After BAE Systems Restructures, What Will Be Left?

By Rich

Well, this should make a splash.

Amidst the steady drip-drip-drip of U.S. defense contractors reporting 3%, 4% and 5% declines in sales, British defense giant BAE Systems came out last month with a plan to shrink one of its businesses by about 15% -- voluntarily. In so doing, BAE may have dumped a big ol' gallon of reality over its prospects for growth. According to press reports, BAE is planning to sell "the U.S. manpower and services businessesof theIntelligence and Security sector, which span technical, mission and IT support services and predominantly serve the federal government." In total, these businesses employ about 8,000 U.S. workers -- 25% of the company's U.S. workforce -- and generate as much as much as $1.75 billion in revenues for BAE annually. That's about 7% of BAE's global revenues.

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BAE will retain its cybersecurity arm, Systems Applied Intelligence, as will its geospatial intelligence business and the company's important warship repair and upgrades operations. But broadly speaking, BAE will be left with two primary areas of focus in the U.S. -- electronics systems and "platforms." (Or as Loren Thompson, a consultant for BAE, puts it: "the enterprise [will focus] on aerospace and defense electronics, armored vehicles,naval guns, munitions and warship modification.")

A history of transformationsThompson notes that transformative moves such as BAE is contemplating are "not new territory for CEO Gerard J. DeMuro, who ran the Information Systems & Technology group atGeneral Dynamics for a decade." What Thompson fails to mention about his client, however, is that DeMuro left General Dynamics in something of a shambles.

DeMuro, you see, was the executive behind a series of acquisitions at General Dynamics' Information Systems and Technology division in the early years of the 21st Century. Although these acquisitions helped to greatly increase revenues at General Dynamics, and at one point turned "IS&T" into the company's biggest profits center (producing more than $1 billion in profits in 2007, according to S&P Capital IQ) DeMuro grossly overpaid for many of his acquisitions.

The result: General Dynamics ultimately had to write off $2 billion in goodwill, forcing the company into its first full-year net loss in more than two decades, in 2012. DeMuro subsequently left the company.

What it means for investors Now at BAE, DeMuro has presided over a 14% decline in sales, and a 17% decline in fiscal 2014 profits at the British defense giant. The BAE businesses that DeMuro seems intent on selling, meanwhile, are ones that Thompson describes as producing "above-average rates of return" for the company. On the one hand, this suggests they might yield proceeds in excess of the company's overall 1.0 price-to-sales valuation once sold -- perhaps $1.75 billion or more. On the other hand, though, selling off "above-average" divisions may not be the best way to grow profits in the long term.

Going forward, it looks like BAE's most profitable divisions will be its UK and international platforms and services units, which generate operating profit margins of 11.8% and 13.2%, respectively; and also the firm's smaller electronic systems business, where operating margins are a robust 15.4%.

Ideally, we'd like to see any proceeds from sale of the U.S. units plowed back into these three divisions -- electronics in particular -- whether through organic growth or acquisitions of complementary businesses. If that's the way things play out, then divestiture could be the prelude to a turnaround at BAE.

For the time being, however, with BAE stock trading for 21.5 times earnings, and with analysts projecting a long-term growth rate only in the low single digits,BAE Systems simply doesn't look very attractive.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 353 out of more than 75,000 rated members.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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