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BAE Systems Holdings Inc. — Moody’s affirms BAE SYSTEMS’ Baa2 ratings; outlook stable

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Rating Action: Moody’s affirms BAE SYSTEMS’ Baa2 ratings; outlook stableGlobal Credit Research – 27 Apr 2021London, 27 April 2021 — Moody’s Investors Service (“Moody’s”) has today affirmed the Baa2 long-term issuer rating of BAE SYSTEMS plc (“BAE Systems” or “the company”). Concurrently, the rating agency has affirmed the Baa2 ratings of the senior unsecured debt instruments issued by BAE Systems, and the Baa2 ratings of the backed senior unsecured debt instruments issued by the company’s subsidiaries BAE Systems Finance Inc. and BAE Systems Holdings Inc. Moody’s has also affirmed the P-2 short-term rating of the backed commercial paper programme issued by BAE Systems Holdings Inc. The outlook on all the ratings is stable.Today’s rating action reflects:** The company’s strong portfolio of defence programmes which are expected to grow revenues and margins over the next 3-5 years** The solid outlook for the global defence sector driven by equipment modernisation, geopolitical tensions and new technologies** Expectations that the company will reduce Moody’s-adjusted leverage to around 4x over the next 12-18 monthsA full list of ratings is shown later in this press release.RATINGS RATIONALEThe ratings reflect the company’s: (1) large scale and long-term defence contracts; (2) position as a strategic supplier to the UK government and critical supplier to the US, Saudi Arabian and Australian governments; (3) high barriers to entry and technological leadership; (4) substantial proportion of stable support and services revenue alongside solid growth profile of its programme portfolio; (5) diversified product base; (6) solid track record of contract execution.The ratings also reflect the company’s: (1) geographical concentration in the UK, the US and Saudi Arabia, which exposes the company to political risk; (2) uncertainties over export licence regimes in relation to Saudi Arabia; (3) potential for reducing defence budgets a result of pressures on sovereign balance sheets resulting from the coronavirus pandemic; (4) relatively high gross leverage for the rating, in part as a result of sizeable pension obligations.BAE Systems serves a solid mix of defence progammes which represent long term key strategic platforms, several of which are well positioned for growth as volumes ramp up. In particular growth is expected on the F-35 Lightning II programme, which will benefit from increased production rates in 2021 and higher sustainment revenues as the size of the fleet grows; in US combat vehicles in which two platforms will transition to full rate production; growth in deliveries of the Hunter Class frigate to the Australian navy; growth in electronic warfare; and increasing sustainment revenues on the growing fleet of Eurofighter Typhoon aircraft. These are supported by a stable base of revenues across other programmes including UK submarine development and support contracts for the Saudi Arabian air force.The defence market remains solid, despite the potential for pressure on budgets as a result of strained sovereign balance sheets due to the coronavirus pandemic. Several important countries have recently increased their defence budgets in response to rising geopolitical tensions, equipment modernisation requirements and a focus on key areas of cyber security, space, hypersonics, and autonomous equipment. These include the UK, Australia, Germany and France. The US defence budget is likely to remain relatively stable or see a small degree of contraction, however BAE Systems benefits from increased spend in recent US budgets for which cash is still being deployed, and its focus on key strategic equipment programmes.BAE Systems performance during the pandemic was very solid, with sales growth of 3.7% and underlying EBITA increasing by 0.7% in 2020. The company’s defence revenues grew by 7%, partially offset by a contraction in commercial aerospace activities, which represented around 5% of 2020 revenues. The company is likely to benefit in 2021 from the non-recurrence of certain one-off effects of the pandemic in 2020, in particular disruptions to the ship repair activities and the Armored Multi-Purpose Vehicle programme. BAE Systems’ outlook for 2021 and beyond is strong, with 3-5% sales growth and 6-8% growth in underlying EBITA guided in 2021, and a market and programme mix to support a continued low to mid-single digit percentage increase in the medium term. As major programmes mature Moody’s expects further margin expansion and also a transition to greater levels of