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07 Jan 16. Changing fortunes for cheap BAE.
Bull points:
• Security tensions escalating
• Trades at discount to peers
• Management buying shares
• Key customers spending more
• Attractive dividend yield
Bear points
• Dividend cover concerns
• Debt and pension deficit
As frequent Isis-inspired terror threats grip the Western world and big companies fall victim to an increasing number of cyber attacks, defence budgets have gone from being one of the hardest hit public spending areas, both at home and abroad, to a ringfenced priority. Europe’s biggest defence contractor, BAE Systems (BA.), has emerged as one of the biggest beneficiaries of this changing landscape, yet based on its valuation compared with international peers (see table below), markets don’t appear to have factored this in.
BAE valuation vs International Peers
The defence giant had a tough year in 2015 when a steady stream of negative news was accompanied by a persistent dribble of broker forecast downgrades. But we think the UK government’s five-year Strategic Defence and Security Review announced in November may have marked a turning point. Indeed, the review prompted broker Investec to upgrade its adjusted EPS forecasts for the next three financial years by 4 per cent, 3 per cent and 8 per cent, respectively, and there could be more to come.
BAE, which generates about a third of revenues from the Ministry of Defence, was the main beneficiary of David Cameron’s pledge to pump an extra £12bn in to strengthening Britain’s defences against Isis and Russia. What’s more, the government’s outlined investments reflected many of the areas where BAE excels, suggesting the defence contractor is at the forefront of the latest, cutting-edge military technologies.
The group will be particularly relieved with the government’s commitment to extend by 10 years the life of the Typhoon combat aircraft, which was recently deployed for the first time in the fight against Isis. Those developments emerged after the defence contractor was forced to cut back Typhoon production because an order for 48 jets from Saudi Arabia was no longer expected to arrive in 2015.
There are good grounds to hope the Saudis will soon be making this order worth £4bn, despite the impact of the lower oil price – a recent Saudi austerity push was actually accompanied by news of some extra defence spending. Encouragement can be taken from the commissioning of 22 hawk trainer jets last year and, despite the sliding oil price affecting the economy, the Saudi government boosted its defence budget by 27 per cent over the summer, leaving it well on track to become the world’s fifth-largest military spender by 2020. Regional conflicts with neighbouring countries help explain why leaders there have made this a priority.
Business across the pond is picking up, too. BAE’s other main customer, the US Department of Defence (DOD), has signalled an end to years of austerity by raising its spending caps. The latest two-year budget deal has finally been given the green light by the Senate and House of Representatives, bringing the Pentagon’s kitty up to $607bn (£403bn) in 2016 and $610bn in 2017. Recent contract wins indicate that BAE figures highly among the DOD’s head honchos.
While it suddenly feels there is much to be positive about, as with all value plays, BAE’s lowly rating is not there without reason. The company’s critics will point to its lumpy revenue streams. But its geographical spread and a shortening sales cycle through growth in areas such as cyber security makes it look healthier than Lockheed, which generates about 80 per cent of turnover from just one customer.
The balance sheet offers grounds for more tangible concerns. As well a