BAE Systems plc (LSE:BA., Financial) is a British global defense company. BAE has a dominant position in the UK, is a top-six supplier to the U.S. Department of Defense and has a strong presence in key defense markets such as Saudi Arabia and Australia.
BAE is more cheaply valued than most of its international peers in the defense sector, with an enterprise-value-to-Ebitda ratio of 7.4 and a price-earnings ratio of 10.7. GuruFocus gives the stock a Valuation Rank of 7 out of 10, meaning it is attractive from a valuation standpoint.
Some of the cheapness could be attributed to, in my opinion, misguided ESG screening. Another part of the cheapness is that UK stocks tend to be cheaper than U.S. stocks, and most of BAE’s peers are U.S. defense stocks. But then there is just plain old sentiment. BAE has been dogged by concerns over the reliability of its cashflow for some time while now. Difficult contracts, cost overruns and large pension liabilities scared away many investors. Exposure to Saudi Arabia, which is not European investors’ favorite risk exposure, also didn’t help.
However, my view is that things are getting better. A 1 billion pound ($1.38 billion) contribution towards the pension liability last year has helped reduce an issue that for more than a decade ate up cash as BAE made successive contributions to try to fill the hole. Management reckons that this £1 billion payment will be the last and that the deficit will go away by 2026. This is good for BAE’s credit rating and frees up dry powder to invest in research and development and mergers and acquisition activity. A three-year free cash flow goal of £4 billion out to 2023 was set by management, which is an increase from the last target of £3 billion set in 2019 for this year.
When investing, we need to understand the investor universe and UK investors are dividend obsessed. So, the greater confidence around the pension situation also improves the outlook for dividend cover going forward.
In July, the company announced its interim results for the half year ending June 30, 2021, which included a share buyback program of up to £500 million. The buybacks started in July and are expected to be completed by July 31, 2022. The interim dividend was also increased by 5% back in July.
It looks like the full year dividend will be just under 25 pence a share, which means the dividend yield now stands at a healthy 4.2%. Share buybacks give investors further room for returns too.
ESG concerns were addressed in a recent presentation where management provided an update on ESG matters, including its net zero target, product trading governance, workforce safety and wellbeing and how the company contributes to society. While it could be argued that all these factors are marginal to some extent, for some European investors they are very important factors.
As an owner of BAE Systems, the issue I’m most concerned about is Directors' Remuneration. While at the Annual General Meeting held on May 6, Resolution 2 to approve the Directors' Remuneration Report was passed, a significant minority of shareholders who voted (23.41%) chose not to support this resolution. This is something I’ll be paying attention to at the next Annual Report.
Big-ticket deals such as the recent contract to make 38 Typhoon aircraft for the German air force are important for the company, but they contribute to a lumpy cash flow situation. So, it’s pleasing to see BAE is trying to grow in areas including technological development, where contract payments are lower but more consistent. One good example is the electronic systems division, which makes products including commercial digital engine and flight controls and navigation systems, and this accounted for about 20% of revenue in the first half.
Growing revenues internationally is also a goal of management. Revenues from the US accounted for more than 40% of sales in the first half. Revenues are growing in Europe and Australia, too. Some analysts believe revenues from the US are rated more highly than revenues from Europe, probably because of America’s greater consistency in defense spending. However, Europe has some catching up to do in terms of meeting its 2% of GDP spend on defense for NATO targets.
Saudi Arabia accounts for just over 10% of BAE’s revenues. It has been higher in the past and as we have seen with Petrofac (LSE:PFC, Financial), Middle Eastern business can be lost as easily as it can be won.
But this political risk goes both ways. Rising geopolitical tensions in various parts of the world can be bad for markets but good for defense stocks, so BAE is a good portfolio diversifier, as it acts as a hedge against very bad outcomes such as war. Obviously, I hope it wouldn’t come to that. Having the U.S. and UK governments as your biggest clients is a pretty safe bet for me, and solid dividends and a share buyback program are giving cash returns.
