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Executives

Ian Graham King - Chief Executive Officer, Executive Director and Member of Non-Executive Directors Fees Committee

Peter J. Lynas - Group Finance Director and Executive Director

Gerard J. DeMuro - Executive Director

Nigel Whitehead - Group Managing Director of Programmes & Support

Kevin Taylor - Group Strategy Director

Guy Griffiths - Group Managing Director

Analysts

Christian Laughlin - Bernstein

Benjamin Fidler - Deutsche Bank AG

BAE Systems PLC ADR (OTCPK:BAESY) Q2 2014 Results Earnings Conference Call July 31, 2014 5:00 AM ET

Ian Graham King

Good morning, and thanks for joining our webcast on this busy morning for reporting. Operationally, the Group continues to perform well, benefiting from good program performance on our large backlog of almost £40 billion. Clearly, we faced some exchange rate headwind, but this is about translation, not transaction.

We expect sales to be weighted towards the second half as a result of a stronger second half performance from contracted deliveries. Margin performance was, in general, very good during the first half with a couple of legacy issues in our U.S. support solutions business, which our new management team are on top of.

Our order backlog of close to £40 billion remains very strong, even though it's reduced by some £400 million as a result of exchange rate translation. There are some £1.3 billion of international orders where contractual paperwork is being finalized and £1 billion of sole source U.K. naval contracts, which are at an advanced stage of negotiations yet to be booked into this order backlog.

Overall, we expect robust underlying performance across the group for the full year. However, as we set out at the results announcement in February, the one of benefits to earnings we enjoyed in the second half last year from the settlement of pricing on Salam Typhoon aircraft to Saudi Arabia will not be repeated this year.

As a result of the non-recurring nature of this settlement, we expect earnings per share to decline by approximately 5% to 10% compared to 2013, excluding any impact from foreign exchange translation.

In the U.S., the Bipartisan Budget approval in December 2013 is providing improved near-term clarity, and should enable some program priorities to be better addressed. Against this background, we have seen an improved level of procurement activity within our U.S.-based electronic system business and on some support programs.

I'm also pleased to report that our U.S. land business is on plan. We continue to bid for the armored multipurpose vehicle to replace the large fleet of U.S. M113 vehicles. A major competitor recently withdrew from this competition, and success and winning this large and valuable program would do much to secure our tracked vehicle industrial position in the U.S. for a number of years. We expect a decision within the next 12 months on the first phase.

Budget constrains and reduced activity are most apparent in our Intelligence & Security business, where we continue to have only short lead time contract visibility. The impact of the 2013 underperformance in the Radford contract and commercial shipbuilding continue to depress margins in the U.S. support solutions business into the first half.

Gerry DeMuro has hit the ground running and he is on top of these support solutions issues. He has been quick to make his mark and have streamlined the organization, reducing four sectors to three to bring new management oversight to the activities of the former support solutions businesses and reduce administrative overhead.

We continue to make ground in our strategy for organic growth in commercial aircraft electronics. Boeing's recent selection of BAE Systems to supply the integrated digital flight control system on its next generation 777X program was a key win, securing an important role on this promising platform.

Turning now to the U.K. Much of the Group's U.K. business is concentrated on a small number of large programs where multi-year contracts provide good visibility and a large order backlog. We continue to perform well on our major U.K. programs. We welcome the discipline that has enabled MOD to balance the defense plan. It has not been easy for either government or industry.

Our military air business continues to benefit from both stable Typhoon production and our extensive support and upgrade business. In the first half of this year, we have delivered four Salam Typhoon aircraft of an anticipated 12 deliveries this year. The phasing of Salam Typhoon aircraft deliveries and European Tranche 3 aircraft results in higher second half sales.

A progressive release of additional capabilities is planned for the already very advanced Typhoon aircraft. A high level of activity is underway to clear additional weapons and sensors onto the aircraft for the four partner nations and international customers.

In addition, at the Farnborough Air Show earlier this month, the Prime Minister announced the £72 million contract to further de-risk E-Scan radar development for the RAF's Typhoon fleet. This activity is part of the U.K. MOD's procurement process, ahead of the award of a full scale development contract.

BAE Systems has an enviable position on the world's two preeminent combat aircraft programs. Our participation in the F-35 combat aircraft program continues to develop. 21 airframe subassemblies were delivered in the period, and we are now starting a significant production ramp as the planned aircraft delivery rate accelerates.

A second phase of highly successful trials of the Taranis unmanned air system has been completed, demonstrating the aircraft's ability to fly in full stealth mode. As a reminder, this is the most advanced aircraft developed in the U.K. by British companies lead by BAE Systems, and we are considering next steps with the U.K. government.

In addition, the U.K. government is also commitment to join U.K.-French funding in this sector with the announcement during the Farnborough Air Show of £120 million funding for feasibility work ahead of a potential demonstration.

We are investing in the Group's maritime businesses in the U.K. following a dream in last year with the U.K. government on the surface ship strategy. As part of the investment phase for the Type 26 frigates we have made a proposal for the design and manufacture of the ships. This activity, along with the commitment to build three offshore petrol vessels and the restructuring agreement, will provide long-term clarity for complex warship manufacturer in the U.K.

The Queen Elizabeth Class aircraft carrier program is progressing well, and the first vessel is structurally complete. The carrier was named in the formal ceremony by Her Majesty, the Queen earlier this month, and has subsequently been floated out of the dry dock in which the ship was assembled, allowing assembly of the second ship to get underway.

