Stockwatch: this FTSE 100 company is a portfolio building block

This £24 billion company won’t be everyone’s cup of tea, but it could be a core holding in a diversified portfolio, argues analyst Edmond Jackson.

How significant is a 7% drop in the FTSE 100 shares of BAE Systems (LSE:BA.), Britain’s largest contractor? It hit an all-time high of 846p on 7 October, having rallied over 40% from around 600p at the end of last February. It then dropped as low as 770p by yesterday, recovering with global markets to around 795p currently. 

I drew attention as a “buy” at 735p last March on grounds that Russia’s rude awakening of imperial ambition underwrote BAE’s long-term earnings prospects. Germany had declared a rise in its defence spending from 1.5% to 2.0% of GDP, setting up an £83 billion equivalent fund to meet this. 

The stock looked fairly priced, mind. Guidance for revenue and profit growth was only in low single-digit percentages versus a 12-month forward price/earnings (PE) of 14.5x and a 3.6% prospective yield.  

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A steady rally to near 850p over six months was therefore driven significantly by war in Ukraine than perceived financial value, making the stock sensitive to any changes in its story.  

Various factors have conflated from second week in October 

First, Turkey mooted another attempt at mediating peace talks between Russia and Ukraine, despite a meeting last March producing no results and Ukrainian president Volodymyr Zelensky saying he will not hold any talks with Vladimir Putin. 

Second, strike action is simmering both in the US and UK. At the end of August, some 800 unionised workers building military vehicles went on strike in Pennsylvania – rejecting a final offer for a new contract after the existing one expired a year ago. 

Here, the GMB union proposed a strike this Wednesday to halt warship manufacture at two Scottish yards, although BAE says it has made temporary arrangements “to ensure no impact to our activities”.  

BAE is hardly alone in this respect. Trade unions are mobilising action across various industries, but it is likely a near-term factor checking investor sentiment.  

Third, and more pertinent for a fifth of group revenues, is the new UK chancellor’s tearing up of Liz Truss’ manifesto, which included an increase in defence spending from 2.1% to 3.0% of GDP by 2030.  

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When Truss campaigned for the Tory leadership it was to build on Boris Johnson’s target for 2.5%, hence her election would also have helped BAE stock. 

Ben Wallace had said as defence secretary only on 25 September, the defence budget would be raised from £48 billion to £100 billion – a huge amount - over eight years.  

Jeremy Hunt’s broadside remark as chancellor is that government departments need to find savings to the collective tune of £7 billion, with “difficult decisions” across the board. 

A fourth aspect may be a sense among investors that the US dollar has reached a zenith - at least for now - if the Federal Reserve has done the heavy lifting on interest rates. 

BAE said in July’s interim results that a five cents movement in the dollar equates to earnings per share (EPS) of 1p, which is quite material when a 50p range is the consensus expectation for 2022 and 2023. 

Last February, its 2022 guidance assumed a $1.38 sterling exchange rate, but this is now $1.13, hence a minimum 3p boost to EPS. Quite the extent it may be reflected in consensus is unclear, but if dollar strength is peaking then near-term profit-taking in the likes of BAE is rational. Markets stay at the current edge of expectations.   

Altogether, such factors are enough to check sentiment currently, yet I believe the medium to longer-term case remains for BAE as a core portfolio holding.  

Russia’s belligerence is expected to galvanise more NATO countries towards a 2%-of-GDP defence spending target, where Canada and various European countries are only in a 1% range. 

Global tensions remain stoked also by Chinese president Xi Jinping’s remarks at the Chinese Communist Party’s congress, that China will never renounce the right to use force over Taiwan.  

First-half order intake soared 70% to $18 billion 

Meanwhile, the backlog – or work in progress – rose 18% to £52.7 billion, which is very strong for an engineering type contractor. 

It would appear to underwrite consensus for 16% revenue growth this year and, given BAE’s double-digit operating margins, the expectation for a near 27% rise in EPS to near 53p. 

BAE Systems - financial summary
Year-end 31 Dec

Source: historic company REFS and company accounts.

The US remained the principal driver at 44% of first-half sales and 48% of revenues, followed by the UK at 25% and 21% respectively. Saudi Arabia and continental Europe were the next two most significant areas. Otherwise, BAE is internationally diversified. 

Yet the CEO was confident well beyond such progress, saying: “Our diverse portfolio, together with our focus on programme execution, cash generation and efficiencies are helping us navigate the current macroeconomic challenges and position us well for sustained top line and margin growth in the coming years.

“We see further opportunities to enhance the medium and long-term outlook as our customers commit to increased defence spending to address the elevated threat environment.”  

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This key take-away from BAE’s last trading update would have been stock-supportive. Likewise, a £1.5 billion buyback programme declared the same day, running to end-June 2023. Recent stock downside might therefore have been greater without such a prop. 

As of 13 October, £452 million had been spent on buybacks, with an average price near 820p paid, illustrating my regular point about how a genuine distribution of spare capital is preferable than helping company boards achieve EPS targets. Has optimal value been delivered to shareholders given the stock has fallen? 

Their enthusiasm is not matched by way of personal share purchases. Various “director/senior manager shareholding” announcements in the last month or so relate to only small-scale incentive scheme trades. 

It conveys BAE is fairly priced.   

Neither a firm ‘growth’ nor ‘value’ category

A current share price of around 795p represents15.0x consensus for EPS of 52.8p this year, easing to 13.7x in respect of 2023 for which 57.7p is anticipated.  

With total dividends of 26.3p and 28.1p projected, covered twice by earnings, the yield rises towards 3.5%. 

Capitalised near £25 billion, BAE is not going to attain a classic 20x growth stock PE, nor is its yield likely to attract income investors.  

Yet quite like AstraZeneca (LSE:AZN), it appeals as a portfolio building block given strong positioning in markets that are robust – certainly relative to recessionary risks. 

BAE also offers a spread of operations: electronic warfare systems; military platforms and services; aircraft, maritime and cyber intelligence; which means investors typically default to owning its equity as a means of exposure to defence spending. 

Mind, the stock could see further downside if the chancellor proceeds to initiate defence spending cuts. Despite criticism of Britain having run down its armed forces, we spend ahead of most NATO countries. 

Yet the next trading statement – historically, in the second week of November – will be strong, capitalising on first half-year orders.

If the price does weaken again in the days ahead then you might consider BAE as a “buy”, and also in a future scenario of declines in response to renewed austerity.

The jolt to UK public spending is impossible for BAE to avoid, but I think the wider global security context – also the group’s international reach – support its longer-term investment case. Hold.  

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.