Good morning, everyone. Thank you for joining this BAE Systems Webex. Today on the call, we have Peter Lynas, Group Finance Director, Peter Earle, Director of Financial Control and Reporting, and the investor relations team of myself, Martin Cooper, and Sage Ireland. By way of housekeeping, there is a slide presentation on the website, which we shall run through, and the slides will be interactive on the Webex. I will now hand over to Pete.
Thanks, Martin, morning, everybody. We are going to cover three things on this call. Firstly, the U.K. pensions triennial valuation of funding, which we agreed yesterday. Then as we trailed in our October trading update, we are going to talk about the reporting sector changes and the move to adopt accounting standard IFRS 15, both of which will be implemented from the 1st of January 2018. Just to be clear, we will not be talking about trading today, as we have nothing to add to our October trading update. I am going to cover pensions and the sector changes, and I am going to hand it over to Peter Earle to run through IFRS 15. We will then have plenty of time for your questions. Let us get straight to the pensions.
As you will have seen, we are pleased to have reached agreements with each of the pension trustee boards, that has been done in consultation with the U.K. pensions regulator on all of our U.K. defined benefit schemes. Whilst targeting to get this done by year-end, I think reaching agreement in half the time allowed statutorily to do so is a good result for all stakeholders. Just to pick out the key points from the agreements, U.K. deficit funding will increase in 2018 by GBP 15 million a year, up to GBP 220 million per annum, with a deficit of GBP 2.1 billion, broadly similar to that at the last funding valuation. In addition, funding will also increase in line with percentage growth in future dividends.
In arriving at that deficit number, an asset-led discount approach has been used, there are contingency plans in place should the funding fall below modeled funding levels. We believe our return assumptions to be prudent, they are below those we target for the future and what we have achieved in the past. Repayment periods for the schemes, which were all previously due to run through to 2026, are now varied. The main scheme, the largest, remains unchanged. The second largest scheme now runs through to 2021, leading to a GBP 50 million step down in expected contributions from 2022. Of the other schemes, five are fully funded and two have accelerated funding profiles.
I think it's worth reiterating a key point we've made in recent investor updates, that is that the cash profile of the main scheme remains positive until 2028, that has allowed us to take a long-term view. Just to complete your models, we expect U.S. deficit funding to continue to run at around $80 million per annum through to 2022. The accounting deficit calculation methodology does remain unchanged, we'll report on that as usual at our prelims in February. Given where corporate bond yields remain, there is likely to be a material difference now between the reported accounting deficit and the $2.1 billion deficit we've reached under these agreements. Moving on to reporting sectors.
As we outlined in the October trading statement, we are implementing some organizational changes to the group, that's going to lead to a change in reporting sectors from the 1st of January. Firstly, you'll be glad to know that the U.S. sectors of Electronic Systems, U.S. Platforms & Services, and the Cyber & Intelligence sector are unchanged. Jerry and the U.S. team streamlined and reorganized a few years back, the current structure is well-placed to deliver in an improving U.S. environment. Replacing the current U.K. and international Platforms & Services sectors, there'll firstly be a U.K. Maritime sector comprising of submarine, ship build, and support businesses. This sector will report directly to Charles, being in the early program stages on the likes of Dreadnought and Type 26, the focus will be on program execution and operational excellence.
For external reporting purposes, the Maritime sector will also include the GBP 300 million per annum revenue U.K. Land business, which is also going to be reporting directly into Charles. The other new sector formed will be Air, this will comprise our U.K.-based military aircraft build and support activities, our KSA business, our Australian business, which is predominantly Air, along with our 37.5% shareholding in MBDA. We're creating this strengthened and streamlined Air sector to bring together our U.K. and international capabilities to best deliver on existing build and support programs and compete more effectively for international opportunities. A key area for us as deliveries on the European Typhoon program move towards completion. At the February results presentation, we will report the 2017 year in the old structure will also restate to the new. 2018 guidance will be given against the new reporting structure.