In the submarines business, Artful, the third of the seven Astute Class submarines was launched in May. Alongside build of Astute Class boats, engineering work continues to accelerate on the successor program.

In Saudi Arabia, the Group continues to make good progress with the provision of capabilities that now support 38 Typhoon aircraft in service. In addition to delivering a high-end defense capability, we are committed to the continued development of Saudi Arabia's industrial base, in line with the Kingdom's stated national agenda.

In June, we have managed the reorganization of our portfolio of interest in a number of industrial companies in Saudi Arabia and an enhancement of an existing relationship with Riyadh Wings. This reorganization is expected to enhance the growth prospects of these businesses in Saudi Arabia and support skills and technology development in Kingdom with increasing local employment.

In Australia where BAE Systems is the largest defense contractor, there was a government commitment to increase defense spending. We continue to perform well on the Canberra class landing helicopter dock program with the first of the two ships completed and expected to be delivered to the customer in the second half of the year. We are discussing with the Australian government options needed to sustain industrial capabilities across the shipbuilding sector. It is important we resolve this key issue.

Other international markets offer a range of opportunities. We now have initial funding for the large Korean F-16 upgrade program and see other military aircraft upgrade prospects. Our MBDA joint venture recently won a key contract for ASRAAM, a precision air-to-air guided weapon with the new government in India. Other prospects in India for M777 Howitzers and the next batch of Hawks continued to be pursued in this new political environment.

We are seeing significant renewed interest in MBDA for ground-based air defense systems from international markets, and we have vibrant campaigns to address international opportunities for Typhoon aircraft and combat vehicles.

In the area of Cyber Security & Intelligence, our U.S.-based business continues to be impacted by delays in procurement awards and increases in the number of award protests. Much of the reduction has come from the Afghanistan withdrawal and the impact on our lower margin IT support activity. The strategy to develop our U.S. government mission support activities remains robust and we continue to address substantial bid prospects.

As you may have seen, we have just completed a small bolt-on technology acquisition with Signal Innovations Group, a provider of imaging technologies and analytics to the U.S. intelligence community. Although small in scale, this acquisition provides us with additional technology that has the potential to be exploited for commercial applications.

Through the Applied Intelligence business we continue to successfully develop our strategy for commercial cyber with good growth in the first half and contract wins across international markets. We achieved further strong order intake, growing the order backlog 25% in the first half. This success builds on our 60% growth in the order backlog last year. We continue to invest in the business as we build our cyber skills base. For the second year running, over 40% of BAE Systems graduate intake in the U.K. will join the Applied Intelligence business.

In addition to the drive into cyber, we invest heavily in the skills and technologies we need to sustain and grow our wider business for the future. We focus company-funded investment in the areas of both defense and commercial aircraft electronics, unmanned technologies, and as I mentioned, to build our commercial cyber business.

We should remember that in defense work we work with our customers to develop the skills and technologies to meet their requirements. Customer-funded R&D is an important component of our overall investment. Today, the overall percentage of both our own and customer-funded R&D is approximately 6% of Group sales.

Group's capital allocation policy remains unchanged. We continue to supplement dividends with returns to shareholders through the share repurchase program announced last year.

I will now hand over to Pete to take you through the detailed financials. Pete?

Peter J. Lynas

Thanks Ian, and good morning. As Ian mentioned, our results have been impacted by the stronger pound, both in absolute terms against 2013 and against the assumptions made in our guidance. And I'll make that impact clear as I give the usual trading review and then move into the 2014 full-year guidance. For reference, the U.S. dollar is average 167 so far this year compared to 154 last.

So the headline numbers and compared to the first half of 2013, sales have reduced by some £900 million to £7.6 billion. Around £400 million of that reduction was due to exchange translation. The volume reductions in Land & Armaments were as expected, and there was a significant second half bias in sales due to the contracted delivery schedules for Typhoon aircraft this year.

Underlying EBITDA decreased by 7% or 4% of constant currency to £802 million, giving a return on sales of 10.5%. Underlying finance cost in the first half was slightly down at £89 million. Underlying earnings per share were marginally lower than in 2013 at 17.7p, benefiting from the Group's share repurchase program and lower tax rate. And there is a bridge charge showing the movement in EPS appended to the presentation posted on the web.

There was an operating cash inflow in the first half of £287 million, benefiting from the sale and lease back of our two residential compounds in Saudi Arabia. Net debt to June 30 was just under £1.2 billion. Order backlog is reduced to £39.7 billion and £0.4 billion of that is due to exchange translation. And finally, the interim dividend has been increased to 8.2p per share, up 2% on the 2013 interim.

In addition to the effect of exchange translation, there were a number of other impacts, items impacting the balance sheet in the first half. Tangible fixed assets reduced as the second of our Saudi residential compound sale and leas back transactions completed in April. As anticipated, advances continue to be consumed on the Omani Typhoon and Hawk program, the European Typhoon contract, and the Saudi training program.

The first of the two payments into the Salam VOP settlement has been received. Cost incurred are being charged against a number of provisions created in previous years. The IAS 19 accounting pension deficit is increased over the six months to £3.6 billion, and I'll cover that on the next slide. And finally, net debt close to £1.2 billion.

