systems had a steady growth in its Net Sales over the last five years. It has consistently outperformed its main competitors and still had better growth than its rivals in 2010 which saw a fall in growth of the company. The strong growth in its revenues has allowed the company to build a healthy balance sheet with virtually no gearing. BAE Systems, with its negative gearing, has in fact more cash in its books than non-current debt at year end.

The level of gearing can be attributed as a major strength of the company which gives it the ability to use the option to raise debt when needed with minimum deliberations. This in itself gives a secure position with adept future prospects for the group. On the other hand, it also raises the question of the cost of finance which BAE is paying. The cost of equity finance is relatively higher than the cost of finance through debt. While this is a positive sign with the current economic environment, the management may want to ensure that the cost of capital is kept at an optimum level through leveraging its equity.

The non-current debt at 31 December 2010 was ? 2,133m and equity at the same date was ? 5,403m. Thus the management is not being over prudent and have adequate level of debt compared to its net assets. A strong balance sheet is particularly important for BAE with the nature of the industry it operates in. Defence companies entail sustained investments in research and development to maintain their position in the market. BAE would have to continue investing in latest products and technology designs to outpace rivals and win contracts.

Chart 5: Total Intangibles as a percentage of Total Assets BAE Systems has gradually increased its research and development expenditure over the years. In 2010, R&D expenditure was ? 1,298m (2009: ? 1,211m) and the intangible assets made up approximately 70 percent of its non-current assets. BAE also has the highest percentage of intangibles of the total assets amongst its competitors. (Chart 5) In addition, the capitalisation of the costs indicates its viability and evidence of future economic benefits.

The current position of BAE Systems is marked with a strong position and reputation in the industry, higher revenue growth compared to its rivals, a healthy balance sheet with low gearing and its continued focus on investing in research and development. The position of the BAE gives it the ability to build on its past performance and develop improved future prospects. The future prospects of the company would be defined by two vital factors; primarily, the markets in which BAE operates, and second, scrutiny of its global business operations. Over the last few years, US and UK defence spending drove the revenue growth of BAE.

Both the countries were among the worst affected by the global economic crisis. These markets would witness declining rate of growth in defence spending as they aim to manage their budget deficits. The Spending Review was announced in the UK in 2010 and US also announced reduction of ? 50bn to the Five Year Defense Plan 2010 to 2015. The full effect of these cuts would only be felt in its 2011 financial statements. Chart 6: Total military spending of top 14 nations With the rise in global spending, the future growth for BAE would come from accessible markets including, India and Saudi Arabia.

BAE has already become the biggest supplier to Saudi Arabia and is developing its position in India. It also has strong presence in Australia; however, US will remain a key customer with its considerable defence spending. BAE Systems has also come under scanner for its bribery and corruption allegations. These cases have put in question BAE’s global business practices and affected its image. Any similar future issues will become even more significant with the enforcement of UK Bribery Act from 2011. The company has already paid hefty fines at many instances to agencies in US and UK in light of these claims.

The future prospects of the company can be dented by any future revelations and results of some of the pending investigations. BAE would have to keep up with legal and regulatory compliance in its global operations and avoid instances like where it paid ? 278m in regulatory penalties in 2009. On the whole, BAE Systems has strong current position with encouraging future prospects. Even though, growth in US and UK may be sluggish in immediate future, the company has enough diversified operations to see through the decline.

The demand in emerging nations like India and Saudi Arabia will only continue to increase. As new markets become more accessible, the long term future of the company looks secure. There is no immediate solution to the conflicts in Afghanistan or Iraq with new issues rising in terms of Libya and Middle East conflicts. The company is in the process of rebasing its land and armaments operations and also developing its presence in cyber security and intelligence sector. It has a strong portfolio of business and is integrating its international operations.

With the assessment of the group using various analytical models, it can be concluded that BAE Systems can build on its strong current position towards a sustainable long term future through some immediate market challenges. 2. 2 Assessment of the value of BAE Systems based on the application of suitable cash flow based valuation techniques The second part of the section uses cash flow based techniques to value BAE Systems. There are a range of models available to evaluate the value of a company and a number of suitable models have been considered to derive the value of BAE Systems.

Shareholder Value Analysis Various valuation techniques at times have been criticised for either being too short term or only looking at what has happened in the past. (Entrepreneur, 1999) Shareholder value analysis (SVA), on the other hand, can have a planning horizon of a number of years and is derived from measuring future cash flows of a company over time. SVA calculates the value of a company based on seven key value drivers. These include, 1. Sales Growth Rate 2. Operating Profit Margin 3. Tax Rate 4. Fixed Capital Investment 5. Working Capital Investment 6. Planning Horizon 7.

Required Rate of Return Rappaport’s SVA identifies these key drivers which should be targeted to enhance shareholder wealth. The model applies the principles to calculate a company’s overall value based on the principle that net present value (NPV) is the most effective measurement of shareholder wealth. SVA as a valuation model would be appropriate for an established company like BAE which has had a stable performance over the years and is expected to continue its business for foreseeable future. SVA is a long term model which takes into account the future cash flow and earnings of a company.

The seven key value drivers are relevant for BAE with its conventional background of industrial manufacturing. The detailed calculation of the shareholder value analysis has been presented in the Appendix 6 of the report. A summary of the seven key value drivers is as follows, Sales Growth Rate| 3%| Operating Profit Margin| 7%| Tax Rate| 26%| Fixed Capital Investment| 5%| Working Capital Investment| -35%| Planning Horizon| 5 Years| Required Rate of Return| 11. 78%| Table A: Summary of Key Value Drivers BAE Systems saw a robust growth in sales between 2006 and 2009 and continually outperformed its key rivals.

However, sales only grew by 2 percent in 2010 which is in line with the industry wide decline in activity as both UK and US embarked on series of defence cuts in light of the economic crisis. The full effects of these cuts would also be felt in 2011 but demand in both countries will remain even. Future years would be stable for BAE with global rise in defence spending and the group’s strong presence in these markets coupled with its strong product portfolio. With these factors in mind, the sales growth rate was assumed at 3 percent.

The group has maintained a strong operating profit margin with an average of 11 percent in last five years. But the margin would be expected to decrease with lower revenue growth which BAE is aiming to manage through cost cutting measures. Future implications on regulatory compliance could also affect the margin as the company is still in the middle of a number of investigations for corruption and bribery charges. The operating profit margin was taken at 7 percent. The tax rate is expected to decrease in future and HMRC has indicated a revised tax rate of 26 percent.

Fixed capital investment in BAE has seen significant decline in the last few years. The year 2010 had a negative net capital expenditure in long term operating assets of the company and the average capital expenditure was 9 percent between 2007 and 2010. The group’s low gearing and number of acquisitions made in early 2011 give an indication of improved capital expenditure in future years. The company may not be able to maintain the average for last five years but would definitely improve from 2010. Thus, fixed capital investment would be at 5 percent.

The working capital investment has been at similar levels over the years and is in line with other companies in the industry. Therefore, the average of -35 percent can be used for working capital investment. The planning horizon of 5 years was selected as most of the analysis in the report has been done for the 5 year period between 2006 and 2010. BAE also uses the 5 year period to present its summary of financial performance. The weighted average cost of capital is used as the required rate of return, which has been calculated in Appendix 5.

Table B below outlines the results of the shareholder value analysis. Shareholder Value| ? 14,781m| Market Capitalisation at 31/12/10| ? 11,300m| Difference| ? 3,481m| Difference Percentage| 31%| Shareholder Price (SVA)| 434p| Shareholder Price (MV)| 331p| Table B: Shareholder Value Analysis As evident from shareholder value analysis, BAE Systems is undervalued by 31 percent with a difference of ? 3,481m between the shareholder value and its market value at 31 December, 2010. SVA is used as a strategic tool in assisting management to maximise the value of the company.