The chart you see on screen now shows in a tabular form the changes from what was the old structure to the new. I've stepped through most of those, just for completeness, you'll note that the U.K. shared services activities will now sit under HQ, along with the newly created chief technology officer role. Just for reference, there are two charts appended to the pack, they provide the 2016 full year and 2017 half year results restated to the new sectors. As I've already mentioned, we will provide pro forma restated 2017 actuals at the February prelims. I'm going to move on to IFRS 15, just before I turn it over to Peter Earle to take you through the detail, there are a few things that I'd like to emphasize.
Firstly, IFRS 15 will impact the way in which we account for revenue from contracts with our customers. Adoption of the new standard will mean that for the majority of our contracts, revenue will cumulatively be recognized earlier as we incur costs rather than as we achieve performance milestones. Profit will continue to be recognized progressively based on risk mitigation and retirement on our longer-term contracts. On the shorter-term contracts in the group's U.S. businesses, there will be some acceleration on both revenue and profit recognition. I think it's important to note that IFRS will not change the way in which we manage our contracts under lifecycle management, which is our mandated project management process, nor will it impact the lifetime contract profitability or cash flow. With that said, Peter, over to you for the detail.
Thank you, Pete. The aim of this presentation is to explain the impact of IFRS 15, revenue from contracts with customers. IFRS 15 is effective for BAE Systems from the 1st of January 2018. As Pete just mentioned, IFRS 15 is an accounting standard that has no impact on lifetime revenue and profitability of our contracts, no impact on the group's cash flow, and no impact on our approach to managing contracts. We expect that the impact of restating our full year 2017 is a reduction of approximately GBP 0.01 of earnings per share. The earnings impact on 2018 and beyond is not expected to be material. IFRS 15 replaces two existing accounting standards, IAS 11 and IAS 18. It will impact how we account for contracts and how we account for sales of certain software licenses.
We will continue to report on 2017 full year under existing standards. At our preliminary announcement of our 2017 results on the 22nd of February 2018, we will represent our 2017 income statement under IFRS 15, and our 2018 earnings guidance will also be under IFRS 15. This slide summarizes the impacts of IFRS 15. On long-term contracts, sales will be recognized earlier based on cost incurred plus margin. We will continue to recognize margin progressively as risks have been mitigated or retired. In our U.S. businesses, sales and margin will be recognized earlier, and margin recognition will be deferred on a few development and production contracts within the MBDA joint venture. As sales we recognize based on cost incurred, the majority of balance sheet work in progress will be replaced by contract receivables.
Finally, some license sales in Applied Intelligence, previously taken at the outset of the contract, will be deferred over the license term. IFRS 15 introduces the concept of over time or point in time for sales recognition. The chart sets out the three technical requirements for over time recognition of sales. Sales that are not recognized over time are recognized at a point in time, for example, on delivery to the customer. The majority of our long-term contracts meet the definition of over time, as our products are typically bespoke to customer requirements, and there is limited ability to redirect to other customers. As a result, on those contracts, sales trading depends on cost incurred. There will therefore be no work in progress in the balance sheet on those contracts as the work in progress will replaced with an unbilled receivable.
This chart sets out the cumulative impact on transition to IFRS 15 as at December 31, 2016 on over time contracts by sector. Balance sheet work in progress of around GBP 3.5 billion, together with margin of GBP 266 million, will be traded as sales of GBP 3.779 billion. To be absolutely clear, this is the cumulative transition adjustment at December 31, 2016 and not the in-year income statement impact. In our U.S. businesses, margin will be traded and work in progress at transition at close to outturn margin. In our P&S U.K. and P&S International businesses, where our contracts are typically higher risk and longer term in nature, margin traded at transition is lower relative to sales traded as the risk mitigation retirement points are not affected by the adoption of IFRS 15. Within MBDA, there are a few combined development and production contracts which are currently correctly traded as one contract.
IFRS 15 requires the price and margin to be allocated to the separate design and production elements of those contracts. This means recognizing the lower margin in the development phase and the higher margin in the production phase on those few contracts. On transition to IFRS 15 at December 31, 2016, cumulative profits of GBP 79 million being our share previously traded on a combined basis will be de-traded and will be traded over the production phases of those contracts. License revenue is either recognized upfront on delivery or spread over the license term. Under IFRS 15, if there is a customer expectation that the group will provide significant updates to the intellectual property, then license revenue would be spread over the license term.