This slide shows the pension scheme assets, liabilities and deficit as accounted for under IAS 19. The value of the scheme assets has increased by £0.6 billion over the period to £22.1 billion. Liabilities increased by £0.9 billion to £26.9 billion.

Real discount rates have reduced by further 20 basis points in the U.K. and by 60 basis points in the U.S., mainly driven by bond yields. So overall, a net £200 million increase in the Group's pretax accounting pension deficit.

As you know, the pension accounting is not the important issue; it’s the funding position that's more relevant. And 2014 is a significant year for triennial funding valuations with all nine of the Group's U.K. schemes falling due.

Discussions between the company and the trustees of those schemes are currently ongoing as to the underpinning assumptions behind the calculation of the liabilities. And we expect those discussions and any subsequent revisions to deficit recovery plans to be completed by the year-end.

Moving on to cash. This slide sets out the movement from our net debt position of £699 million at the beginning of the year. There was an operating business cash inflow of £287 million. Interest and tax payments were £141 million. 2013's final dividend paid in June was £383 million.

Under the three-year share repurchase program of upto £1 billion; we bought back 56.6 million shares in the first half at a cost of £235 million. And since commencement of the program, we have bought back 108.2 million shares at an average price including cost of £4.14. Exchange translation to all other movements totaled £11 million.

We did repay $500 million of long-term borrowings in the period, so we closed at June 30 with gross debt of £2.6 billion, cash of £1.4 billion and net debt of £1.2 billion. The cash flow performance of the five sectors is shown here, and I'll return to this when I get to the results of each of the sectors. But just to note, the total cash outflow for pension deficit funding in the period was £163 million, the cash outflow at head office contains £148 million of that.

Moving now to the sectors, I'll cover the year-to-date performance here and then return to the full-year outlook a little later. And so, to the first of those sectors, Electronic Systems and the figures shown here are in U.S. dollars.

The sector delivered sales of $1.85 billion, almost identical to last year and in line with guidance. Sales in the commercial area of the business now stand at 22%, and growth there is helping to offset the expected pressures on the defense side.

The return on sales achieved the 12.9%, which is consistent with the first half of '13. Cash conversion of EBITDA in the first half was ahead of last year's, and we do expect an improved conversion level over the full year.

Despite the U.S. budget pressures, order backlog stands at $6.2 billion, sustained since the start of the year on further F-35 LRIP awards. And this backlog does not include the currently protested award for enhanced night vision goggles.

The Cyber & Intelligence sector comprises the U.S. intelligence and security business together with BAE Systems' applied intelligence. The numbers again are here in dollars. In aggregate, sales reduced by 13% to $0.9 billion. The U.S. business saw a further 22% decrease, driven largely by reduced budgets of the sector's two largest customers along with further reductions in analysis support on Counter-IED activity in Afghanistan. Growth in the Applied Intelligence business was 7%

Despite the top line performance, margins have improved to 8.9%. Cash flow performance includes the capital cost of the replacement ERP system and stand up of a Malaysian operating center in the Applied Intelligence business.

Order backlog increased to $1.4 billion, and despite the first half, top line pressures, backlog in the U.S. business grew by 8% on imagery analysis and cyber support awards. In the Applied Intelligence business backlog grew by 25% and now stands above $0.5 billion for the first time.

The U.S. Platforms & Services sector aggregates the Land & Armaments and the Support Solutions businesses. As Ian mentioned, in a further cost reduction move the Support Solutions business is being disaggregated across the other three U.S. businesses. For 2014, we will continue to provide transparency of the two businesses within the sector and we will advice of changes to be made to reporting structures for '15.

So I'll move straight on to the performance of the first of those two businesses, Land & Armaments. Sales in the first half reduced by 14% to $1.26 billion. As per our guidance back in February, broadly reset activity has almost halved, the major mine protective vehicle production contract has completed and deliveries of the US M777 Howitzer contracts have largely traded out.

Despite the expected top line reductions, the business has outperformed at the margin level, delivering a return on sales of 10.9% through strong program execution and cost reduction. Cash flow was significantly improved compared to last year with more than 100% profit conversion.

Order backlog is reduced in line with the sales traded. In the Support Solutions business sales of $1.51 billion in the first half were in line with the expectations with good volumes in naval ship prepare activity. However, the return on sales in the period was at just 2.5%.

In addition to the lower margins arising from last year's issues on the Radford contract, a further $20 million of charge have had to be taken on commercial ship build programs.

Order backlog reduced to $4.8 billion on the sales trading outs under the five-year U.S. navy multi ship -- multi-option ship prepare contracts and ordinance programs. The recomplete for the Hawaiian contract was successfully secured in the first half.

In the Platforms & Services in U.K. sector, sales were up $2.8 billion, 15% lower than in the first half of 2013. This year Typhoon aircraft deliveries have a significant second half bias. Under the Saudi Arabian Salam contract, there were four aircrafts delivered in the first half with eight scheduled for the second half. And on he European program, there were eight aircraft deliveries in the first half with 22 scheduled for the second half as we transition to deliveries of Tranche 3 standard.

The return on sales of 13.8% seen in the first half of 2014 has benefited from strong program execution and accelerated risk reduction on the European Typhoon production contract as the Tranche 2 aircraft deliveries moved towards completion.