Even though it appears that the BAE has higher shareholder value than the value in the market, some key drivers can be targeted to enhance the shareholder wealth. The two major factors which could affect BAE’s value are its investments in fixed assets as well as in working capital. But what also appears is that the level of capital investments may have fallen across the industry with Lockheed Martin (LM), the industry leader, itself witnessing significant decline in capital expenditure. (Table C) | 2010| 2009| | BAE| LM| BAE| LM| Purchase of Fixed Assets| 427| 526| 525| 546|

Sale of Fixed Assets| (162)| (512)| (106)| -| Acquisitions| 207| 95| 357| 279| Net Capital Expenditure| 472| 109| 776| 825| Table C: Net Capital Expenditure for BAE Systems and Lockheed Martin (? m) Note: Lockheed Martin’s figures converted to GBP from USD using exchange rate of 1. 56 as at 31/12/2010. While SVA has helped us in calculating the shareholder value of BAE Systems, the model still has certain limitations. SVA is based on future cash flows and there are number of judgements involved when predicting distance cash flows.

It also assumes that a business will continue to grow at the same rate in future which is always subject to potential uncertainties. Economic Profit The economic profit model addresses the limitations of SVA by using existing accounting information provided by the company instead of predicting future cash flows. Thus there are fewer judgements involved in calculating economic profit. ‘Economic profit’s advantage is that it is the only performance measurement which links directly with the intrinsic value of a business’. Cash Focus, 2011) The economic profit of a company is the amount earned by a business after deducting all operating expenses and a charge for the opportunity costs of the capital employed. BAE Systems’ economic profit is calculated in detail in Appendix 7. Economic Profit= Operating Profit before Interest and after Tax – Capital Charge = 1,219 – 996 = 223 The economic profit of BAE Systems is ? 223m. The only judgement involved in the calculation was the classification of the capital employed in calculating the capital charge. The capital can be defined as the money invested in a business.

The money invested essentially involves money put in by the owners (equity) or money taken as a loan (debt). Thus the capital employed of a business would be net assets or equity plus debt finance. The weighted average cost of capital calculated in Appendix 5 was then used to compute the capital charge for BAE. The positive value of the economic profit denotes that BAE has created excess value over and above the value of capital that has been invested in the company. The return on investment earned by the company exceeds the return expected by the company’s capital contributors. Malekian, 2009) As evident from the economic profit value, BAE has had a strong performance and the value gives a good indication of the future prospects of the company. The economic profit can be used to calculate the value of a company. Value= Capital Employed + Present Value of projected Economic Profit = 8,456 + (223/0. 1178) = 8,456 + 1,892 = 10,348 As per the economic profit, the value of BAE Systems is ? 10,348m. The market value of BAE on 31 December, 2010 was ? 11,300m. Thus, BAE is overvalued by ? 952m (8%) according to the economic profit calculation.

With the combination of SVA and economic profit, the report has been able to derive BAE’s valuations based on both future forecasts and past earnings. Where SVA uses a number of assumptions, economic profit has limited judgements involved. Both the methods thus provide us with a balanced analysis of the company. 2. 3 Assessment of the value of BAE Systems based on the application of suitable accounting based valuation techniques The final component of the section looks at the value of BAE through accounting based models. Dividend Discount Model

The dividend discount model (DDM) is similar to cash flow models as it also looks at a series of flows, dividends in this case, over a period of time. DDM would be pertinent for BAE Systems with its stable growth in dividends over the years and a strong dividend payout policy. The model was considered when calculating the cost of equity (Ke) in the weighted average cost of capital calculation (WACC) in Appendix 5. The significant judgement involved in the model is predicting future dividends based on previous trends. BAE Systems had a constant increase in the flow of dividends between 1999 and 2010.

The trend is expected to continue because of the following reasons, * BAE’s strong cash position * The management’s indication to continue with the increase in dividends and the announcements made in the annual report * The annual dividend is covered 2. 3 times by underlying earnings from continuing operations * The historic trend of constant increase in the dividend payout Considering the above factors, the ‘constant growth’ model is used in the dividend discount valuation. The detailed calculation for the model has been done in Appendix 8. P0= D1/ (Ke – g) Where, P0= Price of the share

D1= Future dividend Ke= Cost of equity g= dividend growth rate The Ke calculated in the WACC used the Gordon growth model. The same calculation cannot be used in the dividend discount computation as it will only result in P0 being equal to the actual market price of the company. Thus the Capital Asset Pricing Model was used to calculate the Ke. Ke= Y + [? (X – Y)] Where, Y= Risk free rate of return ?= Beta value X= Expected market return Using the daily share price movement of BAE Systems against the FTSE 100 index, of which BAE is a constituent, the beta value is calculated as 0. 2. Reuters showed a beta value of BAE at 0. 66 as on 1 June 2011. So the value calculated is around the same range and can be deemed reasonable. The movement of the FTSE 100 index was also used to calculate the expected market return, which gave an average return of 15 percent. The index was used instead of the value of London Stock Exchange as it gave a less volatile figure. Also, the return from FTSE 100 would better resemble the expected market return for a large group like BAE. The risk free return was based on average UK Government ten year bonds, which came out to 3. 97 ercent. Using the above figures, the Ke calculation is as follows, Ke= 3. 97 + [0. 62(15-3. 97)] = 10. 81% D1 (18. 94) and g (8 percent) were already calculated in Appendix 5. P0= 18. 94 / (0. 1081 – 0. 08) = 674p The results thus have been summarised in Table D below. Value as per DDM| 22,970| Market Value at year end| 11,300| Difference| 11,670| Difference (Percentage)| 103%| Table D: Dividend Discount Model (? m) The value of BAE Systems under the dividend discount model came out to ? 22,970m, a substantial 103% higher than the actual market value of company at year end.

The model shows that the company is undervalued by ? 11,670m. Because of such significant difference, judgements need to be made before placing any reliance on the results for analysis in the final section. Price Earnings Ratio Price earnings (PE) ratio is one of the most popular models for company valuations used by investors. The ratio has become one of the more widely quoted figures due to its simplicity and easy interpretation. When calculating the PE ratio, there are very few judgements involved and the calculation considers the earnings of a company unlike the dividend discount model.

The PE ratio is a more indicative means to calculate the value of a company and allows easier comparison between competitors. The ratio is calculated as, PE Ratio= Market price per share (MPS) / Previous year’s Earnings per Share (EPS) The detailed calculation of the price earnings ratio has been done in Appendix 9. Chart 7 below presents the PE ratio for BAE and its competitors. Chart 7: Price Earnings Ratio As evident from Chart 7, there has been a decline in the PE ratio over the last five years in the industry itself. BAE saw the biggest decline from having the highest ratio is 2006 to the lowest ratio among its competitors.

Chart 4 before exemplified the net percentage growth of the three companies where BAE outperformed its peers, which is also reflected in the higher PE ratio of the company in 2006 and 2007. The earnings of BAE saw a decline between 2009 and 2010 which in turn had an effect on its PE ratio. The share price of the BAE and its competitors also declined in the same period. When predicting the future PE ratio to calculate the market price, two factors have been taken into consideration; first the decline in the PE ratio of BAE and second the fall in activity in the industry which would not only affect BAE but all its competitors as well.