Therefore, given this change in accounting, on transition at December 31, 2016, GBP 39 million of license sales previously traded up front on delivery will now be deferred over the license term. Putting all that together, this slide sets out the cumulative transition adjustment. Cumulative sales of GBP 3.74 billion and margin of GBP 148 million will be recognized at December 31, 2016. This results in a post-tax impact of GBP 92 million, which increases reported net assets to GBP 3.656 billion at December 31, 2016. In summary, the implementation of IFRS 15 has no impact on lifetime revenue and profitability of our contracts. It has no impact on the group's cash flow or any impact on how we manage our contracts.
The impact of restating our 2017 full year results is expected to be a reduction of approximately GBP 0.01 on earnings per share, and the earnings impact on 2018 and beyond is not expected to be material. As previously mentioned, the restated 2017 results will be the baseline for 2018 guidance. Thank you very much for your attention, and now we can open up the call for questions.
Thank you, sir. Ladies and gentlemen, if you would like to ask a question at this time, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure that the mute function is turned off to allow your signal to reach your equipment. If you find that your question has already been answered, you may press star two to remove yourself from the queue. Once again, please press star one if you would like to ask a question today. We'll now take a question from Robert Stallard of Vertical Research. Please go ahead, sir. Your line is open.
Thanks so much. Good morning.
Morning, Rob.
Pete, a couple of quick questions on the pension update. First of all, I was wondering if you could reconcile the net deficit number you've given here, GBP 2.1 billion I think it is, versus what you gave in the half year results, which I think was around GBP 6 billion. What's going on there? Secondly, you mentioned that the agreement with the trustees sees the pension contribution linked to the dividend. Are there any other restrictions, say, with regard to share buybacks or acquisitions? Thank you.
Okay. That's really all about the discounting rate that you use. Under accounting, you use a discount rate based on corporate bond yields. What we have reached under the funding agreements here is a move to an asset-led discount rate, i.e., you look at the assets you hold in each of those schemes, the different categories of assets, the periods over which you hold them, and you come up with a blended rate based on what you expect prudently to get from those assets. There is now going to be a significant difference between the accounting deficit and the funding deficit. The funding deficit clearly will be the lower of the two.
The second point I'd like to make on that is, if we had not moved to the asset discount rate and had kept with the same funding basis that we did back in 2014, which was based on a gilts plus model, then the deficit we'd have reported today would've been twice as much as the GBP 2.1 billion. This is a really good result for all stakeholders. Second question was around any other issues around restrictions on the amounts we paid. In terms of the dividend linkage, that's really the only one. If we get into anything else like a share buyback, we'd have the same discussions with the trustees as to arrangements we'd have to reach. You know that we've done that in the past. There are absolutely no restrictions in terms of M&A.
Okay. Just a quick follow-up. Is there any mechanism to reconcile or to standardize the treatment of the discount rate between what you've got here on the pension with the trustees and the accounting? Because it seems daft to have completely different bases.
I wouldn't disagree with you, Rob. I've made my point very clear on previous presentation results presentations. The accounting is the accounting. It's marked to market. It doesn't represent the underlying economics of what's going on with the funding. In our accounts, whilst we clearly are obliged to show the accounting number, we will also be reporting upon the funding position. We have an accounting standard which doesn't reflect underlying economics. I can't do anything about that, Rob.
Okay. Thanks very much, Pete.
Now to our next question today, which comes from Rami Myerson of Investec. Please go ahead. Your line is open.
Good morning, gentlemen.
Morning, Rami.
Just some technical questions. The pension from the U.K., is that now going to be coming out of your HQ or will it be coming out of charge to P&S UK?
It will come out of HQ.
Okay. On the outflow for next year, you've guided to around GBP 200 million for this year in the cash flow statement, is that going to be similar next year as well in 2018?
Yeah. What we're saying is that the U.K. payments will be about GBP 220 million and the U.S. will be $80 million, that's what? GBP 60. It's around GBP 280 in total.
The guidance, is that going to be relative to the GBP 200 million that you've guided the outflow for pension deficit funding? Will it be close to GBP 300 million this year?
In 2018, it'll be around the GBP 280 mark.