As expected, the $0.2 billion of cash outflow in the period reflects the consumption of customer advances on the Omani Typhoon and Hawk program, the European Typhoon contract and the Saudi training aircraft program. Order backlog reduced to £20.4 billion, primarily on the trading of Typhoon aircrafts, Indian Hawks and carrier.

Stripping out the exchange translational impacts of sterling against the euro and Australian dollar, sales in the international businesses for the first six months of £1.576 billion are unchanged from 2013. EBITDA was at £157 million, giving a consistent return on sales of 10%. There was an operating cash inflow of £541 million, which includes a net £349 million from the sale and lease back less initial rentals of the two Saudi residential compounds.

Whilst order backlog has reduced from last year and high following the awards in 2013 of the five year support contracts and weapons package, orders totaling £1.3 billion are being finalized with the Saudi customer.

For reference, there is a chart providing a summary of the trading performance of all five sectors appended to the presentation posted on the web, and that summary also contains the numbers of headquarters which include a one-off net benefit of £13 million, and that arises from the reassessment of a long-term liability that's a further charge taken on settlement of U.S. contract pricing dispute.

This chart sets out our guidance for each of the sectors through to the end of the year; and so, firstly electronic systems where guidance is unchanged. We continue to expect 2014 sales in dollar terms to be similar to those in '13. More than 20% of the business is now in commercial markets where we are seeing continued good levels of growth helping to offset reductions on the defense side.

On margins, we expect to see performance of the high-end of our 12% to 14% guidance range. Next Cyber & Intelligence; and here we are revising sales guidance slightly downwards due to the continued pressures in the U.S. business.

In the Applied Intelligence business we continue to expect double-digit growth, and so for the sector in aggregate we now expect sales in '14 to be some 5% below those in '13. Despite the U.S. top line pressures, we expect margins towards the higher end of the improved 8% to 10% range.

Moving to Platforms & Services U.S., once overall guidance is as shown on the chart and aggregate is unchanged; this is best considered in two parts. In Land & Armaments, we reconfirmed previous guidance of the top line that is in the $2.25 billion to $2.4 billion. And our margin level we now expect fully delivery slightly ahead of the previous 9% guidance.

In the Support Solutions business we continue to expect 2014 sales to be only a littler lower than in '13. However, due to the further charges taken in the first half in commercial shipbuilding we are reducing the margin guidance in the Support Solution sector for this year.

On Platforms & Services U.K., here guidance for both sales and margin remained unchanged. And as I've mentioned earlier, due to the timing of Typhoon aircraft deliveries on both European and Saudi contracts, there is a significant bias to the second half. And following the benefit in 2013 of the Salam price escalation catch up, margin in this sector is expected to return to within our usual 10% to 12% range.

And on the last of the sectors, Platforms & Services International, sales guidance is largely unchanged other than for the exchange translation impact from the Australian dollar the euro. That impact is projected at around £150 million year-over-year.

Last year's trading that arose from the Salam price escalation and the high weapons volumes is expected to be largely match this year by increased level of support to the Typhoon aircraft that are now in service. Our margin guidance here is also unchanged. And to complete your 2014 models headquarters' costs are expected to be significantly lowered in '13 and that includes those first half one-offs.

Underlying finance costs are expected to be marginally higher. The effective tax rates guidance for the full year is reduced to around 20%, in line with the rate of the half year. And the final number is, of course, dependent upon the geographic mix of profits.

With last year's non-recurring benefit from the Salam price escalation settlement and before the impacts of the stronger pound, we continue to expect the Group's reported earnings per share to be some 5% to 10% lower than in 2013. Exchange translation assuming average rate of $1.70 is expected to impact earnings by around 1p compared to previous guidance.

This final chart highlights the cash utilization we expect in 2014. The first column shows the position of the half year and the second column provides the full year guidance. In respect of operating cash flow, we are not planning for any material capital expenditure above depreciation levels. We have completed the sale on lease back transactions of both of our residential compounds in Saudi Arabia, and those at the gross level have generated some £400 million of proceeds.

Within working capital we expect to incur cost of around £300 million against provisions created in previous years that are held in the balance sheet. The most volatile area remains the level of customer advances. And as expected, the major advances we received in 2012 on the Saudi Trainer Aircraft contract and the Omani contract are being consumed. And you'll recall that under terms of that Omani contact no further cash will be received until deliveries commence in 2017. Advances are also being consumed on the European Typhoon contract.

The final operating cash flow items is the U.S. pension deficit funding, which will again be around £400 million, and that includes the accelerated funding arising from the share repurchase program.

The non-operating cash flow items are far more predictable. Outflows for interest and tax are expected to total around £300 million. Dividend payments in the full year of the share buyback program should deliver a further £1 billion of cash returns to shareholders.

And so, overall, and as per previous guidance, 2014 is expected to be year of better operating business cash flow, but with an increase to net debt post those shareholder returns.

In summary, then in the first half we have seen some mix performance in the U.S. sectors, but that's been largely mitigated by good delivery in the U.K. business and the lower tax rate. For the full year, other than for exchange translation we are reiterating the earnings per share guidance that we gave in February. Ian?

Ian Graham King

Thanks Pete. So, in summary, a good start to the year. The Group is performing well, and with some anticipated second half bias remains on track to deliver our plan for the full year in line with expectations. In addition, we continue to develop new businesses opportunities laying the foundation for the future growth.

So what we'll now do is we'll take questions. I, as usual, have my colleagues here from the EC to answer the really difficult questions, but who's got the first question? Christian? Christian, you are there?