The average PE ratio for BAE between 2009 and 2012 is 8. 23. The figure should be adjusted for slight decline in the activity of the group. Therefore, PE Ratio= 8. 00 The predicted PE ratio would be used to calculate the market price per share of BAE. MPS= PE Ratio x EPS = (8) x 42. 4 = 326p Actual Market Price at year end= 331p Table E summarises the results from the calculation below. Value as per PE Ratio| 11,110 | Market Value at year end| 11,300 | Difference| 190 | Difference (Percentage)| 2%|

Table E: Market Value (? m) BAE Systems is overvalued by ? 190m (2 percent) according to the price earnings ratio model. Asset Valuation Method The asset valuation method is one of the most fundamental means to analyse the value of a company. The net asset value is essentially the book value of the net assets of a company. Net Asset Value = Non-Current & Current Assets less Long term & Short term Liabilities The market value of a company can never fall below its net asset value; otherwise, someone would buy all the shares of the company and sell the assets of the company to make a profit.

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The net asset value can help in comparing the value as perceived by the investors to its actual value. Due to the factual nature of the technique, there are very limited judgements involved in the calculation. The detailed calculation of the net asset value has been done in Appendix 10. Net Asset Value of BAE Systems= ? 5,403m. The results are summarised in the Table F below. Net Asset Value| 5,403 | Market Value at year-end| 11,300 | Difference| 5,897 |

Difference (Percentage)| 52%| Table F: Asset Valuation Method (? m) The market value of BAE is more than double its net asset value. So is the market value of the company too high? Many of the high technology companies are built on intellectual assets such as patents, brands and even employees. BAE has a strong brand and research and development costs are a critical part of the company due to the nature of the industry it operates in. 70 percent of its non-current assets are intangibles.

Also, the share price of BAE is still trading at the same level as at the year-end; which means that the market price at 31 December 2010 was not inflated or else the market would have corrected the share price of the company. 3. Comparison of the valuation with the ‘market’ valuation The third section of the report concludes the analysis and provides a comparison of the valuations computed through various models with the market value of BAE Systems. Table G below summarises the valuations calculated,

Particulars| Valuation| Market Value| Difference| Note| Shareholder Value Analysis| 14,781 | 11,300 | 3,481 | 31%| Undervalued| Economic Profit| 10,348 | 11,300 | (952) | (8%)| Overvalued| Dividend Discount Model| 22,970 | 11,300 | 11,670 | 103%| Undervalued| Price Earnings Ratio| 11,110 | 11,300 | (190) | (2%)| Overvalued| Asset Valuation Method| 5,403 | 11,300 | (5,897) | (52%)| Overvalued| Table G: Comparative of BAE

Systems’ valuations (? m) Three out of the five valuation models showed that BAE Systems was overvalued at the financial year end. The dividend discount model (DDM) and the shareholder value analysis (SVA) on the other hand provided a valuation which was more than the market value of the group. There are a number of factors which would have affected the various valuation techniques. One of the most significant aspects is the dividend policy of BAE. The dividend payout of the company has seen constant increase between 1999 and 2010.

The high dividends made BAE Systems among the top ten dividend yielding stocks on FTSE 100. BAE also had higher dividend yield than its two competitors. The 8 percent dividend growth rate (g) has been used when calculating the WACC and is a vital element in the dividend discount model. The ‘P0’ in the model directly employs the dividend growth rate in its calculation which gave us a share price of 674p. This, when compared with the actual share price of 331p at year-end, worked out to a difference of ? 11,670m between the two; a substantial variation of 103 percent.

The dividend growth rate is also an ingredient in WACC which have been used in the SVA and economic profit models. The second key factor is the time period of the data. Both SVA and DDM are based on future flow of cash and dividends respectively. Calculating value on the basis of future perspectives could be a fundamental weakness as the predictions may or may not be true. The economic profit and asset valuation method (AVM) on the other hand are based on historical data and can have better reliance. The PE ratio also uses future assumptions but only to a limited extent.

The third factor which would impact the valuation is the level of assumptions made in the calculations. Most of the assumptions do rely on the features of the company discussed in the SWOT analysis. SVA, with its seven value drivers, has greater degree of assumptions made in contrast to other models. Alternatively, AVM uses the book value of the company and involves virtually no assumptions. In addition, both SVA and AVM takes into account the earnings and cash flows of the company; whereas DDM focuses on the dividends of a company and does not include its cash flows and earnings in the calculation.

PE ratio uses EPS in its computation and the economic profit calculation includes the operating profit figure. Though BAE’s dividend payout has remained strong, there has been a decrease in the company’s revenue growth and its cash balance at the year-end. This may have reflected on the valuation of the group under respective valuation models. The average percentage difference between the market value of BAE and all of the valuation models is 14 percent. This means BAE is undervalued by 14 percent. But when DDM is not taken into consideration, the company would be overvalued by 8 percent.

Based on the analysis of the group, this would reflect a more accurate valuation. For example, if the performance declines next year and the company still pay higher dividends, then the model would suggest that the valuation of the company has in fact increased. Nevertheless, the 8 percent difference should be adjusted as dividends still play a role in a company’s overall valuation. Therefore, in conclusion, BAE Systems was overvalued by around 4-5 percent at the year end. The overvaluation of 4-5 percent can be derived from two key factors.

First the flattening of the company’s growth reflected by the decline in defence spending. These cuts only came into light by the end of 2010 and countries are still in the process of reviewing their budgets. The market value of BAE may not have completely replicated the decline in the market. The second factor is the immediate growth of the company. 2011 would be tough year for BAE and the industry itself as the full impact of the cuts is experienced. BAE Systems would face challenging market environment in immediate future but the company can exploit the potential of the global defence market.

Its strong financial position gives it the ability to endure the decline in activity and if it is able to manage its threats, the company can have sustainable long term growth. The only question which remains to be answered is the implication of an optimistic outlook for a supplier of defence and armaments for the future of the world we live in. 4. Appendices 4. 1 Appendix 1: PEST Analysis PEST Analysis can be a very helpful model when evaluating the impact of external macro environment on any business.

For a group like BAE, it becomes all more important in view of its major customers comprising national governments and size of its global operations. The group operates in a technology driven research intensive industry and changes in any of these factors can have considerable impact on the performance of the company. Political Factors Share of Revenue Due to the nature of the industry BAE Systems operates in, majority of its revenue is earned through government contracts in various countries. The US Department of Defense and UK Ministry of Defence are its two biggest customers, with 60 percent share of the revenue.

Table 1 illustrates the revenue share from its major customers. Particulars| Amount (? m)| % Share| UK Ministry of Defence| 5,060| 24%| US Department of Defense | 7,696| 36%| Kingdom of Saudi Arabia Ministry of Defence and Aviation | 2,870| 14%| Total| 15,626| 74%| Total Revenue of the Group| 21,097| | Table 1: Revenue from the Group’s three principal customers (Annual Report, 2010) UK Government Spending Review The comprehensive spending review planned by the UK government could have significant impacts on the future revenue of the group.

The government has proposed 8 percent cut in its defence budget over the next four years, which would be reduced to ? 33. 5bn by 2014-15. (Norton-Taylor, 2010) Even though BAE stressed that the impact of the cuts on its performance would be ‘modest’, the company did warn that the review would lead to lower growth in its UK operations. (Gourley, 2010) Although the group was putting a brave face, the immediate impact of the review could be sensed from the fact that shares of BAE, which were trading at a price of 363. 9p on the day cuts were announced, closed on 357. 2p the day after. Other Countries

BAE Systems now classifies US, UK, India, Australia and Saudi Arabia as its ‘home markets’. In 2007, its home markets also included Sweden and South Africa but since have been replaced by India and Saudi Arabia. UK’s Political Relations UK’s political relations with other countries where BAE operates can have an impact on the company. Healthier relations between governments may well result in BAE, a British company, winning more contracts and orders from those governments. Bribery Allegations BAE Systems came under scrutiny when it was accused of paying bribes to win defence contracts in Saudi Arabia in 2007.

