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3 Reasons Why BAE Systems Plc May Still Be A Buy

BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US) shares have risen by 30% over the past 12months, outperforming the FTSE 100’s 12% rise. Even so, they are still only on a forward price-to-earnings (P/E) ratio of 10.3 — well below the FTSE average — and yield a healthy 4.6%, which should be attractive to most income investors.

The share price performance is, at first sight, surprising. Read any investment article about BAE, and its exposure to US budget cuts and tightened Western defence spending will feature. True, the company is making big strides in sales to other countries, but the core of BAE’s business remains defence sales in the US and UK, each accounting for about 30% of sales.

For me, there are three main reasons why that’s still a solid business to invest in.

Geopolitics

First, geopolitics is on BAE’s side. The US may have drawn back from active involvement in Syria but it’s not hard to imagine circumstances in which it would become militarily involved in the Middle East, and it’s not going to give up the capability to do so.

In another theatre, China is consolidating its economic power with military power, building aircraft carriers, submarines and the like. It was recently described by a Congressional Committee as “the largest challenge to America’s supply chain”.

In consequence, the across-the-board budget cuts of Sequestration targeted operational expenses while procurement projects such as the F-35 Joint Strike Fighter programme were largely unaffected. That’s important to BAE, which has a 17% share in the project.

Long-term contracts

Over half of BAE’s business is undertaken through contracts lasting many years. The order book stands at two and a half years’ worth of sales, but even that understates the length of procurement programmes. The company is still delivering Typhoon aircraft to Saudi Arabia under a contract struck in 2007. This year’s outturn, and full implementation of a planned £1bn share buyback, rest on satisfactory conclusion of price escalation negotiations under that contract.

Very long-term contracts play havoc with annual accounts, distorting sales, cash flow and working capital figures — but they underpin long-term shareholder returns.

National champion

Though BAE’s status as the UK’s national champion was officially abandoned last year, its market dominance in the heavy-duty end of defence procurement effectively secures such a role. For example, in 2009 the government underwrote the costs of maintaining BAE’s three dockyards for 15 years, though they will be under-utilised once the current contract for two aircraft carriers is fulfilled.

Such long-term horizons make BAE a great income share. Its 4.6% yield puts it in the top 20 of FTSE 100 income-payers, and a two-times dividend cover makes it relatively safe.

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> Tony owns shares in BAE.