Question-and-Answer Session

Operator

Yeah. We will now take the question from Christian Laughlin of Bernstein.

Christian Laughlin - Bernstein

Great. Thank you. Good morning, everyone.

Ian Graham King

Good morning.

Christian Laughlin - Bernstein

Just one question, really, and it's kind of in general. I'd just like to get some thoughts and views on you confidence on your ability to be able to continue to take cost out of the businesses going forward as you have done for the last few years. And in terms of how sustainable this is for, I guess to kind of near and medium-term. And then also do you see much variance between the U.S. and the U.K. side of things?

Ian Graham King

You can always continue to drive efficiencies into business. The heavy lifting that we had to do was reduction in land volumes. We're largely through. But as you can see, in the U.S., Jerry is full steam ahead. He has reduced the structure in the business going from four sectors to three sectors, taken administrative overhead out.

In a number of our businesses we're introducing new IT systems, so again that will reduce the cost of -- the administrative cost that we have. And you just got to keep ongoing. You can't stand still. We've got to stay ahead of this game. But we're well aware of the volumes of this business; the benefit of having a £40 billion order book backlog is that you can anticipate where the operational gearing has to be. And we've got to stay ahead of that game which, as you can see, we are by the performance on the margins.

Christian Laughlin - Bernstein

And as a corollary to that I mean how happy are you with the positioning of your industrial base? I guess just generally speaking in the U.S. and the U.K. in terms of rationalization of that industrial base and positioning for dealing with your existing order backlog, and what you anticipate too to come through in the next few years.

Ian Graham King

Well, we probably ask Jerry to comment on the U.S., because as you can imagine coming in he's taken a fairly deep dive due diligence on this. And I think it's fair to say in land which has been the major change in industrial base we're feeling pretty good about life at the moment. Jerry?

Gerard J. DeMuro

Thanks, Ian. I would concur with that. We've spent quite a bit of time, as you know, working with senior leadership at DoD and within the army in particular on the combat vehicle industrial base. That's one of our priorities this year. And I think we made excellent progress. We have several key programs now in the portfolio to sustain that engineering base. And, as you know, we're bidding not only the AMPV program, but several international programs that I think will provide real stability and backlog in that portfolio.

Christian Laughlin - Bernstein

Okay. Thank you.

Ian Graham King

So in the U.K., Nigel, do you think that with the U.K. government which we described is stable? We have good visibility in the air and naval sectors?

Nigel Whitehead

I think we have exceptional view of the workflow going forward. And in particular, as a result of the agreement reached last year with relation to the strategic future for shipbuilding in the U.K. to the sense of the question, there is a major rationalization program that that agreement allows. We're on with that and making good progress. We'll take significant cost out of the cost base, not just in the ships area, but also in our military business over the coming years. And equally we're investing in our submarines area where we actually see growth in the headcount as the successor program grows to a point where we are able to fulfill our offering to the U.K. government.

Christian Laughlin - Bernstein

Right.

Ian Graham King

So does that give you confidence that we have good visibility going forward?

Christian Laughlin - Bernstein

Yes. That's very helpful. Thanks for that color.

Nigel Whitehead

Thank you.

Ian Graham King

Right. Harry? [Harry Breach] (ph)?

Operator

(Operator Instructions) We will now take our next question from [Harry Breach] (ph). Please go ahead.

Unidentified Analyst

Thank you. Hello, Ian and Peter.

Peter J. Lynas

Hello. How are you?

Unidentified Analyst

Not too bad, gents. But thanks for making the time. A quick couple of questions, a very easy one for Pete to start with, and then a couple of other ones. Peter, just quickly you mentioned I think a £13 million charge relating to pricing dispute. I didn't hear that in the language around it. Could you just remind me what you said there?

Second thing, just turning over to order intake, there was a lot of comment, Ian, you made earlier on about the confidence in the items you're expecting to book in the second half. Can you give us a sense of book-to-bill for the year overall with this stronger second half of order intake you're expecting?

And maybe just sort of final thing, with the interesting comment you made on the U.S. slide at the beginning of the presentation where you said procurement activity was improving in many areas in the U.S. I'm just wondering if you can give us a little bit more of a sense of where you see those improvements. And are they are getting driven by sort of return of confidence in the DoD that funding is going to be in place in the congress in coming years. And they can begin to plan again and some of the uncertainties coming out, or what's driving that procurement activity improving, if you can touch on that. Thank you.

Ian Graham King

Well, I'm glad they were very simple questions. Pete's simple, but mine seems to be quite difficult, Harry.

Peter J. Lynas

I'll do the simple one first, Harry. Yeah, there was a net 13 so that’s £13 million benefit in the HQ numbers in the first half. There's two items in there. One we've done a reassessment of a long-term liability and the other one is there is a charge for settlement of a U.S. contract pricing dispute. But the net of the two is £13 million.

Unidentified Analyst

Thank you.

Ian Graham King

Okay. So book-to-bill, Henry, the thing that drives us is that when we look into our forward sales, so if we take '15 as to what percentage of our sales today we have in our committed order book, and so we are planning going forward. Generally, when we start the year we're in the high 80% or 90% and that's what we started this year, and I have the confidence that we're going to be in that same position when we start next year. And that's what drives us when we talk about visibility.