The UK Bribery Act which was introduced in 2010 will be enforced from July, 2011. The act would put the group’s global operations under more stringent political scanner and the company could face consequences in regard to government compliance and its business practices. Economic Factors Challenging Economic Environment The recent financial crisis has impaired spending levels of many governments including United States and United Kingdom. US government made cumulative commitments of $8. 5 trillion to financial rescue initiatives in light of the economic crisis. Pender, 2008) With such investments, it would be hard to maintain previous spending levels in areas such as defence, as evident from recent cuts in the budgets of both countries. Despite the market challenges, BAE Systems has been able to grow its revenue in 2010 as compared to previous year. If they will be able to sustain growth next year is what remains to be seen. Rise in Global Defence Spending Defence spending in countries including India and Saudi Arabia has seen a rise over the years and is expected to increase in future. The company’s increased presence in these markets will help in responding to the decline in US and UK markets.

Social Factors Ethics Operating in the manufacturing and sale of defence equipments has many sceptics. People have questioned the morality of the industry itself. BAE Systems was also investigated for its business activities in countries including, Tanzania, South Africa and Czech Republic in the past. Such events can have an adverse impact on a company’s image in the society. Bribery and Corruption Allegations BAE Systems has been subject of bribery allegations in Saudi Arabia as well as being accused of accounting irregularities in its operations in Tanzania. The company paid a fine of ? 50,000 to Serious Fraud Office in December, 2010 for failing to keep accounting records of sale of an air traffic control system in Tanzania. (Russell, 2010) Redundancies The company announced in September, 2010 that it would make cuts of around 900 jobs from its military division in the UK. These cut were not received well by the Confederation of Shipbuilding and Engineering Union, who said they were shocked by the cuts. (Defence Giant BAE Axes Nearly 1,000 Jobs, 2010) These cuts would meet negative reaction from the union as well as the general public in the UK and could have an effect on the company’s image.

Technological Factors Technology-Intensive Industry Innovation and superior products are centre to the defence and security industry. Companies need to continuously develop new products through high investment in research and development. Barriers to Entry Defence and Security is a much specialised industry. High level of capital investments required in products and operations mean it is tough for new businesses to gain strong hold in the market. Such constraints would work in advantage for previously established companies in the industry, such as BAE. 4. 2 Appendix 2: SWOT Analysis

SWOT Analysis is also an important tool to study and evaluate factors, both internal and external, which can affect a company’s performance and position. The analysis consists of four specific factors, Strengths, Weaknesses, Opportunities and Threats. (Figure 1) The factors can aid in understanding various aspects of BAE Systems, which can help in examining its current position and future prospects. “By understanding these four aspects of its situation, a firm can better leverage its strengths, correct its weaknesses, capitalize on golden opportunities, and deter potentially devastating threats. (SWOT Analysis, 2010) Strengths Weaknesses Opportunities Threats Internal External Positive Negative SWOT Figure 1: SWOT Analysis Strengths Five Home Markets BAE Systems defines US, UK, Australia, India and Saudi Arabia as its five key ‘home markets’. Diverse markets give it the opportunity to balance growth across the regions and not putting ‘all eggs in one basket’. Brand BAE is a global defence, security and aerospace company with customers in over 100 countries. It is the second largest defence company in the world.

The standing of the company gives it the ability to win contracts and attract new customers. Strong Financial Performance The company saw revenue growth in 2010 despite tough market conditions. The profit figure for the year was ? 1. 08bn compared to a ? 45m loss in 2009. Gearing BAE Systems has virtually no gearing. Even as it gives them a huge advantage with the economic challenges, it could also affect the cost of finance for the company. Strong Dividend History BAE Systems has the highest dividend yield among its competitors and its dividend payout has constantly increased over the years.

Weaknesses Reliance on US and UK 73 percent of the company’s revenue is still dependent on organisations in US and UK, with 60 percent alone to the defence ministries in both countries. Research Intensive Industry The nature of industry is such that high level of investment is required in research and development to sustain growth. BAE had intangible assets of ?11bn which represented 70 percent of the total non-current assets of the group. Business Practices The corruption and bribery allegations in past puts into question the business practices adapted by the organisation.

The company is still under investigation and future revelations could dent the prospects of the company. Opportunities Global Markets With customers in over 100 countries, the company is in a superior position to exploit the growth in various economies as countries aim to strengthen their defence and security. Partnership with Local Companies 95 percent of the company’s revenue is still sourced from sale of defence equipments. BAE has been partnering with local companies in countries, which gives it the opportunity to gain advantage in markets and also the opportunities to explore other sectors.

BAE has 40 percent interest in BAeHAL Software Limited, a joint venture with HAL in India, specialising in aerospace software and engineering services. In 2010, BAE also established a land systems joint venture with Mahindra & Mahindra in India. With such partnerships, there is also an added advantage of gaining confidence of national governments in these countries. For example, Indian government would be more willing to award contracts to BAE because of such partnerships and the fact that the company is sourcing its components from local suppliers.

BAE also has a 49 percent stake in Air Astana in partnership with the government of Kazakhstan. Threats Defence Cuts in US and UK Recent cuts in the defence budgets of US and UK could lower the activity of the company in these regions. BAE has already said it will be cutting costs in these regions to maintain margins as a result of the cuts. In addition to the budget cuts, UK Ministry of Defence has also undertaken review of its non-competitive contracts, i. e. sourcing equipments from a single supplier without any competitive pressure.

Because of national security limits, there are cases where contracts are negotiated with a single supplier which increases the cost of such contracts. Of the ? 9bn spent by the ministry on such contracts, BAE Systems accounts for approximately ? 7bn. Competitors BAE’s main rivals are Lockheed Martin and Boeing. Lockheed Martin is the biggest defence company in the world and Boeing is close third. Boeing has an added advantage of a highly profitable aeroplane manufacturing division. Only 45 percent of its total revenue is sourced from the defence division.

For the whole group, Boeing had total revenue of $68. 2bn compared to BAE’s $35. 09bn in 2009. Thus, Boeing is more equipped to increase its investment levels when required in comparison to BAE whose only major revenue source is defence. Image Previous issues in relation the corruption and bribery allegation has had a negative impact on the image of the company. It may affect in future bidding of contracts by the company. US Preference for Domestic Suppliers US are the biggest defence market in world with an annual expenditure of $687bn in 2010.

With the economic pressures, US may be more inclined to award contracts to local companies like Lockheed Martin, which could see BAE missing out such contracts. 4. 3 Appendix 3: Porter’s Five Forces Model Competitive Rivalry within an Industry Threat of New Entrants Bargaining Power of Customers Threat of Substitute Products Bargaining Power of Suppliers Figure 2: Porter’s Five Forces Model Threat of New Entrants Sophisticated Technology The defence and security sector is a much specialised industry. It is not easy for new entrants to gain foothold in the market let alone threaten the position of the market leaders.

Brand Equity Reputation is of key importance in the industry. When there are national governments involved who place orders in excess of billions of pounds, the name of the company itself plays an important role. Customers would only want to deal with reliable and stable companies when buying critical equipments. Investments in Research High level of investment has to be maintained in research and development to sustain the market position and growth. New entrants may find it tough with long gestation periods of investments and uncertainties over the recoverability of such costs. Bargaining Power of Customers

US Government 36 percent of the company’s revenue in 2010 came from the US Department of Defense. One disadvantage to the company would be the high reliance on the US government spending. With the recent cuts in the budget and economic pressures, US may be inclined to favour American suppliers in place of BAE. As a result, to avoid severe implications, the company could resort to discounts and offering favourable contract terms to the government. UK Government Being a British company, BAE has an advantage in the UK. However, there is a threat of conducting business deals with the government.