Okay.
Beyond that, it will decline by GBP 50 million in 2022 as we complete the funding on what's called the 2000 Plan. That's the second largest scheme.
Just on the U.K. exposure, you had about GBP 4.4 billion of revenues last year. Can you just clarify how much of that is short cycle work, book and ship type work? A number of questions have risen recently.
Sorry, Rami. I'm not recognizing the GBP 4.4.
Your U.K. MOD revenues were about GBP 4.4 billion last year.
Okay. How much is short cycle? Very little. I haven't got the exact % to hand, but it's very little.
Okay. Maybe just a quick one. Prime Minister was in Saudi this week. Has there been any progress on the Typhoon order?
We're not going to talk about that today, Rami. Nice try.
Thank you.
We'll now move on to our next question today, which comes from Nick Cunningham of Agency Partners. Please go ahead. Your line is open.
Hi. Good morning.
Morning.
Yes, you can hear me. Good morning. A couple of questions about the pension. First of all, am I right very simplistically to think about this as five years of GBP 280 million, four years of GBP 170 million? If I add that up, that's GBP 2,080 million. That eliminates the deficit. Question one, is that sort of roughly how the plan works?
Roughly, yes.
Roughly yes. Thank you. On the pension itself, its cash flow, if you like, its internal cash flow. As I understand it, I think it's still cash positive because of the balance between contributors and those drawing down on it. At what point does that flip over? Final question, on the IFRS 15, that GBP 79 million and GBP 39 million, i.e., GBP 118 million, which is to be traded over time. Is that effectively the offset for the adverse impact of deferring profit recognition on other contracts? Is the effect of those things together sort of even, or are there any lumpy years that we need to think about in the next few years?
Right. Thanks, Nick. I'll do the easy one first. In terms of how you look at the cash profile, does that get rid of the deficit? The answer is yes. Clearly, you've got some asset returns coming from the assets invested, in terms of the assumption that we're making. The modeling is yes. You asked about the second question was in terms of the cash profiling of the scheme itself. How long does it stay positive? Current modeling says that stays positive through to 2028.
Thank you.
This is not a set of distressed schemes where we are having to sell assets off to meet liabilities, which is my point about taking a long-term view. I will send it back to Pete for the difficult question.
On the IFRS 15 point, Nick, on MBDA and the sort of de-trade effectively on a few development manufacturing contracts, which on transition, there is a de-trade in our books of GBP 79 million, our share. That profit will get traded over the production period of those contracts, and that is going to run out in the sort of five, some of them go out to 10 years. In-year impact on that GBP 79 million going forward will not be lumpy. It will be quite modest in any one particular year. On the GBP 39 million license income, again, on the de-trade, or as a result of the accounting on transition, that GBP 39 million is going to be spread over five years. It is going to be GBP 6 or GBP 7 million per year. Again, it will not be lumpy, and it will not be material.
Thank you, sir.
Thanks, Nick.
Cheers, Nick.
We'll now to your next question, which comes from Céline Fornaro of UBS. Please go ahead.
Yes. Good morning, gentlemen.
Morning, Céline.
Morning.
One question, again, regarding the new pension number and the GBP 2.1 billion. The main assumption that you've changed is really on this asset-led discount rates. Is there anything else on the mortality rates or other assumptions that we should be aware of?
You picked up a good point there, Céline. The two major changes, there are a number of smaller ones, but the two big ones is clearly the move to an asset-led discount rate. As I said, as a result of doing that, the GBP 2.1 billion we've reported today would've been twice that much otherwise. The other benefit has been an improvement in mortality, both in terms of what we've seen over the last three years, since the last valuation, but also taking up the new CMI 2015 tables. The mortality has given us a benefit of about GBP 800 million. Of course, that will also be reflected into the accounting deficit when we come to report that in February 2018.
Okay. What is the assumption now on the mortality rate?
We are using the actuarial tables, which are referred to as CMI 2015.
Thank you very much.
Okay.
Our next question today comes from Sandy Morris of Jefferies. Please go ahead.
Morning, everyone. Imagine not knowing the CMI tables off by heart.
I'm surprised, Sandy.
