BAE holed below waterline by cost overruns on MoD contracts

BAE systems shocked the market again yesterday by warning of "substantial" cost overruns on two huge Ministry of Defence equipment programmes with a combined value of £5bn.

The company, Britain's biggest military contractor, also indicated there were likely to be delays in the delivery of the Nimrod surveillance aircraft and the nuclear-powered Astute attack submarine.

The warning sent BAE shares down by 20 per cent and prompted an immediate Government response that the company had to bear responsibility for cost overruns and would not be protected from the consequences of its "failure to perform".

Shares slumped another 20 per cent in early trading today as the market continued to react to a warning of "additional issues" on two of its biggest programmes.

In early trading today, shares slumped by a further 27.75p to 103.25p, valuing the firm at just £3.2 billion. About £1.8 billion has been wiped from its market value in two days.

The announcement from BAE came only a day after it sought to reassure the market that it was not intending to issue any profits warning this week and that everything within the group was "going to plan".

BAE said it could not yet quantify the size of the cost overruns but aimed to give shareholders an indication when it published its preliminary results for 2002 next February.

The Nimrod programme is costing £2.8bn while the contract to build the three Astute submarines for the Royal Navy is valued at £2bn. Some estimates put the cost overruns on the two contracts at more than £500m.

The company said that it was discussing with the Government "the extent to which these two contracts can be modified to the mutual benefit of the MoD and BAE".

But ministers have warned BAE that they will take a tough line in the negotiations. A Government source said: "We have made it clear to the company that the MoD cannot protect it from cost overruns which have arisen from its failure to perform. We are, however, prepared to explore those areas where the scope of the contracts could be varied on a value-for-money basis for the taxpayer and where these are in the national defence interest.

BAE has already taken a £300m charge to cover cost overruns on the Nimrod, which will mainly act in an anti-submarine surveillance role. Last month the MoD cut its Nimrod order from 21 to 18 aircraft and announced that the first flight of the aircraft would be delayed by a year until the latter part of 2003. Nimrod is due to enter service in 2005.

Industry sources said the problem lay not with the sophisticated equipment being installed but with the airframe itself, which had forced BAE to step back and look again at the design of Nimrod.

Astute, which is being built at BAE's Barrow yard in Cumbria, is due into service in the second half of this decade and it is one of the "legacy contracts" BAE inherited when it bought GEC Marconi in 1998.

BAE shocked the market in September by announcing a £90m charge to cover problems with two other "legacy" shipbuilding contracts to build assault ships and refuelling vessels for the MoD.

The company also upset investors by casting doubt on whether it would honour its pledge to start increasing profits from next year. Shares in the company have fallen 66 per cent from a high of 384p in June, raising question marks about the stewardship of BAE under its new chief executive, Mike Turner.

But a BAE source said: "What Mike has done is actually quite bold. He has shone a light in all the dark corners to see what is going on and get it out in the open. Unfortunately, when you then say you are not going to make money out of your principal customer, the market does not like it."