The UK government also controls the regulations and legislation of the industry and this may work against the company. BAE would not want to get on the wrong side of the government which gives the government, a key customer, a superior status quo in the business relationship. International Governments With many global firms eyeing a share of defence spending of countries, governments at times have an edge over the companies. These markets are very lucrative and there would be other factors involved in winning contracts such as international relations of UK with the country. Nature of Contracts

One key feature of such contracts is its size. Countries usually sign up with one supplier for large one-off orders and then it becomes harder for other defence companies to increase its sales with that country. Thus, customers would have high bargaining power as companies try to win that first big order. Threat of Substitute Products Specialised Industry Today, defence and security has become an imperative industry. High spending in defence has been a major feature of budgets of many countries. Moreover, actual threat in terms of substitute products manufactured by defence companies is at a low level. Product Development

A significant threat would be company’s products becoming obsolete. Companies would have to consistently invest in development of products and keep up with the advanced technologies or a better product from competitors would take away the market share. Bargaining Power of Suppliers Size of Suppliers BAE Systems has diverse range of suppliers, both large and small. But the bargaining power of the suppliers would have minimum effect on BAE because of its size and it may always switch suppliers when needed. It is easier for the company to find new suppliers then for the suppliers to a find a large client like BAE.

Effective Supply Chain BAE uses highly developed supply chain systems like SBAC which means it is easier for the company to manage any glitches from the suppliers and have minimum impact on the operations of the company. Strategic Suppliers With its two tiered approach to suppliers, the company also has number of strategic suppliers and subcontractors on which it is dependent for components and subsystems. If such suppliers are impacted with financial constraints from the economy, it could impair BAE’s ability to readily provide to its manufacturing and also find alternatives. Competitive Rivalry within the Industry

Competitors Lockheed Martin is the largest defence company in the world with $42bn of revenues in 2009. BAE is second with Boeing a close third. The industry is dominated by few large companies but have stiff competition between them to win international contracts. Government Spending Cuts The market is set to become increasingly competitive with pressures on government budgets. BAE has said they would be able to weather the changes with geographically diverse portfolio of businesses. But that impact can be even adverse if its competitors also start to focus on other regions especially US firms like Lockheed Martin and Boeing.

Sole-Source Programmes There have been instances where a government has awarded contract to a single supplier for all work on a particular programme. Such programmes involve competitive bidding and can significantly aid the revenues of a company which wins such contracts. 4. 4 Appendix 4: Key Financial Ratios Profitability Return on Capital Employed, | 2010| 2009| 2008| 2007| 2006| LM| 9. 61%| 16. 87%| 19. 22%| 21. 64%| 17. 68%| BAE| 11. 44%| 6. 11%| 9. 04%| 8. 85%| 8. 83%| NG| 12. 21%| 11. 08%| -0. 30%| 10. 55%| 9. 68%| (ROCE = PBIT / Capital Employed) Net Profit Margin, | 2010| 2009| 2008| 2007| 2006| LM| 2. 9%| 6. 69%| 7. 53%| 7. 25%| 6. 38%| BAE| 4. 99%| -0. 33%| 10. 47%| 6. 23%| 13. 10%| NG| 5. 91%| 4. 99%| -3. 72%| 5. 59%| 5. 11%| (Net Profit Margin = Net Profit / Revenue) Liquidity Current Ratio, | 2010| 2009| 2008| 2007| 2006| LM| 115. 18%| 116. 57%| 101. 34%| 110. 83%| 106. 40%| BAE| 65. 33%| 73. 28%| 74. 78%| 74. 21%| 79. 38%| NG| 118. 10%| 123. 62%| 96. 83%| 105. 29%| 99. 50%| (Current Ratio = Current Assets / Current Liabilities) Solvency Gearing Ratio, | 2010| 2009| 2008| 2007| 2006| LM| 0. 80| 0. 64| 0. 55| 0. 15| 0. 31| BAE| (0. 06)| (0. 18)| (0. 07)| (0. 14)| (0. 11)| NG| 0. 08| 0. 08| 0. 20| 0. 17| 0. 9| (Gearing = Net Debt / Equity) Efficiency Receivables Days, | 2010| 2009| 2008| 2007| 2006| LM| 45. 25| 48. 29| 44. 62| 42. 35| 41. 75| BAE| 21. 36| 25. 66| 35. 70| 40. 46| 18. 42| NG| 42. 02| 36. 20| 41. 47| 42. 87| 42. 58| (Receivables Days = Receivables/Sales x 365) Payables Days, | 2010| 2009| 2008| 2007| 2006| LM| 27. 49| 29. 30| 31. 29| 31. 88| 34. 57| BAE| 52. 63| 56. 42| 55. 30| 54. 77| 54. 18| NG| 33. 09| 34. 15| 34. 28| 34. 64| 40. 58| (Payables Days = Payables/Cost of Sales x 365) (Source: www. infinancials. com) Dividend Yield | Dividend Paid| Share Price| Dividend Yield| LM| 2. 64| 69. 91| 3. 8%| BAE| 17. 5| 331| 5. 29%| NG| 1. 84| 64. 78| 2. 84%| Note: BAE figures in Pence. LM and NG figures in USD (2010) 4. 5 Appendix 5: Weighted Average Cost of Capital The Weighted Average Cost of Capital (WACC) is the proportionate weighted mean of firm’s costs of capital. The current level of wealth of a company would only be sustained if the company’s return on its investments is at least equal to or higher than its WACC. (Besley and Brigham, 2008) It could also be referred as the required rate of return of a company. The formula of the WACC is as follows, WACC = [(MVe x Ke) + (MVd x Kd)] / MVe + MVd Where,

MVe = Market Value of Equity Ke = Cost of Equity MVd = Market Value of Debt Kd = Cost of Debt Market Value of Equity The market value of equity (MVe) is defined as the market value of all of the company’s shares in issue. It is calculated by multiplying the total number of shares of a company by the market price. MVe for BAE Systems has been calculated as at 31 December, 2010, which is the year end for the company. MVe = (Total number of shares in issue) x (Market price) = (3,408,000,000) x (331p) = ? 11,280,480,000 Cost of Equity The cost of equity (Ke) would be the rate of return expected by a shareholder in a company.

The two models used to determine the cost of equity of a company includes the Capital Asset Pricing Model and the Gordon Growth Model. BAE Systems has had a stable performance over the years with constant increase in revenue. There has not been any significant change in the structure of the company and the risk profile of the company has also remained unchanged. With the long term capital structure of the company looking stable, the Gordon Growth model would be suitable to calculate the cost of equity for the company. Figure 3 provides details of the dividends paid by BAE. Figure 3: History of dividend payments on ordinary shares of 2. p each since 1999. With an even average growth in the dividends paid over the years, the Gordon Growth model would be appropriate to calculate the cost of equity. The dividend growth in the last five years has been 1. 44p on an average. The previous dividend growth rate can be used to predict the future dividend for BAE, which had an even performance for the last few years. Based on the average, the dividend for 2011 would be 18. 94p per share. This would mean an increase of 8%. The cost of equity would be, Ke= (Projected Dividend / Market Price per Share) + Growth Rate = (18. 94 / 331) + 8 5. 72 + 8 = 13. 72% The report acknowledges that the Capital Asset Pricing Model is the more widely used method of the two when calculating cost of equity. However, the dividend growth model would be a more suitable for a stable company like BAE with its strong dividend history and management focus on dividend policy. CAPM has also been considered to calculate the cost of equity in the dividend discount model. (Appendix 8) Market Value of Debt Market value of debt (MVd) is the total value of debt held in publicly traded bonds and debt held on books, which includes bank loans and overdrafts.

