Premier Defence & Aerospace Investment (BAE Systems), Aug. 2020

Company: BAE Systems plc. (LSE: BA.; US OTC: BAESY)

Sector: Aerospace & Defense

Price (Aug.28th, 2020): GBp519

Target price (12m): GBp638

Dividend Yield: 4.4%

Expected Total Return: 27%

Rationale for investment

  • Demand for military equipment is on the rise across the globe
  • BAE enjoys strong fundamentals such as high profit margins, no debt and stable dividend (4.3% p.a.)
  • Multiples valuation is significantly below the market or the stock’s historic norms.

Profile

BAE Systems plc (BAE) is a defense, aerospace and security company. Company has leading positions in its principal markets – the US, UK, the Kingdom of Saudi Arabia and Australia – as well as established positions in a number of other international markets.

Market

BAE Systems has strong, established positions in the air, maritime, land and cyber domains.

Source: BAE Systems plc. Annual Report

Investment Case

Demand for military equipment is on the rise as governments across the globe focus on military modernization, given increasing global security concerns. Global defence spending is expected to grow at a CAGR of about 3 percent over the 2020–2023 to reach US$2.1 trillion by 2023 (source: Deloitte study).  While the US administration’s increased focus on strengthening the military is expected to be a key growth driver for defense spending, other large nations, such as China, Russia, and India, are also likely to embark on higher spending on defense equipment.

With some 90% of group sales to the defence market and the US accounting for 43% of group sales (2019 full year), BAE looks well positioned to generate robust earnings in the medium term. BAE enjoys a well-positioned defense portfolio with a strong order backlog and programme visibility. They are also focusing on acquisitions as a unique opportunity to accelerate technology strategy. I estimate BAE top line will grow 5-10% p.a. over next 3 years without major military events.

Valuation

Sustainable dividend yield of 4.3% is among the highest in the industry well covered from earnings. The return on equity of 24% for BAE is also the highest within its Aerospace & Defense industry group.

Compared to the Aerospace & Defense industry group and historical average, BAE is currently trading at a significant discount based on both Trailing P/E (14.2x) and Forward P/E (13x). I suspect the discount is due to the pension deficit issue and a temporary decrease in profit due to COVID-19.

I assume a target P/E ratio of 19x (BAE 5-year historical average).  I then apply a quick and dirty 10% discount for COVID 19 impact. Hence I arrive at an upside of +23% and target price of GBp633.

Financials

For the six months ended 30 June 2020, BAE Systems plc revenues increased 6% to £9.18B. Net income decreased 33% to £532M.  Revenues reflect Platform & Services(US) segment increase of 16% to £1.69B, Air segment increase of 7% to £3.03B, Electronic Systems segment increase of 3% to £2.2B. Net income was offset by Air segment income decrease of 15% to £324M, Electronic Systems segment income decrease of 9% to £281M. Sales are expected to increase by low-single digit percentage compared to 2019.  Earnings per share – expected mid-single digit percentage lower than 45.8p in 2019. Improved second half performance should partially mitigate the COVID-19 impact seen in the first half 2020. Free cash flow, excluding £1bn non-recurring UK pension contribution, expected to be around £800m.

Investment Risks

  • Group is subject to geopolitical uncertainties and ESG risks
  • A cut in the Saudi Arabia defence budget on the low oil price – Saudi Arabia accounts for about 14% of BAE sales. Should the Saudi government decide to cut defence budgets due to a possible economic slowdown with a low oil price, BAE stock could be under pressure
  • Pension deficit of circa £6bn may take priority in capital allocation over dividends and investment

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