ii view: defence contractor BAE Systems locked on to annual target

Exposure to large air, sea and land equipment orders and offering a forecast dividend yield of 3%. Buy, sell, or hold?

First-quarter update to 31 March

• Full-year guidance remains unchanged

Chief executive Charles Woodburn said: 

“Order flow on new programmes, renewals and progress on our opportunity pipeline remains strong. In particular, the AUKUS announcement in March is significant for the company in the medium and long-term and we look forward to supporting our customers in this far reaching programme.”

ii round-up:

Defence equipment maker BAE Systems (LSE:BA.) today detailed first-quarter trading in line with management’s prior expectations. 

Good operational performance during the period continues to leave its estimate of full year 2023 adjusted profit at an increase of between 4% and 6% from 2022’s £2.79 billion. 

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Shares for the FTSE 100 company fell by around 1% having come into this latest news up by a third over the last year and following Russia’s invasion of Ukraine. That’s similar to smaller engineering rival Senior (LSE:SNR), although behind an 82% gain for civil and military aircraft engine maker Rolls-Royce Holdings (LSE:RR.). The FTSE 100 index itself is up by 3% over the last year. 

BAE’s products include parts for jet fighters like the US F-35 and Europe’s Typhoon jet, navy ships and submarines, armoured vehicles, along with electronic systems such as radar and cyber & intelligence systems and services. 

Operational events achieved during the three months to the end of March include the start of construction for the third Dreadnought class submarine, two further Typhoons delivered to Qatar, and good levels of combat vehicle deliveries. 

In March, Australia, the US and UK outlined further details regarding plans to sell Australia jointly developed nuclear submarines under the so-called AUKUS agreement, aimed at preserving a free and open Indo Pacific. 

In the US, the president's 2024 Budget request increased the defence budget by over 3% above full-year 2023 base levels to $842 billion, with BAE believing it remains well aligned to US National Defence Strategy priorities. 

BAE’s three-year buyback programme of up to £1.5 billion, started in July 2022, is now over 60% complete. First-half results are scheduled for 2 August. 

ii view:

BAE Systems is a major manufacturer of defence equipment. It competes against rivals such as Babcock International Group (LSE:BAB) international, QinetiQ Group (LSE:QQ.) and Rolls Royce. It employs more than 90,000 people across 40 countries. Aircraft related sales generate its biggest slug of revenues at around 38%, followed by electronic systems at 21%, naval or maritime equipment at 16%, platform and service sales including armoured vehicles at 15% and cyber and intelligence the balance at under 10%. 

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Geographically, the US accounts for just over 40% of total sales, followed by the UK at close to 20%, Europe and Saudi Arabia at just over 10% each, and other countries including Australia and Qatar each at under 5% each.    

For investors, ethical reasons may prevent some investors from buying BAE shares. Geopolitics and government appetite for spending make demand volatile and difficult to predict, changes of government can come with budget implications, while rising costs and supply chain issues in the wake of the pandemic have also featured in recent years. 

More favourably, BAE offers diversity in both product and geographical terms. The war in Ukraine and current tensions between the West, Russia and China helped push its order intake during the 2022 financial year to a record $37.1 billion, while the dividend payment remains progressive, rising more than 15 years in a row. 

For now, and while an estimated price/earnings ratio above the three- and 10-year averages suggests the shares are not obviously cheap, this major defence contractor arguably still warrants a place in balanced and already diversified investment portfolios.

Positives: 

• Diversity of products and geographical sales
• Forecast dividend yield of 2.8% (not guaranteed)

Negatives:

• Arms manufacturing may generate ethical concerns
• Elevated government borrowing

The average rating of stock market analysts:

Buy