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MVd= Non-Current + Current = 2,133,000,000 + 920,000,000 = 3,053,000,000 As there was no publicly available information on the actual market value of the bonds as at the year end, the book value figures have been used. Cost of Debt BAE Systems has provided details of its total non-current and current loans and overdrafts. A weighted average is used to calculate the overall cost of debt for all the loan items. (Table 2) Particulars| Cost| Amount| Weight| WeightedRate| Non-Current| %| ? m| | %| Class B and Class G Certificates| 6. 88| 266| 0. 12| 0. 86| Euro-Sterling| 10. 5| 100| 0. 05| 0. 50| US$500m| 4. 95| 318| 0. 15| 0. 74| US$750m| 5. 2| 477| 0. 22| 1. 16| Albertville Hangar Bond| 3. 52| 6| 0. 00| 0. 01| US$1bn| 6. 375| 645| 0. 30| 1. 93| US$500m| 7. 5| 317| 0. 15| 1. 11| Derivative Financial Instruments*| 6. 40| 4| 0. 00| 0. 01| | | 2,133| 1. 00| 6. 33| Current| | | | | Bank Loans and Overdrafts*| 6. 40| 11| 0. 01| 0. 08| US$1bn| 6. 40| 656| 0. 71| 4. 56| Class B and Class G Certificates| 6. 88| 108| 0. 12| 0. 81| Derivative Financial Instruments*| 6. 40| 1| 0. 00| 0. 01| US$ Commercial Paper*| 6. 40| 144| 0. 16| 1. 00| | | 920| 1. 00| 6. 6| Table 2: Loans and Overdrafts *Interest rates for Derivative Financial Statements, Bank Loans and Overdrafts and US$ Commercial Paper were not given. An average of the remaining particulars has been used to calculate the cost. With the low level of amount for the three loans, the effect on the cost of debt would be immaterial. The average cost of non-current and current debt therefore is 6. 39%. Tax Shield As the interest paid on debt is deductible for tax purposes, the effective cost of debt is the interest expense less the amount of tax saved as a result of this expense. After-tax’ Cost of Debt= 6. 39 x (1-0. 28) = 4. 60 The effective tax rate used for the year is 28%. As BAE made a profit in the year, it would be appropriate to use the Tax Shield. Therefore, Kd = 4. 60% As a result, WACC would be, WACC = [(MVe x Ke) + (MVd x Kd)] / (MVe + MVd) = [(11,280,480,000 x 13. 72%) + (3,053,000,000 x 4. 60%)] / (14,333,480,000) = 1,688,119,856 / 14,333,480,000 = 11. 78% 4. 6 Appendix 6: Shareholder Value Analysis Rappaport’s Shareholder Value Analysis model applies value management principles to calculate a company’s overall value.

The model is based on seven key value drivers which should be targeted to enhance shareholder wealth. The seven value drivers have been calculated below, 1. Sales Growth Rate The sales growth rate takes current revenue levels and applies an average annual percentage increase based on a number of factors. BAE Systems has had an even growth in revenues over the years, even though 2010 saw a slight decline. As evident from the PEST Analysis, 2011 would be a tough year for the company as the full effects of the US and UK defence cuts are considered.

However, the company is confident that with its broad base of activities it would be able to withstand market pressures. BAE is developing its presence in overseas markets including Saudi Arabia and India, where defence spending is set to grow substantially. Figure 4: Forecast Defence Budgets for BAE Systems’ Home Markets (US$bn) Second important factor is the product portfolio of the company. The company has increased its focus on developing its portfolio especially in intelligence and software. Low gearing would also help the company in using funds to make valued capital investments and acquisitions.

Figure 5: Order Intake (? bn) The future sales would also be impacted by the order book of the company. The reduced level of activity in the business is clear from the order intake which is at its lowest level since 2006. This would also indicate that the momentum of growth from previous years may not be maintained in future years. Figure 6: Group Sales including share of equity accounted investments (? m) As evident from Figure 6, BAE Systems’ group sales grew by 13. 32 percent on an average between 2006 and 2010. But the growth between 2009 and 2010 was only 2 percent which indicates flattening of the growth.

A number of independent analysts predict a fall in the revenue of BAE in 2011 but are optimistic on its growth from 2012 onwards. Taking into account all the factors mentioned and its previous growth, BAE is fundamentally set for future growth despite a tough 2011. Considering the planning horizon for the Shareholder Value Analysis, the growth the company will see may not be similar to previous levels but would still be encouraging. Therefore, sales growth rate = 3%. 2. Operating Profit Margin BAE Systems had a strong growth in operating margin between 2006 and 2010. The operating margin increased from ? ,054m in 2006 to ? 1,636m in 2010 giving an average growth in profit of 11 percent. Figure 7: Operating Profit (? m) Although the growth in revenue in 2010 may have slowed down, BAE would be able to maintain the profit margin through cost cutting measures. This was also evident from the number of redundancies the company made in the year. One significant impact could be the payment of regulatory penalties in regard to the allegations against the company. BAE paid ? 278m in regulatory penalties in 2009 which, in retrospect, if the company had managed to avoid, it would not have had the ? 5m net loss for the year. The costs in 2010 were only ? 18m. But any future revelations could impact this figure. The previous average growth in profit would be appropriate to assume the future operating profit margin. The previous rate of 11 percent is adjusted for the fall in the revenue growth for future years, considering the revenue growth between 2009 and 2010 was only 2 percent. Therefore, operating profit margin = 7%. 3. Tax Rate The main rate of corporation tax in the UK will be reduced to 26 percent from the current rate of 28 percent in effect from 1 April 2011.

The small profits rate applies to companies which have profits at a rate not exceeding ? 300,000. It is unlikely that BAE Systems would fall under the small profits rate. Thus for the purpose of the analysis the future main tax rate would be used. Therefore, tax rate = 26%. 4. Fixed Capital Investment The fixed capital investment adjustment is made for additional capital expenditure required to support increased sales. In other words, it would be the investments made by the company in its long term operating assets. Fixed capital investment would be calculated as purchases of assets less sale of assets and depreciation.

The detail of the purchase and sale of fixed assets was obtained from BAE’s consolidated cash flow statement. (Table 3) Particulars| 2010| 2009| 2008| 2007| Purchase of Fixed Assets| 427| 525| 552| 342| Sale of Fixed Assets| (162)| (106)| (196)| (177)| Acquisitions| 207| 357| 1,090| 1,731| Net Capital Expenditure| 472| 776| 1,446| 1,896| Depreciation and Amortisation*| (774)| (627)| (578)| (462)| Net Capital Expenditure after Depreciation| (302)| 149| 868| 1,434| Movement in Revenue| 402| 3,854| 2,776| 1,921| Capital Expenditure / Movement in Revenue| -75%| 4%| 31%| 75%| Table 3: Investment in Fixed Capital (? ) Note: Impairment Charge has been deducted from the total depreciation and amortisation charge for each year. Table 3 provides a very contrasting picture of the capital growth of the company. The table shows a constant decline in the net capital expenditure of the company and would suggest that the long term operating assets of BAE are in effect, shrinking. On the other hand, the annual depreciation and amortisation charge of the company has increased in the same period. One factor which would impact the net expenditure figures is the fact that it is based on the cash flow statement of the group.

