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BAE Systems exposed to possible defence spending constraints after Brexit, says UBS

UBS said the grim UK economic outlook will inevitably impact the government's defence spending
Shares fell 3.6% in morning trading

BAE Systems PLC (LON:BA) shares fell on Thursday after UBS downgraded the stock to ‘neutral’ from ‘buy’ and cut its target price to 505p from 720p, citing a challenging UK economic outlook as Brexit looms.

UBS said the grim UK economic outlook will inevitably impact the government's defence spending, which could hit BAE’s performance.

Execution issues with US Maritime and Platforms & Services

The delayed UK defence spending review is expected in March or April next year but could be postponed in the event of a general election.

“With circa 28% of its profits from the UK in 2017, we consider BAE to have exposure to budget constraints, including limited wriggle room to rationalise costs and improve margins: in the context where the UK is willing to launch new programmes, it will be hard to argue for a reduced work force,” UBS said.

READ: BAE Systems maintains earnings guidance after mixed first-half

UBS lowered its estimates for earnings per share for the FTSE 100 defence firm on the back of slower earnings growth in the US platforms and maritime divisions and further investments needed for UK air activities.

“We model earnings growing to 48.7p in 2020 versus consensus at 50.40p, and free cash flow down to c.£1.13bn (from £1.49bn) with limited growth opportunity, and downside pressure from investments prepayments un-winding.”

In the first half, the company said there were some disappointments on certain long-standing programmes in US Maritime and Platforms & Services due to execution issues.

The group said it had taken steps to strengthen management and improve programme execution.

BAE could be less well placed than peers, says UBS

UBS expects the 2019/20 financial year to remain challenging, given the steep ramp-up planned for the armoured multi-purpose vehicle, the M109A7 self-propelled howitzer and amphibious combat vehicle for the US Army.

The broker said its analysis highlights the ground BAE has lost in terms of US government contract obligations versus US peers of similar size.

“The risk is BAE could be less well placed than peers and less able to capture the benefits of an enhanced US defence budget,” UBS said.

Shares fell 3.6% to 443p in morning trading.

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