In terms of the U.S. procurement, I mean in the area, I'd perhaps ask Jerry to comment on this, the area we've been particularly pleased about has been in our electronics systems business where, as you know, we about 5,000 individual programs. So I think it is clear that as the budgets started to come in place. They were then committing to these programs going forward and we have had a good year, good six months in electronics systems. Jerry, do you feel that in terms of the Pentagon and the planning they are now getting more forward thinking in terms of the programs.

Gerard J. DeMuro

I would agree. As a result of the Bipartisan Budget agreement not only in the electronic systems area where I think we had a book-to-bill over 1 for the first half, but also importantly, in the Intelligence & Security sector we also had almost 1.1 book-to-bill. And I think for the first time in 18 months we actually have positive build increasing backlog and increasing sales half over half, so a positive trend. We've seen a lot of activity, particularly in the Intelligence & Security area in this quarter. Now it's taking longer for those to mature, but we're once again back up to a rate of proposals that we haven't seen in a couple of years now.

Unidentified Analyst

So if I can just clarify, Jerry, it's the confidence there is about the Intelligence & Security area, would you -- can you give us any color on the other areas, land and support services and procurement terms in the U.S.?

Gerard J. DeMuro

Well, I mentioned electronic systems, and not included in the book-to-bill is a night vision award that we were one of the awardees. That’s now under protest, but they also had a book-to-bill over 1 for the first half of the year. And in Land & Armaments not only are we improving focused on margin improvement, but we've seen significant awards that solidify the industrial base, so I mentioned two or three GCV bridging program what will assist our engineering base. And two, on the Amphib side that are maturing with the marine core as well as the major opportunity that Pete spoke about and I think Ian as well, the AMPV program and a couple of international programs. So we're starting to see a lot of proposal activity. It takes a little while for them to mature, but definite positive trend.

Unidentified Analyst

And Ian, sorry to hound you on this wickedly, on the book-to-bill when we think about the second half, I think in the first half your sterling order intake, when you added up for the individual business segments, came to about £5.5 billion, clearly some currency impact. Can you give us a sense sort of for the second half, would you expect it to be so significantly large and that given the indications you've given us about the order you expect to receive.

Ian Graham King

Yeah. We would expect it to be up. But you got to remember, in our international business, in our U.S. business we're not waiting on any orders to probably deliver sales into 2015 of any great note because we've got massive visibility going forward. So we described this as sometimes lumpy, but that's the nature of the business. I don't know, about 75% of that order book, Pete, will be in the U.S. business?

Peter J. Lynas

Yeah.

Ian Graham King

The order backlog?

Peter J. Lynas

Yeah. Harry, the whole sort of have book-to-bill discussion. In the U.S. when you contract on an annual basis the book-to-bill ratio is a good one. When you look at our international businesses, if you look at our Saudi support business, for example, we get a five-year contract. The book-to-bill metric is just not relevant at all. So I think if you rather look at the whole company, if you drill down and look at the sectors that's probably the best approach.

Unidentified Analyst

Fair point, Pete. I hate…

Ian Graham King

It's interesting point, Harry. So although we've got £40 billion of order book, you've got to remember that about 75% of that covers 65% of the business. The other 35% which is the U.S. we only get on an annual basis just like every other U.S. contractor.

Unidentified Analyst

Great. Thank you very much guys.

Ian Graham King

Thanks. [Celine] (ph)?

Unidentified Analyst

Good morning. Thank you, Ian. Good morning, everyone.

Ian Graham King

How are you, Celine?

Unidentified Analyst

Hi. A couple of questions if I may. The first one would be on the margin and the profits recognized in the Platform & Services in the U.K. business, which is probably fairly higher than what I expected at least. So I just wondering what's the magnitude of this milestone or risk release in that? And I guess then we shouldn't expect that to happen and to be recurrent in the second half.

And the second question would be on your R&D comment, Ian, where I think you gave the level that is being spent at the group level on R&D. And how do you see that trending forward, so over the next two to three years.

And the final question is on the back of Harry's question on the backlog on your U.S. electronics comments. You said the backlog was up. Could I just ask to what's the difference between the defense content and the commercial content on these backlog and what are the trends there as I suppose the commercial backlog must be up as well. Thank you very much.

Ian Graham King

Okay. Pete?

Peter J. Lynas

Yeah, okay. On the margin front in Platforms & Services U.K., you're right, Celine. If you look at our full-year guidance we're saying the guidance is unchanged. There are three things really going on in that sector that give you that high margin. The first one is where we got the Typhoon Tranche 2 aircraft sort of moving towards completion, we are seeing risk reduction and as that happen you see the margins come up.

In the second half we move into Tranche 3 aircraft deliveries. There were none in the first half; there are 12 in the second. And as we start on the new production run, obviously we trade margin at lower level. So you got that mix effect going on.

And then the third element is on Astute program, which is as you know, is a quite low level margin program. There are more milestones to trigger sales in the second half than there were in the first. So, those three sort of give you that high first half margin, but then as you move into full-year guidance, the guidance stays unchanged.

In terms of U.S. backlog in electronics systems, we don't book the commercial backlog. We only recognize the defense side. So that is pretty much all defense backlog. We only take commercial; we sort of take in the orders and the sales and almost in the same period. So there is no impact there. The growth in the backlog is all on the defense side.

