BAE Systems plc : Annual Financial Report

BAE Systems plc

Annual Report 2011

BAE Systems plc has today published its Annual Report and Accounts for the year ended 31 December 2011 ('Annual Report 2011'). The full document can be viewed on the Company's website at:

Copies of the Annual Report 2011 will be posted to those shareholders who have requested to receive communications from the Company in printed form on 29 March 2012.

In compliance with section 9.6.1 of the Listing Rules, a copy of the Annual Report 2011 has also been submitted to the National Storage Mechanism and will shortly be available for inspection at www.hemscott.com/nsm.do

This announcement contains regulated information issued in accordance with section 6.3 of the Financial Services Authority's Disclosure and Transparency Rules and accordingly contains certain sections of the Annual Report 2011 in unedited full text. Page and chart references within the text of this announcement are references to pages and charts in the Annual Report 2011 that can be viewed as detailed above.

The financial information for the year ended 31 December 2011 contained in this announcement was approved by the Board on 15 February 2012. This announcement does not constitute statutory accounts of the Company within the meaning of section 435 of the Companies Act 2006, but is derived from those accounts.

Statutory accounts for the year ended 31 December 2010 have been delivered to the Registrar of Companies. Statutory accounts for the year ended 31 December 2011 will be delivered to the Registrar of Companies following the Company's Annual General Meeting.

The auditors have reported on those accounts. Their reports were not qualified, did not include a reference to any matters to which the auditors drew attention by way of emphasis without qualifying their report, and did not contain a statement under section 498 (2) or (3) of the Companies Act 2006.

The Annual Report 2011 contains the following responsibility statement:

Each of the directors listed below confirms that to the best of their knowledge:

- the financial statements, prepared in accordance with the applicable set of accounting standards, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company, and the undertakings included in the consolidation taken as a whole; and

- the Directors' report includes a fair review of the development and performance of the business, and the position of the Company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they face.

On behalf of the Board

Dick Olver

Chairman

15 February 2012

CHIEF EXECUTIVE'S REVIEW

"BAE Systems has moved quickly to take strategic actions it believes necessary to sustain and position the business for the future."

BAE Systems is operating in a difficult business environment as defence spending reduces in its largest markets, the US and UK. These market pressures have been apparent for some time. BAE Systems has moved quickly to take strategic actions it believes necessary to sustain and position the business for the future.

BAE Systems has been driving down its cost base and improving efficiencies. At the same time, the Group is developing its Services positions, investing in growth streams of business and developing international markets. The high number of export campaigns in the Group is at a level unprecedented in recent years.

In October 2011, the Group announced changes to its external reporting segments. The changes provide improved visibility of the performance of its Electronic Systems and Cyber & Intelligence businesses, and align with the Group's strategic direction.

Services-related activities represented approximately 49% of sales in 2011. These activities include the provision of Cyber & Intelligence and Military & Technical Services, the latter delivering enhanced capabilities, whilst reducing costs for its customers in the air, land and maritime defence domains.

During the year, the Group has invested in cyber and intelligence through both organic development and through a series of small, high quality acquisitions. These acquisitions included, in February 2011, L-1 Identity Solutions, Inc.'s Intelligence Services Group, a leading provider of security and counter threat capabilities to the US government, and Norkom Group plc, a market-leading provider of innovative anti-money laundering solutions to counter financial crime to the global financial services industry. ETI A/S, a recognised provider of advanced security products and services to government and commercial clients worldwide, was acquired in March 2011, and stratsec.net Pty Limited, an information security company with offices in Australia, Malaysia and Singapore, was acquired in January 2011.

Growth opportunities in the cyber domain arise from both the increasing priority of governments addressing cyber threats and the rapid increase in requirements within the commercial sector.

BAE Systems also identifies and prioritises fast growth lanes within the electronics market. The Group is an industry leader in key areas of high technology electronics for both defence and commercial aerospace activities. It continues to see growth opportunities in both its commercial avionics activities and parts of its defence product portfolio. In April 2011, BAE Systems acquired the 91.3% of outstanding equity of Fairchild Imaging, Inc. not already held by the Group. Fairchild is a provider of solid-state electronic imaging components, cameras and systems.

The Group has continued to review its business portfolio and has undertaken a number of non-core business disposals. In January 2011, the Group sold its Swiss-Photonics AG group. In June 2011, the Group sold its remaining shareholding in Saab AB. In July 2011, BAE Systems sold its Regional Aircraft Asset Management and US-based Composite Structures businesses. In September 2011, the Advanced Ceramics business in California was sold. In December 2011, the Group announced an agreement for the sale of its Safety Products businesses, which is expected to complete in the first quarter of 2012.