There could have been instances where the acquisitions made by BAE are not paid through cash considerations. It still highlights the decline in the capital investments made by BAE. In the first quarter of 2011, BAE Systems announced mergers and acquisitions amounting to ? 585m, which is already higher than the total cash acquisitions made in 2010. (Table 3) Thus considering both the factors, a more practical approach should be taken when forecasting the future incremental capital investment. The average capital expenditure in terms of movement in revenue for last five years is 9 percent.

But, this may be adjusted for the considerable decline in revenue and the net capital expenditure for 2010. Therefore, fixed capital investment = 5%. 5. Working Capital Investment The adjustment is made for the additional working capital required to support increased sales. Table 4 presents the movement of working capital investment. There has been a gradual decline in the working capital of BAE. The increase in receivables and inventories has been relatively smaller than the increase in payables, with a period high in the year 2009. Particulars| 2010| 2009| 2008| 2007| 2006| Receivables| 3,559| 3,764| 3,831| 2,933| 2,253|

Inventories| 644| 887| 926| 701| 395| Payables| (9,352)| (10,381)| (9,165)| (8,245)| (6,717)| Working Capital| (5,149)| (5,730)| (4,408)| (4,611)| (4,069)| Movement in Working Capital| 581| (1,322)| 203| (542)| 575| Movement in Cash| (880)| 1,069| (438)| (38)| 519| Total Working Capital Movement| (299)| (253)| (235)| (580)| 1,094| Total Working Capital Movement / Movement in Revenue| -74%| -7%| -8%| -30%| -55%| Table 4: Working Capital Investment (? m) BAE Systems has kept a very tight working capital management and it can be predicted that future years would be more or less on the same lines.

Thus, we can take the average movement for the last five years. Therefore, working capital investment = -35%. The total of the value drivers discussed above should give us the free cash flow from operations. 6. Planning Horizon As most of the value drivers have been analysed on the basis of the performance in last five years, it may give us a good indication to set a planning horizon of five years. BAE Systems have also used a period of five years to provide an overview of its financial results in the annual report. Therefore, planning horizon = 5 years. 7. Required Rate of Return

The free cash flow from operations is then discounted at a required rate of return. For the purpose of the analysis, we would use the WACC as the required rate of return calculated in Appendix 5. Therefore, required rate of return = 11. 78%. The summary of the seven key value drivers is given in Table 5. Sales Growth Rate| 3%| Operating Profit Margin| 7%| Tax Rate| 26%| Fixed Capital Investment| 5%| Working Capital Investment| -35%| Planning Horizon| 5 Years| Required Rate of Return| 11. 78%| Table 5: Summary of Key Value Drivers Table 6 presents the results of the shareholder value analysis.

Particulars| 2010| 2011| 2012| 2013| 2014| 2015| Post 2015| Revenue| 22,392| 23,064| 23,756| 24,468| 25,202| 25,958| 25,958| Operating Profits| | 1,614| 1,663| 1,713| 1,764| 1,817| 1,817| Less: Tax| | (420)| (432)| (445)| (459)| (472)| (472)| Less: Fixed Capital Investment| | (81)| (83)| (86)| (88)| (91)| -| Less: Working Capital Investment| | 565| 582| 599| 617| 636| -| Free Cash Flow from Operations| | 1,679| 1,729| 1,781| 1,835| 1,890| 1,345| Present Value of Cash Flows up to 2015 | | 1,502| 1,384| 1,275| 1,175| 1,083| | Total| | 6,420| | | | | |

Present Value of Cash Flows post 2015 | | 11,415| | | | | | Total Present Value| | 17,834| | | | | | Saleable Financial Assets| | -| | | | | | Less: Debt| | (3,053)| | | | | | Shareholder Value| | 14,781| | | | | | Market Capitalisation at 31/12/10| | 11,300| | | | | | Difference| | 3,481| | | | | | Difference Percentage| | 31%| | | | | | Share Price (Shareholder Value)| | 434p| | | | | | Share Price (Market Capitalisation)| | 331p| | | | | | Table 6: Shareholder Value Analysis (? m) According to the shareholder value analysis, BAE Systems has a shareholder value of ? 4,781m and is undervalued by 31 percent in comparison to its market value on 31 December 2010. Why Shareholder Value Analysis, – It is a long term based technique derived from future cash flows. – Cash is not subject to management judgements or accounting policies. – SVA is a true proxy discounted model which is appropriate for a traditional company like BAE Systems. – The model can help in understanding what the business is worth and how can the management maximise the shareholder’s wealth. – It is future looking and allows the use of a fixed sales growth rate; which is applicable to an established company like BAE. BAE as a company is in a position where it would be able to continue its business for the foreseeable future. The present value of cash flows post the planning horizon takes this fact into consideration. – It takes larger number of factors into consideration with seven different value drivers. 4. 7 Appendix 7: Economic Profit The economic profit for a company is calculated as, Economic Profit = (Operating Profit before Interest and after Tax) – (Capital Charge) Operating Profit before interest and after tax Table 7 shows the calculation for BAE’s operating profit before interest and after tax (OPBIAT). 2010| Operating profit before interest and tax| 1,636| Less: Tax| (417)| OPBIAT| 1,219| Table 7: OPBIAT (? m) Capital Charge The capital charge is calculated as, Capital Charge= Capital Invested x WACC Judgements would be involved when choosing what defines the capital invested for a company. The main issue when calculating the capital charge is what constitutes the capital invested. Capital employed can either be defined as the total assets of a business or only the net assets. Some authors have also used total assets less current liabilities as the capital invested in a business.

When we are looking at capital employed, we have to consider what actually constitutes capital of a business. Capital in its simplest terms can be defined as the money invested in a business. Money in a business is invested in two ways. First, either taking ownership of the business i. e. equity; second, giving a loan or debt. Thus the capital employed of a business would be equity plus debt finance. Therefore, Capital Invested = Net Assets + Debt Finance Capital Invested for BAE Systems, Particulars| 2010| Net Assets| 5,403| Non-Current Debt| 2,133| Current Debt| 920| Capital Invested| 8,456|

Table 8: Capital Invested (? m) The weighted average cost of capital for BAE has been calculated in Appendix 5. WACC of BAE is 11. 78%. Therefore, Capital Charge= Capital Invested x WACC = (8,456) x 11. 78% = 996 Economic Profit= 1,219 – 996 = 223 The economic profit of BAE Systems is ? 223m. Why Economic Profit, – The model is based on past earnings and avoids the uncertainties related with future predictions. – It has limited assumptions involved in the calculations. Judgements are only required in the classification of the Capital Invested and in the calculation for WACC. The model can then help in looking at the valuation of BAE through a combination of a future based model (SVA) and a model which uses its past earnings. 4. 8 Appendix 8: Dividend Discount Model The dividend growth model was considered when calculating the cost of equity for the weighted average cost of capital. Figure 3 in the cost of equity calculation showed an even growth of dividends of BAE Systems over the years. Thus, the ‘constant growth’ model would be used in the dividend discount valuation. The calculation is as follows, P0= D1/ (Ke – g) Where, P0= Price of the share at T0

D1= Future dividend Ke= Cost of equity g= Dividend growth rate The following calculations have already been done in the WACC calculation in Appendix 5. D1= 18. 94p g= 8% The cost of equity calculated in the WACC computation used the Gordon Growth Model. Even though the model was applicable in the calculation, the same calculation for Ke cannot be used in the dividend discount model as it will only result in P0 being equal to the actual market price of the share. Therefore for the dividend discount model, Ke has been calculated using the Capital Asset Pricing Model. Capital Asset Pricing Model

The cost of equity under CAPM is as follows, Ke= Y + [? (X – Y)] Where, Y= Risk free rate of return ?= Beta value X= Expected market return Risk free rate of return, The risk free rate of return, as the name suggests, is a return which does not involve taking any risk on the investment. The original capital and the interest in the investment are at most certain. Usually these are investments in government bonds, which are used to calculate the return for the CAPM calculation. To calculate the risk free rate of return, UK Government’s ten year bond rates were used for the last five years.