cash generation.The company’s Moody’s-adjusted leverage as at December 2020 was 4.7x, in excess of the boundaries for the rating category at around 3-4x. The rating continues to be supported by long term growth expectations, a significant component of volatile pensions obligations within the leverage calculation, and a financial policy to reduce leverage. These factors are balanced against the potential for ongoing debt-financed acquisitions, a relatively aggressive record of shareholder distributions and the history of elevated leverage, within the range 4.1x to 5.7x over the last five years. However, Moody’s expects leverage to reduce towards 4x over the next 12-18 months through earnings growth and as pending maturities are paid in cash, assuming no changes in pension accounting deficits.As at December 2020 the company’s pensions-related accounting deficit amounted to GBP4.9 billion, or 2.1x Moody’s-adjusted EBITDA. This compares to a net funding deficit of around GBP1.9 billion at the time of the last scheme valuations in 2019. The difference of GBP3.0 billion, or 1.2x adjusted EBITDA, relates largely to differences in discount rates applied in the calculation of liabilities. As a result of lower discount rates in 2020 the accounting pension deficit was broadly flat compared to 2019 despite cash contributions to address the funding deficit of GBP1.4 billion in the year. Moody’s uses the accounting pension deficit in its assessment of leverage but also recognises the volatility of this amount, the low current discount rates relative to the long-term average and the lower funding deficit for which no additional contributions will be required at least until the next valuation in 2022.STRUCTURAL CONSIDERATIONSDebt issued by BAE SYSTEMS plc is structurally subordinated to debt issued by BAE Systems Holdings Inc. and BAE Systems Finance Inc. The long-term issuer rating of BAE SYSTEMS plc takes into consideration the levels of debt relative to cash flow at structurally senior levels within the group, the company’s financial policy regarding the position of debt across the group and its future debt issuance. Currently the company’s financial debt (before leases and overdraft) is issued as follows: GBP3.4 billion by BAE SYSTEMS plc, GBP1.5 billion by BAE Systems Holdings Inc. and GBP0.4 billion by BAE Systems Finance Inc. Including lease obligations, pensions and other debt, which is held in operating companies, about 30% of the group’s debt resides at BAE SYSTEMS plc as at December 2020. As a result, there is limited headroom within the current rating category for further debt issuance at BAE Systems Holdings Inc. or BAE Systems Finance Inc.LIQUIDITYBAE Systems has strong liquidity, with cash and cash equivalents of around GBP2.8 billion as of December 2020 and undrawn committed credit facilities of GBP2.0 billion expiring in April 2025. The company’s debt contains a balance of short- and long-dated maturities with $500 million (GBP377 million) due in 2021 and GBP400 million in 2022. There are no outstanding pension deficit recovery payments following the approximately GBP1.4 billion paid in 2020. Moody’s notes the seasonality of the company’s working capital with large receipts towards the end of the year and around GBP1 billion of working capital outflow in the first half of the year. Strong liquidity is an important consideration, given the potential for large working capital swings and for certain programmes to remain cash consumptive over lengthy development phases.ENVIRONMENTAL, SOCIAL & GOVERNANCE CONSIDERATIONSThe company has announced a target of net zero greenhouse gas emissions by 2030.BAE Systems was compliant with the provisions of the UK Corporate Governance Code throughout 2020 except in relation to pension contribution rates for executive directors. The company is committed to maintaining an investment-grade rating and has a balanced financial policy, with recent debt-financed acquisitions alongside a focus on reducing leverage.OUTLOOKThe stable outlook reflects the robust nature of the company’s programme portfolio which is expected to remain stable or growing over the next 3-5 years, enabling the company to generate at least low to mid-single digit percentage growth in EBITDA. Moody’s expects the company to maintain its strong record of contract execution. The outlook also incorporates the expectation that Moody’s-adjusted leverage will reduce to around 4x over the next 12-18 months and that financial policies will remain unchanged and commensurate with these leverage levels.FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGSThe ratings could be upgraded if the company sustainably maintains:** Moody’s-adjusted debt/EBITDA below 