Actually, very dull question, but just to satisfy my idle curiosity. In Platforms & Services U.K., how many years did we have to go back to arrive at that cumulative adjustment? I'm just trying to work, sort of gauge the length at which this IFRS 15 thing ebbs and flows.
Yeah. About two or three years, Sandy.
Right. Three years. Okay. That makes sense. I'm guessing it's similar in international.
Yep.
Yep.
The sort of GBP 435 in the U.S. Platforms & Services, can I sort of regard that as Land & Armaments, or actually, is that not the case?
Predominantly land and L&A, because our ship repair business in the U.S. is predominantly support, where there's not much work in progress.
Yeah.
I.e., we trade it most of the sales anyway.
Right. Okie-dokie. This is almost related to that lumpy thing. Crudely, if we're going back three years and that's the total difference, then it doesn't look like going forward year-to-year, it could possibly generate much more than, I don't know, I'd have said GBP 500 million or something.
It'll be in that sort of number. It wouldn't be much more or less, sir, for that number.
That's sales. Because given that your profit recognition is so patently back-end loaded, even if there was a bit of lumpiness in sales, it doesn't look like there'd be much in EBIT.
As you rightly point out, and I wouldn't describe it as back-end loaded, but certainly it's in line with successful retirement of risk, then yes. As Peter already said, there's a minimal impact.
Yeah.
We will see some volatility on the top line on sales because of this whole move to effectively trading sales on the basis of cost plus a margin on some of these contracts. There is going to be some volatility on sales, but it will make almost no difference to profit recognition.
Okay. Well, that's great. Sorry, I was always a bit of an agricultural accountant, back-end loaders and stuff like that.
Thanks, Sandy.
Thanks very much, gentlemen.
Thanks, Sandy.
Our next question comes from Harry Breach of Raymond James. Please go ahead.
Yeah. Good morning, Peter, Martin. Can you hear me?
Thanks.
Yes, Harry. We can hear you loud and clear.
Great. Just a very simple one. Can you give us, sort of across all the schemes, the current balance between the actives, deferreds, and pensioners?
Ooh.
Hang on.
You know, Martin, do you? Go on then.
I think actives are about 25,000 as we sit. Deferred to about 60,000, pensioners are about 100,000.
Got it.
Normal.
Great. Thank you very much, guys.
That's accurate. Okay. I'm glad we had an answer for you, Harry.
Our next question today comes from David Perry of JP Morgan. Please go ahead.
Yes. Morning, everyone.
Morning, David.
Three questions, please. The first one is to Peter. This restatement for 2016 is helpful for us to start building models. I know you're not changing guidance or adding anything to your trading statement, but could you tell us what the margin range will be for 2017 for Air and maritime? Within the context of your current guidance, because that's what would help us convert to the new sectors.
I think if you look at the charts at the back, you'll see where we've reported the half year and the 2016 restatement. I talked about those two slides that were attached at the back.
Yeah.
You'll be able to see it all there.
Air in 2016, obviously half year will have some lumpiness in it. Air, you've told us, is GBP 11.8 in 2016. Do you have a range for air in 2017? Likewise, maritime is GBP 8.2 in 2016, but what's the range for 2017?
We're not going to give you those, David. We'll report on those when we get there, given that we're this close to the year end.
Yeah. Okay. Presumably it's just moving bits around, isn't it? Within the context of unchanged guidance.
It's unchanged guidance. We're just moving things around. Yeah, absolutely right.
You can't tell us what air or maritime range will be for 2017?
No.
Okay. The second one, just to clarify on the dividend-linked increases in pension funding. Just so I understand that, for argument's sake, you increase your dividend 5%. Does the entire amount in the U.K., which is what, GBP 220, does that go up 5%, or is it just the incremental GBP 15 million that would go up 5%?
It's the entire amount.
The entire amount. Okay.
Yeah.
It only relates to the U.K. piece?
Yes, it does.
Okay. Lastly, this is something I can probably do myself, but just to maybe save me some time. This asset-linked discount rate is really interesting and hugely positive for you guys. Are you aware of other companies that have done it? Is this a now broadly accepted thing for FTSE 100 companies, or is BAE out on a limb here?