In aggregate, approximately £0.3bn was invested in business acquisitions, net of disposals, during the year.

BAE Systems is well positioned on a number of key platforms programmes, such as Typhoon and F-35 combat aircraft, as well as in the areas of naval ships and fighting vehicles. These programmes form a large core of business with good, multi-year order book visibility. Additionally, such programmes can generate substantial Services business throughout the in-service life of the product.

The development of business across a broad international base of operations provides a robust portfolio of activity and contributes to the resilience of the business at a time when defence spending is under pressure in the US and UK markets.

The Group has also moved to capture business in non-defence markets, including commercial aerospace electronics. BAE Systems' strategy to grow its presence in the cyber and intelligence markets is proving successful, with around 7% of its business now generated in this area of activity.

BAE Systems has been quick to recognise that affordability is a priority for customers and has cut costs and improved efficiency to address reducing demand in some activities and to ensure continued value for customers. Cost reduction and efficiency actions have been underway since 2009 and, as part of these actions, there has been a need to reduce workforce across the Group. Excluding M&A activity, there has been a net headcount reduction of approximately 22,000 (including contractors) in the past three years. These cost reduction programmes will assist the Group in winning new business, managing workloads and delivering value for customers, and be of sustained benefit to the Group's performance.

The Group's customers in its home markets of the US, UK, Saudi Arabia, Australia and India have a significant and sustained commitment to defence and security budgets across multiple domains, welcome foreign investment, and sustain a domestic industrial capability.

US

BAE Systems' US-led businesses contributed 47% of the Group's sales in 2011.

As anticipated, vehicle production and reset activity reduced significantly in the US land vehicles business reflecting the drawdown of US overseas military operations.

Delays in approving Department of Defense budgets resulted in the Group's US defence businesses operating under Continuing Resolution limitations for seven months of 2011. BAE Systems' business remained resilient through this period, with only a modest amount of sales lost or deferred as a consequence.

The Group's US-based electronics business was impacted by serious flood damage at its Johnson City facility resulting in some sales deferral to 2012.

The Group had success in winning new business in 2011, but several large contract starts were delayed due to bid protests by competitors. A contract, worth approximately $850m (£547m) over ten years, to manage, operate and maintain the Radford Army Ammunition Plant in the US was awarded to the Group in May 2011, but the programme start was delayed into early 2012 with the US Army confirming the award in January 2012. Similarly, in August 2011, the Group was one of two successful teams selected to participate in the 24-month technology development phase of the US Army's Ground Combat Vehicle programme. BAE Systems, together with Northrop Grumman, was awarded a $450m (£290m) contract, but the programme start was delayed until December 2011 while a protest by SAIC was evaluated and rejected by the General Accounting Office.

Whilst the near-term US budgetary and procurement issues have had only modest impacts on the business, there remains significant uncertainty as to the impact of both planned and potential additional deficit reduction actions on US defence budgets over coming years.

UK

Pressure on UK budgets remains, but following publication of the Strategic Defence and Security Review (SDSR) in October 2010 and resulting actions, there is now greater programme stability and alignment of funding with government defence programme commitments. The post-SDSR programme changes have reduced the Group's annual sales by some £500m. Actions were taken to mitigate the impact of these changes, including workforce reductions, facility rationalisation and contract settlement agreements.

The Group continues to work with its UK customer to help to identify further efficiency improvements.

Other home markets

In addition to its US and UK operations, BAE Systems has established leading market positions in Saudi Arabia and Australia. In addition, the Group is pursuing its strategy, establishing India as a home market.

In the Kingdom of Saudi Arabia, where defence spending remains a high priority and is growing, the Group is working to deliver a broad range of capabilities. The established core business, including support to Tornado aircraft in service with the Royal Saudi Air Force under the Saudi British Defence Co-operation Programme (SBDCP), continues to deliver good performance, and 24 Typhoon aircraft have been successfully introduced into service under the first phase of the Salam programme.

BAE Systems has been in discussions with its customer regarding changes to the Salam programme. The proposed changes relate to final assembly of the last 48 of the 72 Typhoon aircraft, the creation of a maintenance and upgrade facility in the Kingdom of Saudi Arabia, initial provisioning for subsequent insertion of Tranche 3 capability in respect of the last 24 aircraft of this order and formalisation of price escalation.

Good progress on these discussions has been made in 2011, with budgets approved in the Kingdom in December on all items other than the price escalation where negotiations will now continue into 2012. Budgets have also been established for the next five years of support on the core SBDCP, including an upgrade of the training environment. Formal contracts under these budgets are being progressed.

