Loren Thompson - BAE Systems, Third Biggest Global Military Contractor, Approaches Major Leadership Change

On July 1, as Americans are preparing to celebrate Independence Day, a new chief executive will take over at Britain's biggest defense contractor.  Once viewed as a colonial oppressor, Britain is now America's oldest and most reliable ally.  BAE Systems, the enterprise that incoming CEO Charles Woodburn will manage, is the hub of Britain's military-industrial complex.  It is also a symbol of trans-Atlantic cooperation, because BAE isn't just the biggest supplier of Britain's military, it is one of the biggest suppliers of the Pentagon.

In fact, BAE Systems is the third-biggest military contractor in the world, with sales surpassing all other weapons makers except Boeing and Lockheed Martin.  No company has a broader range of competencies in defense and aerospace technology.  BAE builds most of Britain's warships, most of the U.S. Army's armored vehicles, and is by far the biggest foreign-based contributor to the F-35 fighter -- the program that will replace Cold War tactical aircraft in the fleets of three U.S. military services and at least a dozen allies.

On July 1, as Americans are preparing to celebrate Independence Day, a new chief executive will take over at Britain's biggest defense contractor.  Once viewed as a colonial oppressor, Britain is now America's oldest and most reliable ally.  BAE Systems, the enterprise that incoming CEO Charles Woodburn will manage, is the hub of Britain's military-industrial complex.  Image from Wikimedia

On July 1, as Americans are preparing to celebrate Independence Day, a new chief executive will take over at Britain's biggest defense contractor.  Once viewed as a colonial oppressor, Britain is now America's oldest and most reliable ally.  BAE Systems, the enterprise that incoming CEO Charles Woodburn will manage, is the hub of Britain's military-industrial complex.  Image from Wikimedia

Charles Woodburn, 46, a longtime executive in the global energy industry, will take over from CEO Ian King -- the executive who more than any other individual has fashioned the company into a global powerhouse.  I've had the opportunity to watch the American part of the enterprise evolve under King's leadership because it is a consulting client of mine, and I did not expect when King assumed the CEO's mantle in September of 2008 that he would be leaving the company in such good shape nine years later.

At the time, BAE was just beginning to experience the downturn in U.S. military demand that would persist throughout the Obama years, and it was dogged in the United Kingdom by chronic execution problems on fixed-price contracts.  Over the following six years, corporate revenues drifted downward from 22.4 billion pounds in 2010 to 16.6 billion in 2014.  But in the last two years, sales have begun recovering smartly -- to 17.9 billion pounds in 2015 and 19.0 billion in 2016.

Some of this is due to favorable currency translations, but operating profit in the last year has increased 10% on a constant currency basis, and backlog has increased 14% to 42 billion pounds -- over two year's worth of sales at current rates.  With a competitive dividend yield of 3.89% and share price that has risen an eye-popping 70% from its 52-week low, it is clear Ian King is leaving his successor an enterprise that is firing on all cylinders.  Nobody talks anymore about execution problems at BAE Systems.

If BAE Systems has a problem, it's that people outside the U.K. talk so little about it in any regard.  Few Americans realize that it is one of the Pentagon's top suppliers, and has a workforce of over 30,000 in the U.S. distributed across 38 states.  The company's American unit, referred to internally as "Inc." to differentiate it from the corporate parent, is a global leader in electronic warfare, tactical communications, flight controls, thermal sights, signal processing, and cockpit displays, but good luck finding anybody in the investment community who knows that.

Part of the problem with branding the enterprise is secrecy.  BAE Systems is the only foreign-based military supplier allowed to participate in the Pentagon's most sensitive technology exploits, but the price of admission is that not much can be said publicly.  The U.S. unit won a huge cybersecurity contract a couple of years back, but it still hasn't revealed with whom.  Published reports indicate it will be supplying the ultra-sophisticated jamming system for the Air Force's future bomber, but there hasn't been a peep from the company about what that entails.

However, the facets of the business that are visible to outsiders suggest that Chairman Sir Roger Carr got it right when he announced Ian King's retirement with the observation that King leaves a legacy of disciplined performance, a burgeoning order book, and "a track record of delivering shareholder value."  The company's guidance to investors for 2017 envisions underlying earnings per share will be 5-10% higher than in 2016, with operating margins in the electronic-systems business approaching 15%.

Margins in the sprawling "platforms and services" business that includes everything from warships to armored vehicles to aircraft will probably be in the low double-digits across the enterprise, while cyber and intelligence work is projected to generate 6-8% margins.  The latter category requires less investment than hardware businesses, and thus presumably exhibits strong return on invested capital.  The point being that in addition to rising revenues, BAE Systems generates returns competitive with those of rivals across its business portfolio.

So although CEO King has seen some tough years during his tenure, he is passing on a robust enterprise to his successor.  Nonetheless,  the company has repeatedly stated that one reason Mr. Woodburn was selected to lead the company was because he brings a "fresh perspective" to the business.  It isn't entirely clear what that might mean going forward, but anyone who knows BAE's history since it was created in 1999 realizes that changes in markets, products and organization have been frequent.  With a strong background in engineering and global business, Charles Woodburn could take BAE Systems into areas not yet imagined.