Ian Graham King

So -- and the U.S. business, the commercial avionics business is $600 million of business, out of that electronic systems business. It's a -- and don't worry about the backlog in this business. We're on every GE engine, we're on the 737, we're on the 777, we're developing our IntelliCabin. This is an area of business that is going to grow for us. And that is, as you know, the commercial sector some of it which is growing by 5% compound annual growth rate. We'd be pretty disappointed if we didn't beat that growth rate.

Peter J. Lynas

On your other question around the R&D, as you've mentioned, 6%. That's been a consistent rate for the last three years, maybe four years. What varies is the mix between customer funding and self funding. And you'll have seen the announcement of the Farnborough Air Show around customer funding of E-Scan. We've been funding some of that so that will now move to customer funding. So there's always going to be a mix within that overall 6%.

Ian Graham King

But we would see that's a consistent rate that we can cover going forward. That's what we monitor to make sure that we're on the right programs. And between a combination of our funding and the customer funding we're staying ahead of the technology curve.

Unidentified Analyst

And so, you shouldn't see a rate change in the mix between your contribution or the customer contribution going forward.

Ian Graham King

You may, just depending on where the stage of the program is. And as Pete says, we've been developing on our neck a lot of E-Scan layouts. It's not moved to a funded program so the same team move off our funding onto that program. That will be the same in unmanned over the years, but then we'll be investing in other technologies going forward. So that's why we focus on the 6% to make sure that we're keeping on refreshing the technology bank.

Unidentified Analyst

Okay. Thank you very much.

Ian Graham King

Okay. Thank you. Andrew?

Unidentified Analyst

Hello. I think that's [Andrew Gollan] (ph).

Ian Graham King

It is Andrew. You are the only Andrew on this list. Sorry, I should have given to the second Andrew around. Good morning, Andrew.

Unidentified Analyst

Well, it's defiantly me. Anyway, good morning. I've got three questions. First one, forgive me for talking an old money, but Detica, you've mentioned the strength of order intake. I mean it's 25% in the period and 60% last year. The revenue growth was only about 7%. I mean can you just talk about the expected top line growth for that business and does it accelerate sharply, and how does the business cope with that if it is commensurate with the order, scale of order intake?

Ian Graham King

Well, let's do that one. I mean we would expect double-digit growth. And as you said, it takes a little bit of time to ramp up. And you can see we're taking 40% of £400 million into that business. We are ramping up lots of people into that business.

Unidentified Analyst

Okay. Thank you.

Ian Graham King

We opened up a new technology delivery center in Malaysia where we are now got over 100 people in there and plans to get upto 200 people. So we are investing. Pete mentioned that in his financial update. We are investing in this business to create the infrastructure. So we've got Kevin Taylor, do we have a problem recruiting into this business, Kevin?

Kevin Taylor

No. As you highlighted, a large percentage of the BAE intake is in this area. Because it's a growing business, we attract the right kind of people. And just to add further clarity on the order book, we've taken in significant multi-year service contracts so the sales will catch-up in subsequent years. So no, we don't have any problems at all getting the right sort of talent, but we're vigilant with the levels of growth that we got, but we need the right training programs as well.

Ian Graham King

Okay. Andrew. So, next question?

Unidentified Analyst

Okay. Yeah, secondly, a slightly broader question on the market. Just your views already when we talked about improved outlook and stability within or more stability within the U.S. environment. Can you just talk about what you're thinking beyond 2015 in terms of risks and how that fits within your own planning background?

Ian Graham King

Yes. I mean we're not expecting in terms of the U.S. that when you go par, say you're going to get nothing other than the modest growth in terms of budgets. We're not expecting that you're going to go back to the Afghanistan-type funding arrangements. So that's our planning assumption. So we tend to focus on the areas of emphasis of the forces and the key program. So we still think the desire to maintain a large fleet which is capable of protection around the Pacific Rim is going to be key to them.

F-35 programs, the air force has been pretty clear about what its key programs and its key technologies are. So that's why we think with having the two-year budgets plus actually much more clarity on definition of what they want to focus on that we think that we can -- we're in the right areas. And as Jerry said, we're very pleased on the level of intelligent conversation that industry and the government are having on the land structure as well.

Unidentified Analyst

Okay then. And then finally, within the naval sector, I just wonder if you could help us think about on the U.K. side what the revenue outlook or profile will be through this, there's quite a lot of transition going on. We've go CVF completing, we've got OPV filler, if you like, and then Type 26 where there's a little bit more uncertainty. Maybe you are also within the context of what the new agreement with the U.K. government means relative to what we were think about the ToBA which at the time was 15 years, some certainty type agreement which is now appears to have changed.

Ian Graham King

No. The ToBA still exists and until the timing of the ToBA turns into firm contracts it's an obligation of both the U.K. government and ourselves. This is a sector that goes through the height of carrier which we all knew is a massive bubble which we would then have to restructure. And the restructuring program that we and the U.K. government are entertaining take us through these OPVs, the three OPVs and then into the Type 26 program. And its our obligation under the ToBA to make sure that we got industrial capability to make sure that the U.K. still has ability to design, develop and manufacture complex warships and that’s what we're doing. At the same time, you've growth in the submarines business as you go through Astute that on to successor. So the naval sector is a very vibrant sector for us.

Unidentified Analyst

Okay then. And just switch to Australia then, you mentioned about the potential reduction activity after the LHD contract. I think you said it's important that an agreement is reached. But by when and what would be BAE's exposure as the restructurer in that business?