These budget approvals underpin both the Salam and SBDCP programmes.

In Australia, the Group has continued to build on its position as the leading in-country provider of equipment and support to the Australian armed forces, working with the Australian government to deliver against a clearly laid out multi-year defence and security plan.

Defence spending in India is also expected to grow substantially. The supply of Hawk aircraft continues with local assembly by Hindustan Aeronautics. A land systems joint venture with Mahindra & Mahindra has been established with significant armoured vehicle and artillery opportunities being pursued. In January 2012, the Group was notified that Typhoon had not been selected as the lowest priced compliant bid to meet the requirement for a Medium Multi-Role Combat Aircraft. The programme has a long way to go before a contract is awarded and we continue to actively support the bid.

Pension funding

In April 2011, the trustees of the Group's two largest UK pension schemes, the BAE Systems Pension Scheme and the BAE Systems 2000 Pension Plan, commenced triennial funding valuations. These have been concluded and revised funding profiles agreed.

Balance sheet and capital allocation

Pension funding is a significant obligation for BAE Systems, but it remains only a part of the allocation of capital. In addition to meeting its pension obligations, the Group expects to continue organic investment in its businesses, plans to continue to pay dividends in line with its policy of a long-term sustainable cover of around two times earnings and to make accelerated returns to shareholders when the balance sheet allows. Investment in value enhancing acquisitions will continue to be considered where market conditions are right and where they deliver on the Group's strategy.

The Group's balance sheet will continue to be managed conservatively, in line with the Group's policy to retain its investment grade credit rating, and to ensure operating flexibility.

Total Performance

Total Performance is not just about what the Group does, but also about how it does it. Building a culture of Total Performance means focusing on delivering shareholder value, on meeting the needs of the Group's customers and acting responsibly at all times.

Embedding the importance of non-financial performance measures in the culture of the Group, through the drive for a more integrated, Total Performance, approach, is an important part of the Group's development.

BAE Systems is committed to becoming recognised as a leader in business conduct. The Group continues to reinforce a culture of Responsible Behaviour across the business. Mandated policies and processes within the Operational Framework are reviewed and, where appropriate, updated to ensure they best reflect the Group's Responsible Trading Principles. Employees in all markets receive training to help them apply the Group's global Code of Conduct. The Group-wide rollout of this training was completed as scheduled in May 2011 and refresher training continues.

BAE Systems continues to drive high standards of safety across the business. This year, the Group achieved an 11% improvement against its targeted metric and progressed the implementation of the safety maturity programme. Looking forward, the Group will be focusing on a broader set of metrics, whilst ensuring that safety remains a priority.

Maintaining and developing the skills and capabilities of its employees is a key factor in the sustained success of the Group. As well as Total Performance Leadership programmes, the Group provides appropriately tailored leadership and competency frameworks in each of its principal markets. The Group's 'Developing You' programme continued to deliver training across a number of functional specialities, and a diversity and inclusion strategy was adopted to better support the recruitment, retention and engagement of talented employees from all backgrounds.

Although we are operating in a challenging business environment, BAE Systems' continued focus on cost efficiency, together with its broad geographic base, and strong positions in defence, aerospace and security markets, are expected to sustain this resilient business.

Ian King

Chief Executive

Extract from
CHAIRMAN'S LETTER

Directors and management

George Rose, Group Finance Director, retired from the Board on 31 March 2011 after 19 years with the Group. Peter Lynas, previously Director, Financial Control, Reporting and Treasury, was appointed Group Finance Director with effect from 1 April 2011, and joined the Board and Executive Committee on that date.

Also with effect from 1 April 2011, Ravi Uppal, a non-executive director, stood down from the Board and Paula Rosput Reynolds was appointed a non-executive director of the Company. On 1 June 2011, Lee McIntire was appointed a non-executive director. Having completed a second term of three years as a non-executive director, Roberto Quarta stood down from the Board at the end of 2011. Also, after nearly nine years on the Board, Michael Hartnall will stand down at the Annual General Meeting on 2 May 2012. I would like to record my thanks and appreciation for the contributions that both Roberto and Michael have made to the working of the Board and its committees.

REPORTING SEGMENT PERFORMANCE REVIEWS

Electronic Systems comprises the US- and UK-based electronics activities, including electronic warfare systems and electro-optical sensors, military and commercial digital engine and flight controls, next-generation military communications systems and data links, persistent surveillance capabilities, and hybrid electric drive systems.