Year| Rate of Return| 2006| 4. 79| 2007| 4. 57| 2008| 3. 02| 2009| 4. 01| 2010| 3. 46| Average| 3. 97| Table 9: UK Government ten year bonds The average of the last five years is a good indication of the risk free rate of return. Therefore, Y= 3. 97% Beta value, The beta value of a company represents the movement of its share price compared to the movement of the market. A beta value of less than 1 is regarded as less volatile and hence less risky. A company which has a value of more than 1 would be more risky but has a greater chance to outperform the market.

The year-end beta value of BAE Systems was not publicly available from third party sources. Thus, the beta value of the company has been calculated against the FTSE 100 index, of which BAE is a constituent. The daily price movement of BAE and the FTSE 100 index was analysed for the period between 1 January 2010 and 31 December 2010. The slope was then calculated on the basis of the movement between the two variables. The beta value calculated for BAE Systems is 0. 62. The beta value as per Reuters dated 1 June 2010 was 0. 66. So the value derived in the analysis can be deemed reasonable.

Therefore, Beta Value = 0. 62 Expected Market Return, The expected market return was calculated based on the FTSE 100 index movement, of which BAE is a constituent, for the last five years. | Price| Movement| 2006| 6,220. 80| 9%| 2007| 6,476. 90| 4%| 2008| 4,434. 17| 32%| 2009| 5,397. 86| 22%| 2010| 5,899. 94| 9%| Average| | 15%| Table 10: FTSE-100 Movement The average of 15% from the last five years would be takes as the expected rate of return. Therefore, Expected Market Return = 15%. Ke= Y + [? (X – Y)] = 3. 97 + [0. 62(15-3. 97)] = 10. 81% Using the Ke in the dividend discount model,

P0= D1/ (Ke – g) = 18. 94 / (0. 1081 – 0. 08) = 674p The dividend discount model suggests that the market price of the share of BAE would be 674p in contrast to the actual share price of 331p. Table 11 summarises the results. Market Value as per DDM| 22,970| Market Value at year end| 11,300| Difference| 11,670| Difference (Percentage)| 103%| Table 11: Dividend Discount Model (? m) Under the dividend discount model, BAE Systems is undervalued by ? 11,670m (103%). Why Dividend Discount Model, – The dividend policy has been one of significant features of BAE Systems. DDM is one of the most fundamental and a widely accepted financial model which is based on the principle that a company is worth the present value of its future dividend payments. – There are fewer assumptions involved in DDM compared to other models. – The model would be appropriate for a stable company like BAE where the dividend payment policies are expected to remain in place. 4. 9 Appendix 9: Price Earnings Ratio ‘Price earnings ratio is a measurement of a company’s rating, calculated by dividing the share price by the annual earnings per share’. LSE, 2011) PE Ratio= Market price per share (MPS) / Previous year’s Earnings per Share (EPS) The price earnings ratios for BAE Systems and its competitors is given in Table 12 below, | 2010| 2009| 2008| 2007| 2006| LM| 9. 60| 9. 70| 10. 40| 14. 40| 15. 60| BAE| 8. 10| 9. 00| 10. 20| 16. 50| 17. 90| NG| 9. 40| 11. 30| -| 15. 00| 15. 20| Table 12: Price Earnings Ratio Note: PE Ratio = MPS at year end / Underlying EPS from continuing operations As Table 12 illustrates, the ratio has gradually diminished across the industry with BAE witnessing the biggest fall among its rivals.

A higher price earnings ratio is an indication of how the company is rated by the investors in the stock market and a fall in the ratio suggests that the prospects of the company have declined among the investors. BAE Systems had the highest PE ratio in 2006 when compared to Lockheed Martin and Northrop Grumman. On the other hand, it now has the lowest ratio in 2010 among the same group. Chart 4 in the report exemplified the net percentage growth of the three companies where BAE outperformed its peers, which is also reflected in the higher PE ratio of the company in 2006 and 2007.

The earnings of BAE saw a decline between 2009 and 2010 which in turn had an effect on its PE ratio. Also, the high earnings ratios between 2006 and 2007 could also signify that the valuations of these companies were stretched at times and could be artificially high. The fall in the ratio over the industry means the valuations reaching a more even level. As earlier stated in the analysis, the company and the industry would continue to face tough market challenges with the decline in defence cuts of many countries. Thus, when forecasting the future earnings of BAE, these two factors would need to be kept in mind.

Though a number of analysts are optimistic about the long term future of BAE and the industry in general, there are doubts in some sections about the immediate growth of the company. BAE Systems itself is confident on its performance and the group’s position on various programmes. A large order book and cost efficiency should help BAE in sustaining its earnings if not improve performance from previous years. Table 13 gives the predicted PE ratio by one of the analysts for BAE and its competitors. | 2011| 2012| LM| 10. 60| 8. 80| BAE| 8. 00| 7. 80| NG| 9. 70| 9. 00|

Table 13: Predicted Price Earnings Ratio Considering the opinions of the company and the market, what appears is that the industry would not witness significant improvement in performance but would be able to maintain its level of earnings. The average PE ratio for BAE between 2009 and 2012 is 8. 23. The figure should be adjusted for slight decline in the activity of the group. Therefore, PE Ratio= 8. 00 The predicted PE ratio would be used to calculate the market price per share of BAE. MPS= PE Ratio x EPS = (8) x 40. 8 = 326p Note: 40. 8p is the underlying EPS from continuing operations for 2010.

The underlying EPS provides a measure of shareholder return that is comparable over time. Actual Market Price at year end= 331p BAE is overvalued by 2 percent as per the price earnings ratio model. Why Price Earnings Ratio, – PE Ratio is one of the most widely used methods and favoured by investors for its easy calculation and understanding. – There are limited judgements involved in the model and there are very few uncertainties associated with its future predictions. 4. 10 Appendix 10: Asset Valuation Method The net asset value of a company is simply the book value of its net assets.

Net Asset Value = Non-Current & Current Assets less Long term & Short term Liabilities Net Asset Value of BAE Systems, Non-Current Assets= ? 16,414m Current Assets= ? 7,616m Long term Liabilities= (? 6,969m) Short term Liabilities= (? 11,658m) Therefore, Net Assets= ? 5,403m The market value of the company at year end was ? 11,300m. There is a difference of ? 5,897 between the value of the net assets and the market value of BAE. Why Asset Valuation Method, – The method virtually involves no judgements in its calculation and there are no uncertainties associated as it is based on past figures. Thus, the model provides a balanced approach towards BAE’s valuations against other models. 4. 11 Appendix 11: Share Price Movement The figures below present the share price movement of BAE Systems and its main competitors. Figure 8: Share Price Movement of BAE Systems (02/01/06 – 23/05/11) Figure 9: Share Price Movement of Lockheed Martin (05/05/06 – 23/05/11) Figure 10: Share Price Movement of Northrop Grumman (03/01/06 – 23/05/11) The most significant feature of the movement is the steep fall in the share price of all three companies at the same time.

The period around July, 2008 was when the economic crisis had a major impact on indices around the world. BAE has relatively remained at the same level after the initial decline in that period. Of the three companies, Northrop Grumman has seen an improved performance since the decline.]. Refer to Table 1, Appendix 1 [ 26 ]. Source: Defense News, 2010