“Space”, a certain generation will remember, “is the final frontier”. That, essentially, is the rationale for BAE Systems (LSE:BA.) agreeing to spend more than £4 billion net on Colorado-based Ball Aerospace, the leading space-specialist subsidiary of what is, ironically, the world’s largest beer-can manufacturer.
When recently reviewing the FTSE 100 stock around 1,000p after a “buy” stance at 840p at end-2022, I tempered to “hold” after a strong run, but suggested market volatility could offer another opportunity.
Yesterday, BAE fell nearly 5% to 956p in response to news of the deal, the chief drop happening before markets slid in response to hawkish minutes of a Federal Reserve meeting on US interest rates.
It has firmed only slightly this morning to 958p, still an overall cautious response to a deal of which BAE’s chief executive said: “[It is] rare that a business of this quality, scale and complementary capabilities for a business, with strong growth prospects and a close fit to our strategy becomes available.”
Does this move intrinsically raise risk, or is the market just fearful?
Financial theory says all takeovers are risky; generally more so with size, given uncertainties with integration and so on. Moreover, the record of UK firms buying in the US is chequered. In such context, BAE’s move on Ball Aerospace is the largest takeover by a UK firm this year.
Comparing price/sales for BAE and Ball, the deal also looks a bit expensive; although management stressed in a presentation and analyst call, the EBITDA multiple being paid for Ball is in line with other US defence deals, and they are confident in its prospects.
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There is always going to be an element of investors wary about reliance on EBITDA and projections, Warren Buffett for a start.
Yet Ball Aerospace has a long-standing pedigree; has been known by BAE some time; and recently appears to have been sought by a range of buyers including private equity. BAE has likely had to pay a fair to full price to succeed, it hopes to justify with synergies.
The logic for parent Ball Corp (NYSE:BALL) selling is to reduce its near $10 billion debt and raise organic growth across global packaging operations.
Pedigree in space technology bolsters strategic appeal
BAE contends that Ball Aerospace hits the mark on its strategic priorities and aids “future-proofing”.
It was founded after the Second World War amid concern that refrigeration would reduce demand for Ball’s food canning. It then capitalised on the space race and has built components for the Hubble and James Webb telescopes.
Nowadays it is defence-oriented: instruments, sensors and spacecraft, including satellite technologies; but also civilian applications such as monitoring weather patterns.
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Over 90% of its contracts are with the US government, hence questions as to whether there might be some kind of regulatory check; BAE contends not.
The business is projected to make $2.2 billion (£1.7 million) revenue this year on a 10% EBIT margin with 10% annual revenue growth expected for “the medium term”. Forward-revenue visibility is at an all-time high of $8 billion; but in an inflationary environment, so you would hope it to be.
Three strategic trends are posited in support:
- Defence is shifting to space – “the final frontier” – with a global surge in spending on military and spying technology. The US in particular, is in an arms race with China. Warfare is evolving to link infantry and drones via satellite; with the need for tracking systems to monitor other spacecraft as military competition rises.
- Earth science is raising demands to analyse what is happening - whether from space or of space itself – amid concerns over global warming.
- Supply-chain demand for munitions and missile systems is increasing as countries try to keep up. Take your ethical view of backing this, but BAE says it offers double-digit growth.
Current times therefore offer “an exceptional opportunity to increase scale” with Ball offering key synergies as BAE customers increasingly recognise space as a priority. Ball’s technological offering complements BAE’s well, it has invested around $1.5 billion in recent years and there are said to be “rich collaboration opportunities”.
BAE thus argues that it is aligning itself with the US defense department’s highest priorities; yet addressing different stages in the supply chain means vertical integration, hence a low risk of US anti-competition regulators blocking the deal.
Classic takeover promises: enhanced revenue, EPS and cash flow
To a large extent you have to trust that management is making the right strategic judgement to scale up in the US.
Its presentation otherwise ticks all the usual boxes you expect to hear: enhanced financial metrics, with $2 billion cross-selling opportunities over 10 years; with earnings per share (EPS) and cash flow enhanced from the first year as margins rise.
They say Ball will help raise the group EBITDA margin over 12% although the table shows the operating margin was anyway over 12% in 2021.
During the call, analysts were repeatedly curious as to this promise; but management insisted their projections are conservative and more scope exists than they are declaring, for example, achieving synergies in supply-chain procurement. For now, some $30 million cost savings are identified.
BAE Systems - financial summary
Year-end 31 Dec
|Turnover (£ million)||17,790||17,224||16,821||18,305||19,277||19,521||21,258|
|Operating margin (%)||9.8||8.2||9.5||10.4||10.0||12.2||11.2|
|Operating profit (£m)||1,742||1,419||1,605||1,899||1,930||2,389||2,384|
|Net profit (£m)||913||827||1,000||1,476||1,299||1,758||1,591|
|Reported earnings/share (p)||28.7||24.1||31.1||46.1||40.5||54.7||50.5|
|Normalised earnings/share (p)||28.8||33.3||35.6||43.4||38.4||41.6||47.9|
|Operating cashflow/share (p)||38.6||59.3||37.5||49.9||36.3||76.2||90.0|
|Capital expenditure/share (p)||15.4||14.9||15.5||14.7||14.9||14.4||22.0|
|Free cashflow/share (p)||23.2||44.4||22.0||35.2||21.5||61.8||68.0|
|Covered by earnings (x)||1.4||1.1||1.4||2.0||1.7||2.2||1.9|
|Return on capital (%)||11.0||9.2||10.4||11.5||10.6||13.0||11.0|
|Net Debt (£m)||1,452||723||901.0||1,954||3,723||3,245||3,499|
|Net assets per share (p)||110||148||174||169||144||235||364|
Source: historic company REFS and company accounts.
The deal looks slightly expensive on a revenue basis, given a net acquisition price of $4.8 billion implies a price/sales ratio of 2.2 – with $2.2 billion revenue expected for Ball this year, versus BAE capitalised just below 1.4 times expected revenue.
Yet it is said that Ball has nearly doubled revenue in the last five years and offers 10% annualised growth over the next five. US sales will promptly rise to 47% of group total from 43% in the first half of 2023.
While the gross acquisition price will be $5.6 billion, it nets down to $4.8 billion after a circa $750 million, net present value tax benefit.
BAE emphasises a 13 times EBITDA multiple, which it says is consistent with other US defence takeovers.
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Despite BAE having had £3.2 billion cash at end-June, management speaks of the deal being majority debt-financed with a bridge facility; hence materially raising BAE’s end-June £5.1 billion financial debt (before leases) with interest rates rising.
The deal is said to be cash-accretive at the outset, with post-acquisition deleveraging promised over the medium term.
Management also says it is important to emphasise that the share buyback programme will continue, with £1.5 billion to be “returned” this way over three years, being evenly distributed, which sounds like quite a technical prop for the stock.
Yet BAE has cut a good track record of acquisitions
It has acquired 27 companies, eight in the past five years, while also divesting seven. In the US, this has involved 10 different states.
Ball Aerospace is by far BAE’s largest move, yet perhaps this reflects the defence firm’s rising growth prospects than management dropping its guard as to risk management. In the US, rocket engine maker Aerojet Rocketdyne was sold for $4.7 billion last month.
I incline to give BAE the benefit of doubt, hence a case to consider purchasing the stock again. Around 960p implies a forward price/earnings below 15 times. “Growth at fair price”, you might say. Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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