3.0x** Moody’s-adjusted retained cash flow (RCF)/net debt above 25%** Operating margins above 10%In addition, an upgrade would require the company to maintain financial policies consistent with the above framework in the context of debt-financed acquisitions and shareholder return initiatives, and would also require the company to maintain strong liquidity. An upgrade would also require continued demonstration of effective contract execution, and a solid outlook for the company’s programme portfolio.The ratings could be downgraded if the company sustainably maintains:** Moody’s-adjusted debt/EBITDA above 4.0x** Moody’s-adjusted RCF/net debt below 15%** Operating margins below 7%The ratings could also be downgraded if there are significant execution issues on key contracts, a declining profile for the company’s programme portfolio or indications that the company may no longer be a critical supplier to the US or UK government. A more aggressive financial policy tolerating higher leverage through shareholder return initiatives or material acquisitions, or weakening liquidity, could also lead to a downgrade.The ratings could also be downgraded if there is material new debt issuance or increase in debt by BAE Systems’ subsidiary companies.PRINCIPAL METHODOLOGYThe principal methodology used in these ratings was Aerospace and Defense Methodology published in July 2020 and available at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1224306. Alternatively, please see the Rating Methodologies page on www.moodys.com for a copy of this methodology. LIST OF AFFECTED RATINGS Affirmations: ..Issuer: BAE SYSTEMS plc ….LT Issuer Rating, Affirmed Baa2….Senior Unsecured Regular Bond/Debenture, Affirmed Baa2..Issuer: BAE Systems Finance Inc…..BACKED Senior Unsecured Regular Bond/Debenture, Affirmed Baa2..Issuer: BAE Systems Holdings Inc…..BACKED Commercial Paper, Affirmed P-2….BACKED Senior Unsecured Regular Bond/Debenture, Affirmed Baa2Outlook Actions:..Issuer: BAE SYSTEMS plc….Outlook, Remains Stable..Issuer: BAE Systems Finance Inc…..Outlook, Remains Stable..Issuer: BAE Systems Holdings Inc…..Outlook, Remains StableCOMPANY PROFILEBAE Systems is the UK’s leading defence contractor and a significant supplier and contractor to the US government, as well as other global markets including the Kingdom of Saudi Arabia and Australia. With a broad product line, BAE operates its business through the following segments: Electronic Systems, Cyber and Intelligence, Platforms and Services (US), Air and Maritime. Headquartered in London, England, the company generated GBP20.9 billion in sales in 2020.REGULATORY DISCLOSURESFor further specification of Moody’s key rating assumptions and sensitivity analysis, see the sections Methodology Assumptions and Sensitivity to Assumptions in the disclosure form. Moody’s Rating Symbols and Definitions can be found at: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_79004.For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody’s rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider’s credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.The ratings have been disclosed to the rated entity or its designated agent(s) and issued with no amendment resulting from that disclosure.These ratings are solicited. Please refer to Moody’s Policy for Designating and Assigning Unsolicited Credit Ratings available on its website www.moodys.com.Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.Moody’s general principles for assessing environmental, social and governance (ESG) risks in our credit analysis can be found at http://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1263068.The Global Scale Credit Rating on this Credit Rating Announcement was issued by one of Moody’s affiliates outside the EU and is endorsed by Moody’s Deutschland GmbH, An der Welle 5, Frankfurt am Main 60322, Germany, in accordance with Art.4 paragraph 3 of the Regulation (EC) No 1060/2009 on Credit Rating Agencies. Further information on the EU endorsement status and on the Moody’s office that issued the credit rating is available on www.moodys.com.Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody’s legal entity that has issued the rating.Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating. Martin Robert Hallmark Senior Vice President Corporate Finance Group Moody’s Investors Service Ltd. One Canada Square Canary Wharf London E14 5FA United Kingdom JOURNALISTS: 44 20 7772 5456 Client Service: 44 20 7772 5454 Richard Etheridge Associate Managing Director Corporate Finance Group JOURNALISTS: 44 20 7772 5456 Client Service: 44 20 7772 5454 Releasing Office: Moody’s Investors Service Ltd. 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