Ian Graham King

This isn't a massive financial exposure for this. This is just a fact that we are in the Australia, the custodian of, again, the complex warship capability, and we need to agree with the Australian government what they want to do. And there's been some particular developments on that. I'll perhaps ask Guy Griffiths who is responsible about those, just to cover in some detail, Guy?

Guy Griffiths

Yeah. So, I mean what is happening in Australia at the moment is that the navel shipbuilding sector is very heavily loaded today. We're discharging the landing helicopter dock program, which will complete in 2015. There's an air warfare destroyer program being led by ASC, a state-owned Australian Submarine Corporation. And we are heavily loaded through to the middle of this decade. The Australian customer is saying that he has a massive recapitalization plan for his navy commencing at the beginning of the next decade.

And the question we're asking really from an industrial strategy point of view is how collectively can we sustain the key shipbuilding capabilities we've built up between the completion of the current series of programs and the launch of the new programs. And I think the Australian government is very heavily focused on answering that question with us and is exploring a range of options including potentially accelerating some procurement activity in order to at least to contribute to bridging that gap.

Unidentified Analyst

Okay. That's very clear. Thank you.

Guy Griffiths

Okay.

Ian Graham King

Okay. Next question is from Ben Fidler.

Benjamin Fidler - Deutsche Bank AG

Yes. Good morning. I have a few questions. The…

Ian Graham King

We'd be very disappointed if you didn't, Ben.

Benjamin Fidler - Deutsche Bank AG

Well, Ian, two please. The first is just around the U.S. Support Solutions business. The additional charges you've taken on the commercial ship contract, I think it takes the cumulative charges about $50 million on these. Does this now draw a line under it? Are you pretty confident that you scoped the risk and provided for that risk? And can you remind me the size of the contracts that it actually refers to?

Another question related to that same business, as you've talked about you've reduced the margin outlook for support solutions. Previously I think you've guided to a mid-single-digit. I wondered what we should think of now, and how quickly does it take those margins to recover?

The next question was just looking at Platforms & Services U.K. So you've got your 10% to 12% margin guidance range there, more towards the top end by the sounds of things. There's obviously a lot of moving pieces as we move forward beyond 2014 Tranche 3 Eurofighter that you mentioned which have lower margin recognition upfront. I guess Type 45 is running through, just to understand the margin trajectory and outlook for Platforms & Services U.K. is a number of moving pieces in that business, particularly the shift to Tranche 3.

And then the one final one which is, I hate asking questions on tax rate, apologies, but it's just the sustainability of that 20% tax rate and whether it's also cash flow effective as well as P&L effective. Thank you.

Ian Graham King

They sound like mostly yours, Pete, by the sound of it

Peter J. Lynas

Yeah, so I work in there.

Ian Graham King

You'll work in reversal and we'll come back to Jerry to support.

Gerard J. DeMuro

On the tax rate, yeah, we've taken the expected rate for this year than the 20%. Our guidance for next year when we get there would be, we think 20% is sustainable. I think as you all know, the U.K. is reducing it's corporation tax rate by further 1% commencing 1 April '15, and then has I think the lowest jointly with Turkey in the June 20. So we think the 20% will be sustainable through '15.

On the Platforms & Services U.K., you asked the question about the 10% to 12% guidance. I think as we've said in the past, we view that not just an in-year guidance, but sort of an enduring range. It's always going to move within that 10% to 12% based on where you are on the cycle of production, whether you've got development contracts going through or production contracts going through. But we're comfortable with 10% to 12% range going forward as well not just for 2014.

Looking at the page, Support Solutions. Yeah, we did give guidance that we expected H2 to be around mid-single-digits and what we're saying today is mid-single-digits minus the $20 million charge.

Benjamin Fidler - Deutsche Bank AG

So I think Jerry what do we feel? You've got your hands firmly around the throats of anybody involved in this program.

Gerard J. DeMuro

I don't know about the throats, but I think we have the program well-bounded. We have four ships currently in production, one in planning phase; one of those four ships that’s in production should be delivered next month. And we think we have a very balanced plan going forward in terms of risk and opportunity. We've seen some metrics over the last few months that support that contention, positive trends in the build metrics. We'll be working at aggressively and keeping an eye on it through the balance of the year. But we're comfortable with the forecast that we've made to complete the balance of ships.

Ian Graham King

Okay, Ben.

Benjamin Fidler - Deutsche Bank AG

Thank you. Could you just remind me, if you're able to unless it's commercially sensitive, what the scale of the contract is for all these ships, total value?

Gerard J. DeMuro

Roughly what is left to ship out is about somewhere between US$400 million to US$500 million.

Ian Graham King

Yeah.

Benjamin Fidler - Deutsche Bank AG

Thanks very much guys.

Ian Graham King

Thanks.

Peter J. Lynas

I think that's the end of the…

Ian Graham King

Are they?

Peter J. Lynas

Yeah. I think I'm not sure there's anybody else?

Ian Graham King

So, do we have any other questions for us?

Operator

(Operator Instructions)

Ian Graham King

Okay. Well, thanks very much, everyone. I understand it's a busy day, so we won't it as a sleight if you've come off the phone. Thank you very much.

Peter J. Lynas

Thank you.

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Source: BAE Systems' (BAESY) CEO Ian Graham King on Q2 2014 Results - Earnings Call Transcript
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