No. We are aware of three other companies that have done it. They're not all quoted. This is not something that the regulator has said you cannot do. Indeed, historically, there's not been a need to look at this. It's always been done on a gilts plus approach. Given that the gilts rate has fallen so far and now bears little reality to the expected return you get on the assets you hold in the schemes, we've been through this with each of the nine trustee boards, their independent lawyers, their independent actuaries, and we've taken it through the U.K. pensions regulator. There is a consistency of acceptance across all parties.
All right. Thank you very much.
As a reminder, ladies and gentlemen, to ask a question today, please press star one on your telephone keypad. Our next question now comes from Tristan Sanson of Exane. Please go ahead. Your line is open.
Yes. Good morning, everyone. It's Tristan from Exane. I have a few follow-ups. First, I would like to understand the acceleration of the funding of the smaller fund in the U.K. is driving a drop in the annual contribution by GBP 50 million in 2022. Can you say by how much it increases, actually, the contribution in the years before you are accelerating the payments? That's the first one. Second, I kind of understand what you're saying on the restatement of the accounting of the contracts in backlog, or that you started executing according to IFRS 15. If I look at, I don't know, a large export contract that could be placed in 2018 for whatever ships or fighter aircraft, how would it change the recognition of revenues and profits compared to what we knew in the past?
Should we assume it's going to be exactly the same, or should we assume slightly slower profit recognition in the early stage of development, that would be useful. Final question is more of a request. I'm sure you have that in mind, but if you could give us updated pie charts of breakdown of activity of the new air and maritime revenues with full-year results, that would be fantastic. Thank you.
Okay. Okay, Tristan, three questions. I'll take the first one, Peter will take the second, and Martin will take the third. On the first one, you talked about the accelerating payments. The acceleration is all within that GBP 220 million that we're now talking about for the U.K. contribution commencing in 2018. The second-largest scheme, which is called the 2000 Plan, comes then fully funded in 2021. At the moment, as part of that GBP 220 million, GBP 50 million of that is going into that scheme. There will be a step down, therefore, in 2022 of GBP 50 million on the back of that scheme. The other schemes are much smaller. They're not material. If your modeling assumption is GBP 220 million a year on U.K. schemes through to 2021, and then GBP 170 million a year through to 2026, and then we're done.
Actually, what I wanted to know is whether the contribution to the 2000 Plan, until now was GBP 30, GBP 40, compared to the GBP 50 that you're going to have going forward.
No, it's the same.
It's the same.
It hasn't changed. What has happened is, because of the change to the difference in the discount rate, the actual deficit is lower.
Okay.
Which is why it became fully funded earlier.
Good.
Peter, do you want to talk about recognition?
Yeah. On your second question around about our new large export-type contract, saying 2018 under the new accounting, you will see a difference in sales recognition. On sales recognition, the new standard requires us to book sales on cost incurred. As we incur those costs, there will be a sort of backward shift, earlier recognition than today of sales. There'll be no change on the timing of profit recognition. On those types of contracts, we will continue to trade profit as we hit milestones and mitigate risk. You will see a bit of a difference between sales and profit in terms of timing going forward versus today. Profit recognition in timing will be the same. As we said, 2018, we're not expecting the impact of IFRS 15 to be material.
Okay, Tristan, Sorry, go on.
I mean, just to be clear, it means that the margin % share will be slightly more backloaded, but the contribution in GBP million will be similar.
Yeah. As a % of sales, absolutely right.
Okay.
Tristan, just on your third point then, in the year-end presentation in February, we will do a restatement and split out sectors and give the traditional pie charts by OE production and service revenue.
Fantastic. Thanks, Martin. Thank you very much.
Thanks, Tristan.
Ladies and gentlemen, that concludes today's question and answer session. At this time, I would like to hand back to Mr. Peter Lynas, Chief Financial Officer, for any additional concluding remarks.
I have no concluding remarks. Thanks for your patience. As I think you'll tell, we're very pleased with the pension outcome both for the company, the schemes, and including the shareholders. IFRS 15 has no material impact to us and certainly has no economic impact. The accounting restatements, sorry to screw up your models. We'll do our best to help you through that. We'll certainly have a clear presentation in February when we see you. Thanks for your time.