Bombshell over defence contracts leaves BAE friendless

BAE Systems may have changed its name, but it has not lost any of its capacity to shock. This week's bombshell that the world's second-largest arms manufacturer is facing substantial cost overruns on two of its biggest Ministry of Defence contracts sent BAE shares into a fresh tailspin yesterday. They have now fallen by 40 per cent since Wednesday's profits warning. At one stage yesterday they dipped briefly below 100p – the kind of level last seen just over a decade ago when the company was still called British Aerospace and it was teetering on the brink of bankruptcy.

The cause of the crisis back then in the autumn of 1991 was a piece of financial engineering that went disastrously wrong. The chairman at the time, Professor Sir Roland Smith, had embarked on an audacious plan to buy Austin Rover and Royal Ordnance and then rationalise the two businesses, selling off chunks of BAE's vast landbank to pay for the resulting redundancy bill. When the recession arrived and property prices duly crashed, BAE's strategy was left high and dry. Sir Roland was ousted and only an emergency £432m rights issue saved the company from being swallowed up by Arnold Weinstock's GEC.

Today BAE is staring down the barrel of a gun once more, although this time the crisis is of a different nature. It is not financial engineering but aeronautical engineering that threatens to be the company's undoing. The problem can be summed up in one word: Nimrod. The plane has been around since the 1960s. GEC-Marconi almost came unstuck in 1986 trying to develop an airborne early warning version of the Nimrod. Sixteen years later BAE, which now owns GEC-Marconi, has run into trouble with the £3bn development of a maritime reconnaissance version.

The contract involves stripping the existing fleet of Nimrods down to their fuselages and then rebuilding them with new wings, tailfins, cockpits, engines and mission systems. As an executive from a rival defence company admits: "It's a huge and horribly complex job. When the Nimrod was built originally, it was put together with little men using rubber hammers and rivets who could bend things to fit. Today, they are using computers and lasers. It is a question of having to take a 1950s design and apply 21st century technology."

The City thought BAE had got all of the bad news out of the way two years ago when it announced it was taking a £525m charge, £300m of which related to delays and cost overruns on the Nimrod programme. This week's profit warning demonstrates that is emphatically not the case.

Together with cost overruns on the Astute nuclear-powered submarine programme, analysts fear BAE could be looking at a balance sheet hit of anywhere between £800m and £1bn.

Unsurprisingly, the company is now virtually friendless – in Whitehall and the City. The Ministry of Defence reacted with unusual speed and vigour to Wednesday's warning, making it clear that BAE would have to accept responsibility for the cost overruns and pay the penalty for its "failure to perform". In the City the reaction was scarcely less scathing. Even BAE's own joint house broker, ABN Amro, switched its recommendation on the shares to "sell".

What alarmed the City was not just the cost overruns themselves but the damage that has been done to the credibility of BAE's management. The profit warning followed several days of increasingly fevered speculation in the market that a just such a statement was imminent and equally emphatic assurances from within BAE that all was well.

The City's anger at being misled made the subsequent punishment all the harsher. In a withering note headlined: "The leopard has not changed its spots", Goldman Sachs said it was cutting its forecasts for BAE "severely" and estimated the Nimrod and Astute fiascos would cost the company £800m. Sash Tusa, the bank's defence and aerospace analyst, added: "Our lack of confidence in either the guidance of BAE's management or in its ability to manage programmes leads us to impose an additional 20 per cent discount on the value of the company in its current form."

Credit Suisse First Boston was equally critical. Its defence analyst, Harald Hendrikse, said: "In our view, with the shares down 200p since August, the charge is not the problem, management credibility is. How can we be sure there is no further bad news on other contracts?"

The man with whom the buck stops at BAE is Mike Turner, its chief executive. He was parachuted into the top job when the previous occupant John Weston was unceremoniously dumped last March. This is Mr Turner's second profits warning in three months. In September, he caught the markets offguard by announcing a £120m write-down on two other military programmes. He then further unnerved investors by appearing to renege on BAE's long-standing pledge that profits would start to rise in 2003. In a curious formulation, he said: "We are more confident than ever that we are going to get profit growth but we can't say in what year."

It was not the message the City wanted to hear and it accelerated the slide in the share price. As a former BAE executive says: "The company still operates on a need to know basis and unfortunately it applies that attitude not just to secret weapons programmes but also to its relationship with the City."

Pessimists such as Goldman Sach's Sash Tusa now believe BAE will have to slash its second-half dividend by a half. Worse, the profit warning has reawakened fears about BAE's Achilles heel – cash flow – given its reliance on very big and lumpy procurement contracts that can very easily fall behind schedule, as Nimrod now has.

Goldman Sachs reckons BAE will suffer a cash outflow of £1.5bn over the next two years, taking its borrowings up to an eye-watering £3.6bn and stretching its balance sheet considerably. "BAE in our view needs to take radical action to staunch this bleeding," it adds.

BAE was supposed to have overcome its vulnerability to shocks like this by widening its geographic spread and concentrating its mix of businesses. Throughout the 1990s, investors were treated to a string of mind-bogglingly large write-offs on its regional aircraft activities until BAE finally exited the business altogether.

Save for its 20 per cent stake in Airbus, which accounts for some £3bn of sales a year, it is now even more defence orientated. But it is the Pentagon, not the MoD that is now BAE's biggest single defence customer. It will become even bigger as the £100bn F-35 joint strike fighter goes into production. By contrast, UK defence programmes – such as Nimrod and Eurofighter – now account for just 18 per cent of turnover.

But, as BAE has repeatedly demonstrated over the years, just when investors think it is safe to get back into the water, along comes another nasty surprise. BAE says it will "never again" take on a "lousy" fixed-price contract such as Nimrod or Astute. "We have learned our lesson," a spokesman said. History has had a tendency of disproving that.