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02 Mar 17. BAE buoyed by geopolitical change. Expanding defence budgets in key markets have helped lift the value of shares in BAE Systems (BA.) by about a quarter since we made it our Value Tip of the Year for 2016. But we believe this is just the beginning as defence budgets go from being one of the hardest hit public spending areas, both at home and abroad, to a ringfenced priority – a contention given added ballast by the group’s recent full-year figures.
Revenue and cash flows strengthened substantially, although sterling’s post-referendum depreciation was obviously a factor. More revealingly, underlying profit of £1.91bn was 13 per cent to the good, while the order backlog of £42bn increased from £36.8bn at the end of 2015. Perhaps most tellingly, order intake jumped by 50 per cent to £22.4bn. And those orders were nicely spread across the group’s business units.
Order activity from Saudi Arabia (21 per cent of revenue) and the US (36 per cent of revenue) gives cause for encouragement, particularly as Donald Trump is looking to pass a 9 per cent increase in the US military budget through Congress. A pointer to future growth channels is provided by the continued growth in commercial cyber security and counter-fraud activity.
An area for anxiety is BAE’s exposure to the F-35 Joint Strike Fighter programme. The group delivered the 250th electronic warfare suite for the F-35 Lightning II during the year, and garnered orders worth £637m, including production and construction of engineering and training facilities in the UK. Ostensibly, as a tier-one partner in the project, things are moving along well, but comments by President Trump during the US election campaign over the programme’s controversial cost overruns cast doubt over the project’s future – at least in its present form. However, BAE’s outgoing chief executive, Ian King, pointed out that unit costs have fallen significantly as more aircraft have been ordered. President Trump has made more conciliatory noises since entering the White House, but it remains an area of contention.
In reality, the election of Donald Trump is a potential boon for the defence industry. Not only does the new President want to boost defence spending by $54bn domestically, but he has given notice to America’s partners in NATO that they had best comply with the organisation’s minimum annual defence spending commitment of 2 per cent of GDP. Only a handful of members, including the UK (23 per cent of BAE’s revenue), have consistently complied with the requirement, but the controversial new Commander in Chief has made it be known that the US is unwilling to take up the slack in the future.
There has been some resistance to the President’s calls, particularly from inside Germany and from various apparatchiks in the European Union. But playing hardball with NATO partners actually constitutes one of the President’s more deliverable election promises.
There were no alarm new bells on the financial front for 2016’s figures, although BAE’s share of the net pension deficit increased by £1.6bn to £6.1bn. The rising deficit is a reflection of the slump in bond yields through the period. Anxieties could start to alleviate as yields may now be on an upward trend, having already reversed last year’s pull-back. Fears about the pension could also ease as a result of expectations that free cash flow should improve from this year onwards, so we might actually expect some benefits from BAE’s financial gearing.
IC VIEW: Based on estimates from broker Investec, BAE’s shares trade at close to a 30 per cent discount to US peers on an earnings multiple basis. While the level of the pension deficit explains some of this, the discount is wide by historic st