Stockwatch: stay strapped in for the ride at this FTSE 100 stalwart

This FTSE 100 company has shrugged off the market gloom to surge within reach of a record high. Analyst Edmond Jackson explains what he’d do next.

BAE Systems (LSE:BA.) provided a bright spot versus Wednesday’s market falls after US credit was downgraded. The FTSE 100 defence and aerospace stock jumped 60p to 993p and has easily absorbed any profit-taking now to reach 1,000p.

It follows strong interim results that showed £21 billion of orders achieved in the six months to end-June, aiding a record £66 billion backlog (or work in progress).  

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Numbers vary somewhat according to whether a “group reported” or International Financial Reporting Standards (IFRS) perspective is taken. For example, revenue up 11% and 13% respectively; underlying EBIT up 10% and operating profit up 20%; underlying earnings per share (EPS) up 17% versus basic EPS up 62%; free cash flow of £1.1 billion versus net cash from operations of £1.5 billion. 

Anyway, BAE is distinguished versus the vast majority of stocks, and it affirms why, at the end of last year, I included it at 840p among four “stocks for a long hard recession” - given its spread of activities as UK defence sector leader, and with European leaders raising defence spending. 

There is a nice balance of delivering returns and investing for growth. Net cash from operations has trebled near £1.5 billion, amply covering £508 million paid out as dividends in the first half, also £376 million spent buying back shares. Capital expenditure was £303 million, mitigated by £123 million dividends from equity accounted investments.  

The interim dividend thus rises11% and enjoys twice earnings cover, something hard to find elsewhere, especially from a £30 billion company, although the yield itself is a modest 3%.   

Upgrades to full-year guidance help the stock 

Having fallen to 888p in early July, might BAE soon re-test April’s all-time high of 1,032p? 

Sales guidance is upgraded by 200 basis points (2%) into a 5% to 7% range “reflecting good demand and operational performance across all sectors”. Similarly, underlying EBIT is upgraded 200 basis points (bps) into a 6% to 8% range. For better or worse, it implies a lack of operational gearing. 

Where BAE is sensitive to change is exchange rates. For example, a five-cent movement in the £/$ exchange rate would impact sales by £400 million, underlying EBIT by £55 million and EPS by around 1p. Ironically, and despite the US credit downgrade, the dollar has actually risen over 2% versus sterling. 

Most significantly, underlying EPS guidance jumps 500 bps into a 10% to 12% growth range – amid higher profit, interest income and a reduction in the expected tax rate to 19%. I do also wonder if BAE’s fondness for buybacks is also helping, as another £1.5 billion buyback programme kicks off. 

The reference to higher interest income is curious given the end-June balance sheet had stable year-on-year debt of £5.0 billion, likewise £3.2 billion cash. Rising interest rates explain a five-fold jump in finance income to £69 million but curiously the finance cost is down 60% to £104 million. 

Higher NATO defence spending helps sales   

A geographic breakdown of sales and revenue under note two in the results shows the UK driving sales growth, up 24% to £3.2 billion, also Europe up 33% to £1.1 billion and the US by 12% to £5.2 billion. While the Ukraine war gets no mention in the release, it has been a wake-up call to NATO countries. Given their stretched public finances, however, I would not assume spending momentum is going to continue at recent rates; albeit likely to remain higher than it has been in past years. 

The CEO is nevertheless confident in a growth trajectory: 

It says: “We’re well-positioned to continue delivering sustained growth in the coming years, giving us confidence to continue investing in new technologies, facilities, highly-skilled jobs and in our local communities.”

Another bright spot is Saudi Arabia where sales are up 15% to £1.2 billion, significantly offsetting weakness elsewhere in the Middle East. Other countries grew sales modestly overall.  

I drew attention to BAE as a “buy” at 735p in March 2022 chiefly on a rationale how Russia’s rude awakening of imperial ambition underwrote BAE’s long-term earnings prospects as NATO countries raised defence spending commitments.  

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

Latest consensus forecasts imply a similarly-based PE multiple around 16 times and a yield of 3.0%. It is possible they are yet to fully reflect the upgraded guidance, meanwhile the higher PE reflects BAE’s financial security relative to most other equities this year. 

Series of strategic milestones in operating review 

They underline BAE’s capabilities and lend medium-term confidence, even if financial upshots are as yet hard to quantify: 

• The group will play a key role helping Australia acquire its first nuclear-powered submarines, as part of a tri-lateral programme with the UK and US. This will be based on UK design incorporating technology from all three nations. 
• New investment by way of a £700 million contract extension from the Ministry of Defence to boost technologies for the UK’s future combat aircraft. 
• Collaboration with a Swedish electric airplane maker: on a first-of-kind, battery system for a conventional civilian plane, allowing it to operate efficiently with zero emissions and low noise. While competition seems inevitable in airplane batteries, such a project could be a medium-term game-changer – also improving BAE’s image as an ethical/green stock. 
• A strategic agreement with Microsoft, supporting rapid development and management of digital defence capabilities. 

Not mentioned in the release but picked up by BAE observers at end-July, was the published Ministry of Defence departmental minutes of 28 June, indicating intent to contract BAE for the “detailed design and long lead items” phase of a new class of nuclear submarine.  

Another three years of share buybacks 

A third tranche of a £1.5 billion share buyback programme commenced on 1 June, and once this completes the board has approved a further £1.5 billion buyback programme – providing a further three years of reducing issued share capital, thus enhancing EPS. It is around a tenth of market value for a £30 billion company, hence not immaterial. 

You probably know my stance, that most private shareholders would likely prefer a higher dividend, although with earnings cover established around twice, it seems unlikely.

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It does at least sustain the perception of a “growth company” if EPS can be squeezed along. Mind, the current upgrades driving possible annual earnings growth of 30% would mark an exceptional year, although settling back into low double-digits would still remain relatively superior. 

BAE’s volatility this year – a second rally from mid-March had fully retreated by early July – shows the market senses not to get too greedy in the short run. Yet I would not sell this spike, the upgrades are too material, and valuation is not stretched.  

With fresh money, you would be buying a quality business at a fair price, a proven strategy. Mind how August can be a troubled month in stocks, and I would let Wednesday’s surprise element abate. So for now: Hold.  

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